The most common complaint that I have heard from investors over my 40+ years in the financial services industry is as follows: "Everyone wants to tell me what to buy and when, but no one ever tells me when to sell."
Not only do I consider this a legitimate complaint, I also consider it an extremely important investing principle that investors face and must deal with. Knowing when it's the appropriate time to sell a stock can be a very challenging task. But perhaps most importantly, the prudent investor must simultaneously recognize and accept that it can rarely, if ever, be done with perfect precision. In other words, as the old saying goes, they do not ring a bell at market tops or bottoms on Wall Street. Consequently, the best that an investor can expect to accomplish is to make sound and rational sell decisions.
However, before I go any farther, I want to clarify my position. This article on when to sell a stock is based on how I believe a rational prudent long-term investor might consider behaving. In other words, this article may not be of value to active traders or speculators. Personally, my investment philosophy is based on the long-term ownership of attractive businesses that I want to be a long-term shareholder partner of. Consequently, I have little or no experience that might be of value to the more active trader or speculator. Therefore, I also have little knowledge about how that type of individual might or should rationally behave. For that reason, I will offer no comments or advice on something that I know so little about.
Additionally, the majority of my writings are oriented to the equity portion of the portfolios held by individuals either already in retirement, or planning for it in the near future. Consequently, much of what I write about is also focused on dividend paying stocks. I feel this is important, because I personally see a distinction regarding how to implement the important decision of when to sell a high-growth stock versus a blue-chip dividend paying stock. On the other hand, many of the principles that I will discuss do apply equally to both classes. The primary distinction I am referencing relates to the amount of risk or aggressiveness that a given investor can take or handle.
When To Sell a Stock
I have long held that equity investors are faced with the challenge of correctly answering 3 important questions:
1. What to invest in? I believe the individual security selection is vital to long-term success.
2. When to invest? I believe you must not pay too much for even the best companies.
3. When to sell? Even the best choices can, from time to time, become dangerously overvalued or experience a permanent deterioration of their fundamentals.
I have written extensively in the past about correctly answering the first two questions. However, I must admit to being somewhat negligent regarding answering the important question, number 3. Part of my negligence stems from the fact that I tend to agree with legendary investor Philip Fisher and what he wrote in his great book "Common Stocks and Uncommon Profits." Chapter 6 in his book, which I enthusiastically endorse to anyone who has money invested in common stocks, was simply titled: When to Sell and When Not To. I quote the last sentence of chapter 6 as follows: "If the job has been correctly done when a common stock is purchased, the time to sell it is-almost never."
I consider Philip Fisher one of my most revered mentors even though I never met him personally. However, I feel that I learned as much or more from reading him than any other teacher I have come across. Consequently, when he states that the best time to sell is almost never, I take his words to heart. Therefore, my first and perhaps best advice regarding when to sell a stock is to engage in this activity as little and as seldom as possible. This is aligned with one of my favorite old adages "a portfolio is like a bar soap, the more you handle it the smaller it gets."
Nevertheless, and with great reverence to my teacher Phil Fisher, I have developed a selling philosophy that may be a little less strict than Philip Fisher would agree with, but one that has served me well over the years. Therefore, I have two reasons for why I might consider selling a wonderful business that I have thoroughly researched and invested in. However, I also have a few secondary reasons, but they are not investment related.
My Secondary Reasons for Selling A Stock
There can be many good reasons why an investor might decide to sell common stocks that are not investment related. For example, it might be to fund an important purchase such as building or buying a new home, or funding a child's education, etc. However, since these reasons are not investment related, they are not the subject matter of this article. On the other hand, I do believe that if the investor needing money for a good reason is required to sell some of their common stocks, I do recommend that considerations about valuation and portfolio balance be included in their decision process.
Furthermore, the issues regarding maintaining balance in your equity portfolio, which is investment related, can represent another secondary reason for selling a common stock. This could be the subject matter of a separate article in its own right.
