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These 2 Billionaires Sold PayPal Holdings. Should You Sell, Too?

By Alex Dumortier, CFA - May 28, 2016 at 8:25AM

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Legendary investors Seth Klarman of Baupost Group and Carl Icahn sold big chunks of their PayPal stakes in the first quarter. Is there a case for getting out of the stock now?

With all the brouhaha created by Carl Icahn's disclosure that he had sold his entire multi-billion dollar position in Apple during the first quarter, his sale of roughly $300 million worth of PayPal Holdings (PYPL -5.42%) shares appears to have gone unnoticed. Furthermore, he is not the only legendary investor who reduced his position in the digital payments company during that period.

Two legendary names

Most everyone with a passing interest in the stock market has probably heard of Carl Icahn, the outspoken corporate raider turned activist investor. Two features have enabled Icahn to accumulate a fortune that Bloomberg estimates at more than $19 billion: sharp elbows and a superb nose for value.

But just as you've probably heard of Icahn, I can confidently venture to say that you've likely never heard of the Baupost Group, nor its founder Seth Klarman. Nevertheless, in the hedge fund industry, Klarman commands a rare status, not only as an exceptional investor, but also as the author of a highly sought after manual on value investing, Margin of Safety.

In the first quarter, Baupost roughly halved its position (as a percentage of reported holdings), selling just over 4 million shares with an estimated value of roughly $150 million (based on the average closing price in the first quarter).

When two investors of this caliber start selling the same stock, surely it's time to ask:  What do these canny investors know about the company that the rest of don't? Should you consider selling your PayPal shares, too? These are questions worth asking.

Carl Icahn is still PayPal's sixth-largest shareholder

First, let's put some of these numbers in context. Icahn's exposure to PayPal remains significant, with a position worth nearly $1.5 billion at the end of the quarter. Furthermore, after the sale of his Apple position, PayPal now represents a larger percentage of his reported holdings, going from 5.7% to 6.8%. Finally, according to data from Bloomberg at the end of the first quarter, Icahn was PayPal's sixth-largest shareholder, with a 3.1% stake.

As far as Baupost goes, PayPal still represents almost 4% of the value of its reported holdings.

That said, does the fact that these super-investors are reducing their exposure to PayPal mean retail investors ought to do the same? Let's take examine that question systematically.

The only 3 reasons to sell a stock

There are only three rational reasons relating specifically to a company and its stock that should prompt a long-term fundamental investor to sell:

1. You realize that your original assessment of the company was wrong.

2. The company's fundamentals have deteriorated and the impairment looks permanent.

3. The company's fundamentals are unchanged or have even improved, but the stock has become hugely overvalued.

In this case, we can skip the first reason because that will vary from person to person. If we can address the second one adequately, the question of a bad assessment will be moot. So: Did PayPal's business deteriorate over the past couple of quarters? My answer is no -- I think PayPal continues to demonstrate it is well-positioned in the marketplace and has strong momentum in its business.

PayPal is doing great

In fact, CEO Dan Schulman called the first quarter "in many ways... our best quarter in the time since I joined PayPal" [Schulman came aboard in September 2014]. That isn't the boast of a promotional CEO: Total payments volume rose 31% to $81 billion as PayPal took market share, and that rate represents an acceleration from the fourth quarter's 29% year-over-year advance. Free cash flow to equity owners more than doubled to $584 million.

Xoom and Venmo, two of the businesses that PayPal acquired to complement its core payments activity, are showing strong growth. Transaction volume on Venmo, a peer-to-peer payments app, increased over 150% year over year to $3.2 billion. Although Venmo is currently free, PayPal is expanding a pilot program to begin monetizing the service.

Is PayPal's position permanently secure? No. The digital payments market is competitive and it's changing quickly. You can expect a shakeout at some point. However, PayPal is well positioned to be one of the winners, and it has made what looks like smart acquisitions to expand its reach in new areas (in-app payments, peer-to-peer payments, etc.).

But is too expensive?

Having established that the business is sound, let's address the third possible reason to sell the stock: Valuation. At nearly 26 times this year's earnings-per-share estimate of $1.50, PayPal's shares don't look cheap. However, given the quality of the business and its expected growth, it's far from being wildly overvalued -- which is the only circumstance under which shareholders ought to consider a valuation-based sale.

Assuming you bought the shares at a reasonable valuation, you will almost certainly be much better off holding PayPal for the long run than trying to trade the stock on valuation. It may at times become overvalued, but this will even out over the long term. If you simply aim to earn the company's economic return over a long time period, and it continues on this trajectory, you ought to do quite well.

Did Icahn and the Baupost Group spot a problem at PayPal? It's possible, I suppose, but I don't see it. If you have your own thoughts on that, let me know in the comments section below.

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Stocks Mentioned

PayPal Holdings, Inc. Stock Quote
PayPal Holdings, Inc.
PYPL
$71.82 (-5.42%) $-4.12
Apple Inc. Stock Quote
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AAPL
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