Whether it's an opportune time to start taking profits at market tops seems to be a popular subject lately and I suppose it is the question, which reminded me of Hamlet's soliloquy:
To sell, or not to sell-that is the question:
Whether 'tis nobler in the mind to suffer
The slings and arrows of outrageous price volatility
Or to take arms against a sea of troubling trends
And by opposing Mr Market end them. To profit, to sleep well at night-
Or something like that. My apology to Mr. Shakespeare notwithstanding, I've enjoyed the ensuing discussions taking place around these articles even with the few snarky comments scattered here and there, but have for the most part resisted throwing my hat in the ring. I guess you might consider this article then a hat toss. One of the comments that jumped out at me was this one: 1) you have to be right when you sell and 2) right in whatever you replace it with. As much as I am loath to borrow a quote from and paraphrase Bill Clinton in this instance, I'd have to say that it depends on what the definition of right is. Here's what I mean.
Whether 'tis Nobler to Sell
In October 2012 in an article dealing with how I apply a margin of safety to my purchases, I described a purchase of Norfolk Southern (NYSE:NSC) I had recently made. In the October article I stated I had calculated the intrinsic value of NSC to be about $75 and I had purchased it at $64.40 when it moved into my buy zone. Below is the chart I included in that article detailing where I thought the intrinsic value of the company was and my buy zone.
The Slings And Arrows
Two days after the article was published NSC had its quarterly earnings announcement and consequently gapped down. Here is a chart of what happened after the quarterly earnings announcement.
At the October quarterly earnings announcement it did not miss the earnings estimate. The price decline appeared to be concerns over declining coal shipments and the expectation they would have a future impact on earnings. It's a valid concern since utility coal usage has been declining. Over the next two weeks it continued to slide, dropping from a high of $68 five days before the earnings announcement to a low near $56. So would it have been "right" to sell at this point? I don't think so. Someone selling here would have been selling because of what the price was doing, not whether the value of the company had changed. But Eddie, that's not the type of selling we've been talking about, we're discussing selling at market tops. I know, bear with me.
To Take Arms Against
The day after the earnings announcement when it opened below my entry point, my view of NSC being a fundamentally sound investment had not changed so I decided to buy more. I set a good to cancel limit order at $60 for the same quantity as the first order, doubling my position size. After hitting the low at $56.05 in November, NSC started to move upward. At the next quarterly earnings report in January NSC exceeded the earnings estimate by a significant amount and spiked upward. It continued trending upward and reached a high of $75.71 on March 6, and closed at $75.62 on Friday, March 15. The chart below details the sequence of events.
I've added a red line that shows horizontal resistance if you're into technical analysis. Someone using TA might even say that it's a double top, which is a sign of an eminent pullback. So do I think it's going to go higher or do I think it's going to pull back? To be quite candid about it, I don't have a clue. Wouldn't it be better to go ahead and take profits then because after all, a bird in the hand is worth two in a bush?
To help answer that, look at this Fast Graphs chart on NSC. Notice it is still undervalued as indicated by the black price line below the orange earnings line. Additionally the current PE of 14 is below the historical PE of 16.5. I said earlier that someone selling on the earnings drop would have been selling because of what the price was doing, not whether the value of the company had changed. How is that different than selling when the price has moved up if the value of the company hasn't changed, or even if the value of the company has increased? Would it be "right" to sell here, and would I have to be "right" with my replacement selection? Well, selling for profit is different than selling for a loss you say and it's never wrong to sell for a profit. Oh, really?
And By Opposing Them
In his 1958 investment classic "Common Stocks and Uncommon Profits" Philip A. Fisher said there were only Three reasons to sell a stock. 1 - When a mistake has obviously been made in the original purchase, i.e. you were wrong about the company; 2 - When the company no longer meets his 15 point criteria for investing, which in today's world would be when the company no longer meets the specific fundamental criteria you used to select it (for example, you're a dividend growth investor and it cuts its dividend); 3 - There is a better investment identified that outweighs the continued holding of the existing stock.
In the same book Fisher used a great analogy that I'll condense and use here as well. Suppose you had just graduated from college and on graduation day each of your classmates had an urgent need of immediate cash. They each then offered you the same deal, that if you would give them a sum of money equivalent to 10 times what they would earn during the first 12 months after they had gone to work, that classmate would for the balance of his life turn over to you one quarter of each year's earnings. You like this deal but you only have enough cash on hand sufficient to make such a deal with three classmates.