However, I offer the following hypothetical example that represents a situation where an investor might do some selling in order to maintain a proper balance in their portfolio. Additionally, this type of selling can simultaneously represent a strategy of raising cash to exploit an uncommon opportunity. I do want to be clear that the following example is purely hypothetical, and therefore, I offer it as an example to illustrate the principles behind this type of selling.
For illustration purposes, let's assume that an investor had the foresight to invest in two high-quality blue-chip dividend paying stocks at the beginning of 2009. In my example, I will utilize historical Earnings and Price Correlated F.A.S.T. Graphs™ on International Business Machines Corp. (IBM) and Nike Inc. (NKE). At the beginning of 2009, both of these companies were fairly valued, and I placed a green dot on each graph to indicate a purchase.
As time progressed, both of these blue-chip companies generated consistent earnings growth and both raised their dividends each year at high rates. However, and perhaps even ironically, IBM grew earnings almost twice as fast as Nike during this period. Nevertheless, and for reasons that I believe are not understandable, Nike's stock price dramatically outpaced IBM's, even though both grew appreciably. However, this created a conundrum of sorts. During calendar year 2013, Nike's valuation became historically extreme, while IBM's valuation became historically low, or undervalued.
This price action creates both some portfolio issues and an opportunity at the same time. In addition to now being overvalued, Nike has also become a portfolio overweight. In contrast, IBM's price has become undervalued, and simultaneously, a portfolio underweight. Consequently, the owner of the portfolio is faced with some hard decisions. For example, should they sell a portion or even all of their Nike and use some of the proceeds to average down their IBM holdings? In essence, this would be more of a rebalancing sell decision; notwithstanding that Nike shares are clearly currently overvalued.
Since a picture is worth a 1000 words, the following Earnings and Price Correlated Graphs with performance on Nike and IBM graphically illustrate the validity behind this rebalancing opportunity. I chose the time frame 2009 to current because both of these examples looked attractively valued at that time. As you examine the graphs be sure and check the FAST Facts boxes to the right of each graph and note the operating earnings growth rate for each company. I find it interesting and even confusing that IBM's earnings growth was almost twice as fast as Nike's, yet it is Nike's price that has moved into overvalued territory.
The performance results associated with the above graphs illustrate that both Nike and IBM produced attractive total returns for their shareholders. Moreover, regarding IBM, this is in spite of their shares currently being underappreciated by Mr. Market. Consequently, a rebalancing sell, full or partial, of Nike followed by a purchase of IBM appears to be a sound long-term portfolio management decision.
My First Primary Reason for Selling a Stock - Fundamental Deterioration
My first and most primary reason to induce me into selling a stock is if, and only if, I believe that the company has become faced with a permanent deterioration in its fundamentals. The classic metaphor goes something like this: you wouldn't want to invest in even the best buggy whip manufacturer after Henry Ford came along. Of course, there are other reasons for fundamental deterioration than creative destruction. But my point is, if you come to believe that a company no longer possesses the salient fundamental characteristics than you originally believed, it is time to sell.
Fortunately, if you've done your homework correctly in the first place, this primary reason for selling only comes around rarely. On the other hand, I believe it is an integral and critical part of a proper due diligence effort. Perhaps one of the most obvious examples of fundamental deterioration, and the buggy whip metaphor would be the now defunct Eastman Kodak (EKDKQ). (Note: Eastman Kodak has reorganized and now trades on the NYSE with the symbol (KODK). What should be obvious from the historical Earnings and Price Correlated Graph is how the diligent investor would have had ample opportunity to see operating stress and act appropriately.
Pitney Bowes (PBI) represents a second, but less dramatic example, of a company suffering operating stress that provided the diligent investor with information that fundamentals were deteriorating. Two years in a row of falling earnings would indicate an obvious reason for concern. But more importantly, the shareholder would have had ample opportunity to minimize price erosion damage and avoid the eventual dividend cut.
To summarize the rationale underpinning fundamental deterioration as a primary reason to sell, I will again turn to Philip Fisher and his book "Common Stocks And Uncommon Profits" as follows:
"This is when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed. The proper handling of this type of situation is largely a matter of emotional self-control. To some degree it also depends upon the investor's ability to be honest with himself."
