It’s where stocks are going that counts…(ll) an illustration

Monsanto–up 650% from 2004-2007

Background

In 2004, I was managing a number of growth stock portfolios when a broker called me and my co-manager to say one of his firm’s better analysts was beginning to recommend Monsanto (MON).

The story was simple, but powerful.  The “old” Monsanto, a chemicals conglomerate, had broken itself up into three parts:  pharmaceuticals, agricultural chemicals and basic chemicals.  The agricultural chemicals business retained the Monsanto name.

The attraction of the “new” MON was its dominant position in genetically engineered seeds.  This business looked as if it could grow in a number of different directions–new products, new variants of existing products, new geographical areas–at a very rapid rate (20%+ annually) for, say, ten years.  The stock was not well-known.  Its virtues had been obscured while it was part of the bigger entity.  It was also cheap.  And growth investors like us were just beginning to find out about it.  In other words, this was a classic, open-ended, growth stock situation.

MON did have some warts.  The conglomerate’s top management, which went with the pharma business, attempted to insulate itself from potential environmental cleanup claims in the basic chemicals business by structuring the breakup so liability would fall on MON before them.  Also, MON’s main moneymaker, Roundup (glyphosate), had gone off patent and was being attacked by generics.

My colleague and I researched the stock for a couple of weeks–really learning the company would take a year or more of steady work, though–and bought the stock at about $19 a share (I’ve adjusted the price for a subsequent 2/1 split).

MON quickly rose to $22, as more growth stock investors established positions.   At this point, my co-manager, a value investor at heart, decided that we should sell.  Her reasoning was that we had a 16% profit, that the stock was now overvalued, and that we could consider repurchasing it when it fell to $20–as it surely would.

I was strongly opposed to selling, given that I thought the stock could double or triple, so we did nothing.

(By the way, this kind of short-term trading maneuver, which depends on the other guy being the “dumb money” who will allow you to repurchase at a lower price, invariably backfires with growth stocks.  The seller ends up either having to repurchase at a much higher price, or misses out altogether on the bulk of the stock move.

There’s a matter of prioritizing, as well.  All of us, professional or not, only have a limited amount of high-quality thinking time that we can devote to finding and monitoring investments.  I think we should focus that time on what we hope will be big long-term winners, not on trying to exploit short-term market volatility.)

The stock did drop to $21 but then immediately reversed course and rose to $30.  At that point, my co-manager and I had a more emphatic version of the $22 discussion, but we did nothing.

Some months later, MON had risen to $52-$53, as the company announced a steady stream of good operating news.  I had just about convinced myself that as a stock MON had achieved almost all the outperformance it was going to, when I was visited by a health care analyst who was relatively new to our firm.

He was beginning to look into MON, which he considered to be substantially undervalued (remember, the stock had almost tripled in less than two years).  By this time, MON was talking about seeds that would produce plants that would not only resist insects or drought, but would also contain extra amounts of healthy substances, like omega-3 fatty acids.  Relative to drug stocks–other companies with important patents and earnings that don’t ebb and flow with the overall business cycle–MON’s earnings looked really good to him. And, again relative to other health care-related issues, the stock didn’t look expensive.

The new analyst thought MON could reach $70.  I wasn’t convinced, even though I knew the analyst was a careful researcher and had good judgment.  Maybe I was also looking in the rear-view mirror at the profit MON had made for my clients.  In any event, I sold the stock.

If you’re looking at a chart of MON, you know what happened next.  The stock went to $70.  Then, in a market worried about the business cycle–and therefore more favorably disposed to earnings not dependent on it–Congress passed biofuel legislation encouraging farmers to grow more corn.  That’s MON’s main crop.  The stock doubled again, to $140.

Lessons for a growth stock investor

1.  In my experience, the bulk of a growth stock investor’s outperformance comes from a relatively small number of stocks that he holds for a long period of time.  He holds a portfolio that’s much larger than that because, at least early in the game, he doesn’t know which ones they will be.  And he needs to develop new holdings to replace stocks that have matured, or that have never lived up to their potential.

Selling to realize a small short-term profit is one of the most foolish things one can do.  In addition, for a professional it’s very hard to explain to a client why you’re buying back at $28 a stock you sold a few weeks earlier at $22.  And of course, cognitive dissonance may kick in and stop you from buying back at all.

2.  It pays to take out a clean sheet of paper every once in a while and reexamine one’s strategy, and preconceptions, about a stock.  I should have done this when I heard a skilled colleague’s argument for undervaluation.

2a.  Although I’m not sure it’s true in this case, good growth companies have a way of reinventing themselves when their initial growth thrust is over.  MSFT, for example, initially sold PC operating systems, then spreadsheets, then the Windows interface, then the Office suite.  Each iteration in the reinvention process gives new life to earnings growth and lengthens the period of superior stock market performance.  In the best (though rare) cases, the company can sustain rapid eps growth for well over a decade.

3.  Growth stocks can become significantly overvalued.  When the story is well-known, the stock is a market darling and everyone owns it, the pe multiple can be stretched way above the growth rate.  This happened with MON during its biofuel speculative period.  On the one hand, behavior like this is a strong sell signal.  On the other, one should probably save some stock for sale during a period like this.

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