At that point your reasoning would closely resemble the methodology for selecting your investments. You would analyze each classmate from the standpoint of how much money would they be making over their lifetime. Those classmates you didn't know very well you might disregard for lack of sufficient information to make an informed decision. You pick three you know and that you think will provide the greatest future earnings power. You make your deal with them and 10 years pass by. One of the three has done exceptionally well. He has been promoted rapidly up the corporate ladder, is very well thought of, and insiders are saying that he is in line to be the future CEO of the company. He will be in line for great compensation, stock options, and great retirement benefits, all of which will continue to provide you with the 25% of yearly earnings according to your deal.
At this point would you consider selling out after 10 years just because someone offers you a goodly profit on your original investment? Would it matter whether the profit was 50%, 100% or 500%? According to Fisher you would need to have your head examined if you decided to sell your contract with this classmate and replace it with another classmate whose annual earnings were still about the same as when he left school 10 years earlier. The argument that your successful classmate had had his financial advance while the financial advance of your unsuccessful classmate still lay ahead of him would be rather silly. Fisher also said that while your classmates' life spans are finite, the corporation in which you invest may not have a similarly finite life span, continuing to replace management talent, improving methods and techniques for continued earnings power, and growing the company for generations. That difference actually increases the reason for never selling the outstanding stock. Fisher summed up his three reasons for selling (noted above) by stating "if the job has been correctly done when a common stock is purchased, the time to sell it is-almost never."
To Profit, To Sleep
Going back to my NSC example I have no intention of selling it here. And quite frankly the question of whether it would be "right" to sell it here is the wrong question. That question of rightness refers to price movement, inferring that I need to take profits before it moves back down. The correct question would be is it still a good investment, is it still expected to provide future earnings growth that meets my expectations, and continue to provide me the income that I expect to receive from it? The earlier comment that it is never wrong to sell for a profit wouldn't hold up to the successful classmate analogy above. I'll stay in NSC because among other reasons I like its 15% dividend growth rate over the past five years. I also like the policy stated by their CFO at the last quarterly earnings call which was: "Our priorities are -- first, reinvesting our business; followed by protecting our dividend policy, which targets a one-third payout of earnings over time; then any incremental cash will be applied to share repurchases, guided by our assessment of market conditions." I think railroads have a longer lifespan than I do which is another reason I'll stay invested.
Would I also have to be "right" in what I replaced it with? Again, it depends on how you define right. If I sold and replaced it with a company that didn't grow with as fast a price appreciation as NSC was showing, would that mean I was wrong? No, it does not. I could very well replace it with one with a slower price appreciation that actually yielded a greater income and if income was my objective, then I wasn't wrong. But what is right for me doesn't make it right for someone else, and the opposite is true as well. NSC could go back down to $60 in the next week and that wouldn't mean I was wrong in not selling at $75. Since I don't know what the market will do I look to the company to determine its value as an investment.
I could provide the same illustrations with the Coca Cola Company (NYSE:KO), McDonald's (NYSE:MCD), and Procter & Gamble (NYSE:PG), all of which I hold and none of which I intend to sell. They are long-term holdings and while MCD is approaching its all-time high of $102.22 I see no need for me to consider selling. KO continues to just gently ease on down the road kicking off a $0.28 per share dividend each quarter, with a 43% payout ratio (based on cash flow from operations) and being the dependable company I expect it to be. PG has been in business since 1837. Is that a mature company or what? Yet it is growing its dividend at 10% per year over the past five years, and has grown its earnings at 9% per year over the past 10 years (TTM included). Could either of these three be that top classmate Fisher used in his analogy?
The Soliloquy Concludes
There are those who will sell to take profits when their stocks arrive at a point where they think it is time to, whether it is horizontal resistance on a trend line, being fundamentally over-valued, or a certain percentage point target. I'm not going to tell them they're wrong. I can't because I don't know their goals or objectives for investing, or their reasons for being in a particular stock. For that same reason I can't tell them it is right to sell at a given point. We can say that there's a value point here, or there's a probability here based on this indicator, or experience has shown me this. For myself I may even "top off" an investment by selling a portion that has grown beyond my diversification criteria (gotten out of balance) while still maintaining a full position. But ultimately each of us has to decide when to sell based on our own goals, objectives, and criteria used for our investments. Here's the thing each individual investor has to understand. You will always find someone who wants to tell you that you should have sold here, or bought there, or held at this point. But that advice, often unsolicited, is coming from a person who isn't in your shoes. And while it may be well intentioned, that doesn't make it correct. Mr. Market is often one of those people, using his price movements to do it. And he isn't well intentioned.
Disclosure: I am long NSC, KO, MCD, PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.