My Second Primary Reason for Selling a Stock - Dangerous Overvaluation
My second primary reason for selling a stock is when valuation becomes extreme enough to be what I consider dangerous. The idea that overvaluation has become dangerous is an important distinction. The prudent long-term holder of blue-chip companies, especially dividend paying blue chips, must accept that short-term volatility with stock price is a certainty.
Consequently, they should also be willing to accept the reality that moderate overvaluation will often manifest. However, since the exact timing and duration is unpredictable, I suggest that the prudent long-term investor be willing to ride these moderate overvaluation situations out. This is especially relevant to blue-chip dividend paying stocks possessing a long legacy of increasing their dividends each year.
Moreover, the concept of fair value is not as precise a calculation as many would like it to be. In truth, there are often many shades of gray that prudent investors would be wise to consider. For example, there are certain companies that are often afforded a quality premium valuation by the market. This piece of information might be given consideration by some investors, and rejected by others. At the end of the day, whether it's wise to pay a quality premium for a given company comes down to the individual investor's own judgments.
In the comment thread of my most recent article, I received a reader's question that was actually the inspiration for this article. Additionally, the comment references Automatic Data Processing (ADP) a classic example of a blue-chip that the market typically applies a quality premium to. The following is an excerpt from that comment:
"Just an example: At this juncture in the market, I don't know what do with a couple of stocks that have performed well. ADP, for example. I'm up 64%...but its price is at really lofty levels. I'd like to be a buy and hold investor, but the risk of this becoming cheaper seems extremely high. I'd rather not try to time the market though..."
I feel, based on the comment above, that we see an example of a prudent and conservative long-term buy-and-hold investor facing a conundrum. This individual clearly wants to be a prudent buy-and-hold investor, but is emotionally torn. Let's see what the fundamentals analyzer software tool F.A.S.T. Graphs™ reveals about Automatic Data Processing.
First of all, we see from observing the orange earnings justified valuation line representing a fair value P/E ratio of 15, that Mr. Market has historically priced this company with a quality premium valuation or normal P/E ratio of 21.8 (the dark blue line). Here I would like to interject that the reader should recognize that both the orange and dark blue lines represent calculations that provide a barometer or measuring guide, if you will.
In other words, across the entire dark blue line we have a measurement of a P/E ratio of 21.8. Consequently, when the monthly closing price line (the black line) touches the blue line, the stock is valued at a P/E ratio of 21.8. A quick observation shows that there are periods when Automatic Data Processing was trading at a P/E ratio above 21.8, and other times when Automatic Data Processing was commanding a P/E ratio less than 21.8. Moreover, we do see for a brief time during the Great Recession when Automatic Data Processing was trading at a P/E ratio of 15 (the orange line).
Therefore, based on what the graph reveals, we see clear evidence of the historical quality premium valuation referenced above. However, the real question is what do we do with this information, or more relevantly, how do we interpret it in order to make a sound buy, sell or hold decision? This is where the "tool to think with" concept or individual judgment comes into play.
One investor might conclude that it makes sense to pay a quality premium when investing in Automatic Data Processing based on the evidence revealed. Conversely, another investor who's more of a stickler for only being willing to invest when fair value exists might reject paying a quality premium. Nevertheless, it is clear from the graphical evidence that paying a quality premium for the blue-chip Automatic Data Processing might not work out so badly.
Perhaps as it relates more specifically to the reader's question on Automatic Data Processing cited above, one could also conclude that even today's overvaluation based on the historical evidence is not really that dangerous. After all, from 2004 to most of 2007, Automatic Data Processing was valued near its current P/E ratio of 25.7, and short of the Great Recession, long-term investors fared pretty well. Stock price is currently higher than it was during those years but valuation is not, and investors who invested during any of those periods of overvaluation enjoyed a reliable, increasing dividend income each year.
Utilizing the overlay P/E ratio function of the research tool I have added an additional P/E ratio line (the bright magenta line) to the Automatic Data Processing graph illustrating what I discussed above. Here we can see how representative a P/E ratio of 25.7 was from 2004 to most of 2007. Now, with all this information and analysis in hand here is how I might respond to my reader's question about Automatic Data Processing above.
