I don’t know what it is about my personality but as the bull market chugs along I start to feel more uncomfortable. When prices rise and people are posting about their winnings then it makes me think this game seems too easy. And it can not be that easy and it is not easy.

I look at something like Altium (ALU) which I own. It is quality, has earnings momentum and is in the fan favourite tech sector. But I am an uneasy owner who is now a seller. I hate selling quality and I hate it even more when the story has not really changed. This is the hardest. When the story changes or management does something stupid then this selling is easy. You adjust the odds and move on.

The hard selling is when the story does not change but the markets perception of success changes to such a level that the reward on offer you are not being compensated by the difficulty of achieving business success.

I have to think about what expectations are built into the price. ALU has been a star. Last year its revenues were $US110m. It has an aspirational target of $US200m by 2020. I would not bet against them achieving this target in the next few years.

ALU produced free cash flow of just over $30m for FY2017. It is a capital light business that requires minimal capital for every incremental dollar of revenue. At a share price of $14 it has a EV of around $US1.35 billion. Looking at the revenue growth chart is has compounded revenue growth at 15% pa in the last 5 years.

ALU target is $US200m in revenue by 2020 with a 35% margin. This is going to come from acquisition as well as organic growth.

So let’s say they grow revenue at 18% for the next 5 years. By then they will be doing $US250m in revenue and producing close to $US60m in FCF at a 30% margin. Closer to $US70m if they do a 35% margin.

So what do you pay for something that is going to grow revenue at 18% for the next 5 years (a growth rate larger than the previous 5 years which is working off a smaller base) and throw off $60m in FCF? 20x would be an EV of $1.2bln undiscounted. Whatever the number a lot is juiced into the price already

Please don’t nitpick I get that this is not a precise model and I understand there may be a margin of error. You would be missing the point. Investing is an expectations game. As Munger has said the best horse carries the shortest odds, but the best horses are known to everyone. Winx has won 22 in a row we all know this, that is why its odds are where they are when it races.  ALU is quality and the odds are now short that it will grow revenue by 20% for the next 5 years.

But really I want to find the horse that has a 1 in 5 chance of being great but it’s price is trading at 10 to 1 odds. And this is hard at the moment which makes me feel uncomfortable when everyone feels comfortable buying these odds at 2 to 1.

Not to mention some nags (shares) that should not even be running at a country meet are now running on tracks (ASX) that should never let them on. And they are being priced at much shorter odds of success than the base rate would suggest.

The other thing that burns at me is I know these odds can shorten from here and prices still climb. Money slushing around in momentum factor models are all over these stocks and while momentum is there the bid will be there.

ALU will be no different. Having built and run some of these factor models you can see them hitting the bid and moving from darling to darling. The basics of these factor momentum models are pretty simple. Rank stocks in performance over the last x months typically 3-12 months. Do this by regressing the slope of their price chart, the bigger the slope the bigger the momentum. Run the r2 score on the slope for fit, the higher the r2 the smoother the ride and rank the highest numbers. Thrown in some volume filters, add a liquidity filter, add a trend filter to be super sexy and then whatever stocks you are left with jam the bid. Rinse and repeat on your rebalance date whether monthly or quarterly. Oh and chuck in a hefty management and performance fee and call yourself a hedge fund.

So selling some ALU is such a hard choice when you see a 45 degree chart from left to right you know momentum is there. But on an odds basis I have to take the trade as it doesn’t matter how good the horse is when the odds are really short there is little margin for error as eventually another horse will come out of the pack with better odds and beat it.

The problem is that a lot of horses running at the moment are priced at 2 to 1 or less. History suggest to me that they all can not win their respective races.

This is basically an extract of my decision journal. I want to look back and review the reasons I sold ALU and whether I made a good decision. If the price goes up after I sell or if they do get taken over then the natural reaction will be to say my decision was wrong. But then this is missing the point about decision making. Good decisions can lead to bad outcomes and bad decisions lead to good outcomes. I will still be happy with my decision but I can use the experience to update the way I make decisions.



6 thoughts on “Uncomfortable Odds – Altium (ALU)”

  1. Totally agree with your reasoning there Ben.

    Of course, I reached the “great but too expensive” conclusion back in October and sold when shares were 15% lower than they are today…

    C’est la vie!

  2. Oh well maybe we should just pack it in and become trend/momentum traders. But this style has god awful drawdowns when momentum crashes.

  3. Interesting article as always. Do you have any stats on your past sells (of winners) and how successful or otherwise you have been? Like you, I have no problem selling losers but winners are where I struggle. My big worry about selling winners is selling what I like to call perpetual winners. Those companies that continue to outperform and grow into their valuations against expectations. These are companies that can change investors lives if they are held onto rather than continually rebalanced.
    Thanks again for the article always nice to hear other investors thoughts on situations like this. Dis. (ALU held and going through similar thoughts as yourself)

    1. Thanks Alan.
      I guess what you are asking is am I an early seller? Yes my data says I am and will probably expect to be in the future.
      So yes the risk is that I have underestimated ALU ability to grow revenue at a CAGR of 15% for the next 10 years. If they do this then they will do $440m in revenue and they will look cheap here at $14.
      But what are the odds of this happening? Using Mauboussin’s work on base rates, only 5% of companies have managed to CAGR rev at 15% for 10 years. So ALU is being asked to do this for 15 years. It might be the 1 in 20/25 chance, but at the current price the odds are much shorter. So I will stick to my discipline.
      Thanks Ben.

  4. Hi Ben
    I think what I was asking is what is your success rate with this approach? I understand you are being disciplined and I appreciate that but what is your real life experience?
    Has this approach been successful? I have rules that I buy and sell by and I might take another look at different scenarios over the break. Thanks again. I always like to keep challenging my ideas. Merry Xmas to you and your family and a great investing 2018. Alan

  5. Sorry forgot to ask. In such a situation like ALU where you have decided to sell. Do you sell the lot in one hit? or do slowly reduce exposure ? Again do you have any past results which support either approach? Thanks

Comments are closed.