Why It Can Be The Right Move To Sell 'Too Early'
If you’ve ever sold a stock that’s rallied strongly, only to see it then rise even further, you know how difficult investing can be – particularly the timing of your exit. But is selling ‘too early’ the wrong move? Not always.
Let’s consider the stock of Take-Two Interactive (Nasdaq: TTWO), a business that produces hit video games such as Grand Theft Auto (GTA). The global funds held TTWO since their inception when the stock was trading around $30. Our investment thesis was based on the growth of high-margin in-game transactions, and this largely played out over the course of the subsequent two years. TTWO increased to above $70, where we sold on our view that, on a fundamental basis, the company’s future growth was being more than baked in by the market. The stock has since rallied to $115. Does that mean that we were wrong?
On the one hand, by selling in the $70s we left an additional ~50 per cent return on the table. That sounds unconscionable, but we must recognise that this outcome is being viewed through the 20/20 lens of hindsight. We must rewind to the facts we had at hand when making our decision to sell TTWO.
At the time, TTWO was performing strongly but management had been signalling a slowdown in the revenues from the company’s core GTA franchise. We felt that a moderation in GTA revenue was impending, yet the market was still expecting continued growth. What also made us cautious was CEO Strauss Zelnick having sold $22.5 million worth of shares in April 2017, a significant reduction in his c.$50 million stake held through Zelnick Media Corporation.
As always, we view the valuation of each stock as a range. And in TTWO’s case, the stock was trading close to the higher end of our valuation range. Based on the fundamentals, and the likely future outcomes for the business, we were not able to hold TTWO at that price and stay true to our philosophy of owning only undervalued businesses.
Despite being out of the stock, we have continued to follow the business very closely, keeping an updated financial model on TTWO and processing each quarterly earnings result. It turns out that GTA has continued to grow strongly, outperforming management expectations. While we knew this was possible, we did not view the strong growth that has been achieved as likely (neither did management, for what it’s worth).
Predicting that GTA revenues would continue their strong trajectory more than four years after the initial launch of the game would have relied on knowing: (i) how much longer gamers would stay engaged with GTA, particularly in light of the release slates of other gaming companies and the potential for other hit games to steal away gamer mindshare; (ii) the success of future GTA additional content releases; and (iii) the willingness of gamers to continue to spend on this older game title. Much like forecasting the success of any entertainment property, these are extraordinarily difficult variables to accurately predict.
Some might point out that we were too conservative in our estimates. In hindsight this is true. However, a scenario was possible where GTA revenues cooled, and there would have been material downside to the stock in the $70s if this occurred. At the time, it could have gone either way, and we were simply unable to build enough conviction that our bull case scenario would be realised. We see TTWO as an overvalued stock that, despite having grown at a stronger-than-expected pace, continues to be overvalued.
It’s worth bearing in mind the pithy adage uttered by Warren Buffett: “What the wise man does in the beginning, the fool does in the end”. The Montgomery Global team is virtually never going to be the most bullish on a stock such as TTWO. Our valuation is based on the financials of a business, hard data, and tangible evidence of business quality. Many other market participants are simply not constrained by the same standard, and are able to suspend disbelief to hold a stock at stretched levels. We are likely to have exited the stock before this mindless bullishness takes hold. While the tremendous growth in these video game businesses is real, we will always eschew the pursuit of growth at any price and, above all, seek to protect the capital of our investors.
Roger's step-by-step guide to valuing the best stocks and buying them for less than they're worth, Value.able, is available exclusively at rogermontgomery.com. Skaffold is an online stock-picking application that rates ASX-listed stocks from A1 to C5. Watch a demo of Skaffold at www.skaffold.com.