Generac Holdings Inc. (NYSE:GNRC) is a fundamentally strong company. The decision to invest thus depends on the margin of safety. The current market price of GNRC is USD $270 per share (as of 2 Jun 2022). There is a sufficient margin of safety at this price to invest in.
However, if you had bought GNRC at a higher price, my recommendation is
- Hold if you had bought it at USD $300 per share.
- Sell if you have bought it at USD $500 per share.
- If you have bought it at USD $400 per share, you should hold it if you have an optimistic view of the company. Otherwise, sell.
The above recommendations are based on my decision framework as presented in the following sections.
GNRC’s share price had declined from its peak of USD 500 per share in Nov 2021 to about USD $270 per share currently. In my 3 May 2022 article, I concluded that GNRC is a fundamentally strong company. Refer to “Generac: Not Running On Full Power As The Earnings Seem To Be From Generators.”
Based on my valuation, I had opined that there was a sufficient margin of safety to invest in GNRC then. This, of course, presupposes that you have not invested in GNRC.
Unfortunately, many investors have bought GNRC at prices much higher than USD $270 per share. Think of those who bought it when it was USD $500 per share.
Seeing a decline in the share price after you have bought is a common feature for many investors. The challenge is how to decide what to do when this happens. Should you hold and hope for the price to recover or do you cut loss and live to fight another day?
Over the years, I have had situations when I sold off my stocks too early. I later found out that a year or two after I sold it, the stock price rose. I lost money when I sold it off. If I had held onto it, I would have made money.
I have also had the bad experience of holding onto the stocks for too long. The stocks never returned to their peak performance and the stock price never recovered to my purchased price level. In such instances, I lost more money compared to if I had sold it earlier.
I have since adopted a decision-making framework that helps to reduce the mistake of selling off too early or holding on for too long.
I will illustrate my approach with GNRC.
My Hold or Exit Decision Framework
This decision framework assumed that the current market is significantly lower than the purchased price. I would summarize the decision framework with the following decision tree.
You can see that there are 3 decision stages, 2 Sell positions and 2 Hold positions
Decision 1. When the price drops below your purchased cost, the first question you need to ask is whether your cost is still lower than the intrinsic value. You should review the intrinsic value to cater for the changing prospects.
Decision 2. If there is still a margin of safety, you should ask whether the business is a buying opportunity if you did not own any shares. You would analyze the business prospects as well as the downside risk. I have this step to cater against the various behavioral biases.
Decision 3. The reason to sell and incur the loss is that you think you can make better returns with other stocks. But this is not guaranteed. You want to check that the returns from an alternative investment far outweigh the prospects of the stock turning around.
Sell 1. The sell decision is because the intrinsic value had declined to be below your purchased cost. From a value investment perspective, it would be tough for the price to rise above the intrinsic value.
Sell 3. The sell decision is because you are more likely to make money from the alternative investment than with the existing stock.
Hold 2. You hold because this is still a good investment.
Hold 3. While you would not buy more, you hold because it is still better than alternative investments.
GNRC Case Study
For this case study, I will look at three scenarios based on the purchased price of GNRC.
- Scenario 1 – you had bought GNRC at USD 300 per share.
- Scenario 2 – you had bought GNRC at USD 400 per share.
- Scenario 3 – you had bought GNRC at USD 500 per share.
The first step is to compare your purchased price with the intrinsic value as shown below. Refer to the Valuation section for the details on how I determined the intrinsic values.
Your decision will of course depend on your purchased price and the estimates of intrinsic value.
- Based on Scenario 1, there is a margin of safety under both the conservative and optimistic valuations. You would not sell and thus proceed to Stage 2.
- Under Scenario 2, you would sell if you use the conservative estimates of intrinsic value. However, if you accept the optimistic estimate of USD 440 per share, you would proceed to Stage 2.
- Under Scenario 3, you would sell as there is no margin of safety.
As can be seen, the decision hinges on your estimates of the intrinsic value. The objective of this article is to share my decision framework so I would not debate the intrinsic value.
But if you had bought GNRC at USD 500 per share or higher, I would suggest that you relook at your valuation. You are challenging the “wisdom of the crowd” and you have to be sure that you are right if you believed that it is worth more than USD 500 per share.
There are two issues to consider – the business prospects and the financial risks.
In the case of GNRC, I do not see any fundamental changes to its business prospects or financial position since my 3rd May 2022 article. The drop in price from the Nov 2021 peak was market sentiments driven rather than a decline in the business prospects.
- I would buy GNRC shares at the current price if I had not invested in this stock.
- For Scenario 1, the decision is to hold.
