Signposts

Sell Discipline

Most investors, if asked, would say that knowing when to sell is much more difficult than knowing when to buy. We agree. We have defined criteria for selling, although we retain conviction in owning

great companies for long periods of time. Despite what happened to stocks in the 1930’s, the 1970’s and in the severe downdraft of 2007-2009, there are numerous companies whose earnings streams have expanded powerfully over decades and have made large amounts of money for their long term shareholders.

Despite our wish to reduce risk and to avoid loss of principal, we remind investors that being largely in cash is a terrible way to face the prospect of the risk of inflation as a result of the enormous jumps in government deficit spending and the expansion of

the monetary base by the Federal Reserve. Under similar circumstances cash became worthless in 1920s Germany. The value of the 1965 U.S. dollar is about 10 cents. We therefore remain advocates of owning important amounts of equities, notwithstanding the need to hold a prudent degree of other liquid assets whether it is bonds or other liquid short term assets. Nonetheless, there are times to sell stocks.

Certainly, stocks of companies in more cyclical industries need to be trimmed or sold when times are ebullient and such stocks have one of their typical, cyclical big advances in earnings. Otherwise, like Sisyphus, it will be the investors’ fate to push the descended stone back up the hill again. Industries such as autos, housing, steel, mining and chemicals fit this category. Normally, we have only limited exposure to companies in these fields because they do not generally possess the investment criteria we seek; for example, sustainably strong ROIC or operating margins, high barriers to entry, and lots of free cash flow, among other things are not found abundantly in these industries.

Stocks can become overpriced just as they can occasionally become undervalued, for long periods of time. We do not concern ourselves if a stock we like experiences modest over-valuation. A 10%-20% over-valuation does not bother us much. To exit a

stock for a short time, and to try to reenter a few points lower is too much like trading and cannot be done consistently by anyone we know. On the other hand, when a stock is discounting earnings expectations several years into the future or where the P/E ratio is substantially higher than its historical range, we may cut back the position materially or completely exit the stock.

Then, sometimes our judgment is just plain faulty, and we have to admit a mistake was made in the initial analysis and decision to invest. This tends to happen where the research we have done missed some important consideration, or we missed a change in competitive conditions. In such instances, we will cut our losses to live for another day.

Of course, sometimes we come up with a new idea that is better than something we already own.

We footnote this discussion with the statement that in decades of investing, the opportunity cost of exiting stocks too early has far outdistanced the losses sustained in owning stocks that simply went down after we invested. Patience is still a necessary ingredient of successful investing.

Llenroc’s investment approach causes us to hold a small number of positions for which we take a long-term time horizon. Therefore, we have the opportunity to research and understand our holdings well. We believe the combination of this opportunity, our experience as investors and our consistent application of our investment philosophy enables us to make decisions based upon our expectations of fundamental events.

In the same way we look to identify fundamental material events through our assessments, we attempt to identify fundamental events which may act as signposts along the road to assessed events. We methodically think about the future in order to identify fundamental signposts which may cause us to take action.

Signposts help us anticipate rather than react to events which are likely to move the shares of each of our holdings.

Considering signposts helps us to think about the impact of additional information in advance and prepare to take action when we think a signpost is likely to happen or act quickly and decisively after a signpost has occurred.

We attempt to identify signposts which can be readily observed or measured, but also consider more subjective situations.

Readily observed or measured signposts could be:

• the onset of the law of large numbers

• changes in key management

• shift to a second business or a change in overall business plan

• a newer higher level of debt on the balance sheet

• regulatory actions

• deteriorating earnings quality

More subjective and perhaps more important signposts are:

• changing competitive conditions

• maturing of a company’s markets

• falling barriers to entry

• changes in the nature or economics of an industry

• a worsening regulatory climate.

Once we have identified signposts for each portfolio holding, we monitor each signpost in order to be aware that they have happened or even better, anticipate that they are likely to happen. In addition to meeting and speaking with company management and speaking with competitors and customers, we monitor news sources by identifying specific terms related to each signpost. The combination of these research activities enables us to move quickly when signposts are triggered.