- For Scenario 2, the decision to hold or sell is dependent on your view of the intrinsic value. If you are not holding, you would proceed to Stage 3.
- For Scenarios 3, you would have sold at Stage 1.
While Stage 2 is to check against behavioural biases, Stage 3 is a cut-loss analysis. There are two ways to reach Stage 3:
- The business fundamentals have deteriorated from the time of your original analysis. This is despite the intrinsic value being greater than your purchased price. So you would not buy under the Stage 2 decision. We do not have such a Scenario for GNRC.
- The Stage 2 hold is not so clear-cut. This is the situation for Scenario 2 with the purchase price of USD 400. You would hold based on one view of the intrinsic value and sell based on another.
For Stage 3, you want to see whether it is better to cut loss and recoup it via another investment or to continue to hold.
It is obvious that the option to hold or sell depends on your purchase price and what you can achieve with alternative investments.
When looking at the gain from alternative investments, I suggest that you look at your stock portfolio return as the reference. This is because you do not know how a particular stock will perform and picking the wrong stock as a reference may lead to a wrong decision.
Let me illustrate this for Scenario 2. Assume that your stock portfolio has historically achieved a compounded 10 % per annum total return. On a per-share basis, we have:
Current market price = USD 270
Loss if sold now = USD 270 – USD 400 = USD 130
Portfolio gain over the next 5 years at 10 % CAGR = 61 %. Based on USD 270, this = USD 165. Note that I assume that there is no dividends.
Net gain = USD 165 – USD 130 = USD 35
To breakeven by holding onto GNRC, its price in 5 years must be = USD 35 + USD 400 = USD 435
If you are confident that within 5 years the market price of GNRC would reach USD 435 per share, then you would hold onto the share. If you do not think that the price will reach this level, then you should sell now and reinvest the money into another value stock.
Looking at the optimistic intrinsic value of USD 440 per share, I would exit.
You can see that this decision would depend very much on when you undertake the analysis. At some price points, you would hold. At some price points, you would exit. That is why I regularly review the stock position.
When you reach Stage 3, it is a cut-loss analysis. It is a question of whether you are better off with GNRC or another investment.
Valuation of GNRC
GNRC can be viewed as made up of a legacy power generation business and a new energy technology solutions business. The former currently accounted for the bulk of the bottom line. Refer to my 3 May 2022 Seeking Alpha article.
I had opined that the new energy technology business had total assets of USD 1.78B. This meant that the legacy power generation business had total assets of USD 3.10B. I derived this based on the 2021 group total assets of USD 4.88B.
I had estimated a conservative value of the legacy power generation business to be USD 13.75B. Refer to the Seeking Alpha article for the assumptions and model. This meant an intrinsic value to total assets ratio of 4.4
Assume that the new energy technology business would be able to achieve the same performance as the legacy power generation business. As such the intrinsic value of the new energy technology business would be USD 1.78B X 4.4 = USD 7.83B.
A sum-of-part value of GNRC = USD 13.75B + USD 7.83B = USD 21.58B.
This would be equivalent to USD $340 per share.
This is of course a simple-back-of-envelope assessment of the intrinsic value.
The optimistic estimate of the intrinsic value of the legacy power generation was based on a 2-stage growth model. In addition to the assumptions used for the conservative estimates, I have the following assumptions:
On such a basis, the value of the legacy power generation business was estimated to be USD 20.1B.
I am assuming that this high growth only applies to the legacy power generation business. As such the value of the new energy technology business remained at USD 7.83B as derived earlier.
The sum-of-parts value of GNRC = USD 20.1 b + USD 7.83 b = USD 27.93 b
This would be equivalent to USD $440 per share.
When you buy a stock, there is no guarantee that the price will go up. There may be a large drop in price after you have bought it. I hope that if you ever meet such a situation, instead of reacting emotionally, you can use my framework to think it through.
It is of course a value investing framework where the comparison between price and intrinsic value is still core. Also, it addresses the various behavioral biases and opportunity costs when deciding whether to hold or exit.
I also hoped that this case study of my GNRC investment has illustrated the nuances. This is not to suggest that this is a mechanical decision process. There are still judgement calls to make. But I hope that it provides a consistent basis to decide what to do.
The decision framework is not without its weaknesses.
- Stages 1 and 2 are dependent on how you determine the intrinsic values. I would not suggest that you use relative valuation.
- Stage 3 requires you to determine the return from the alternative investments.
- The decision would be different depending on when you carry out such an analysis. This affects the price vs intrinsic value assessment as well as the Stage 3 comparison.
I am very sure that all investors would have faced this hold or exit situation. I hope I have provided a useful framework. If you have a different approach, I would be very interested to hear from you.