Based on the historical precedent of the market applying a quality premium valuation to Automatic Data Processing, I could conclude that Automatic Data Processing is currently fully valued, even moderately overvalued, but not necessarily dangerously so. Consequently, if the objective was to own a high-quality company with a rising dividend, and further considering that the original cost basis is lower, it might make sense to continue holding this blue-chip Dividend Champion and Aristocrat. On the other hand, if you're a stickler for fair value, as I am, I would not be willing to purchase Automatic Data Processing here, but even I might not sell it. In fact, disclosure long ADP (I have added a green dot to the graph illustrating where I actually purchased ADP).
I thought it might also be worthwhile to see what Philip Fisher had to say on the subject as follows:
"When we say that the stock is overpriced, we may mean that it is selling at an even higher ratio in relation to this expected earnings power than we believe it should be. Possibly we may mean that it is selling at an even higher ratio than are other comparable stocks with similar prospects of materially increasing their future earnings. All of this is trying to measure something with a greater degree of preciseness than is possible. The investor cannot pinpoint just how much per share a particular company will earn two years from now. He can at best judge this within such general and non-mathematical limits as about the same, up moderately, up a lot, or up tremendously."
Sherwin-Williams Company - Dangerously Overvalued?
My own personal definition of "dangerous overvaluation" is simple and straightforward. Once a company's market price deviates from my calculation of True Worth™ to the magnitude that it is more than two years ahead of its earnings justified price, I will flag the company as a potential sell. To be clear, I do not mechanically or immediately sell it when this occurs. Instead, I put it on a potential sell list and monitor the stock very closely.
I will utilize the Earnings and Price Correlated F.A.S.T. Graphs™ on Sherwin-Williams Company (SHW) to illustrate my point. Furthermore, I chose this example to further illustrate that the sell decision is more complex and challenging than what first meets the eye. Clearly, the 15 calendar year graph clearly illustrates that Sherwin-Williams' stock price has historically tracked earnings very closely. Moreover, from this longer-term perspective we see vivid evidence that price has separated from earnings over the last couple of years. (Note: that Sherwin-Williams' operating earnings growth rate was 11.1% per annum over this 15-year span).
However, if we shorten our time span to only the last 4 calendar years we are given a slightly different perspective. Operating earnings growth has accelerated during this time frame to just less than 18% per annum (17.8%). Consequently, we see some justification for Sherwin-Williams' higher valuation, but not total justification. In other words, even considering the recent acceleration of earnings growth, Sherwin-Williams still appears overvalued even on that basis.
But perhaps most importantly, we now have to consider what Sherwin-Williams' future growth might look like. An examination of the 15 calendar year graph shows that part of the earnings acceleration could be attributed to earnings coming off of a low base as a result of the Great Recession. Taking that into consideration, let's look to the consensus earnings forecasts of 19 analysts reporting to Capital IQ.
Here we discover that leading analysts do expect Sherwin-Williams to continue growing at an above-average rate (14.4%) over the next 5 years. However, we also discover that they expect growth to be less than what the company has achieved over the last 4 years. Therefore, we now have an additional perspective relating to how overvalued Sherwin-Williams may actually be today. This adds an additional challenge and consideration to our sell decision.
I have drawn a red line on the Estimated Earnings and Return Calculator from today's current price out to the estimated earnings justified valuation to illustrate that Sherwin-Williams' stock price is currently more than two years ahead of fundamental value. Furthermore, recent flat price action over the last year (highlighted yellow) may be providing an alert that share price overvaluation may be beginning to wane. But once again, judgment is required.
A Few Clear Examples of the Potential Danger of Overvaluation
I offer the following examples of companies that have historically become overvalued at one time or the other. I will let the Earnings and Price Correlated Graphs speak for themselves. However, I suggest that the reader review each graph focusing on what inevitably happened to the stock price after overvaluation occurred. By doing this it will hopefully become clear that there are many faces of overvaluation. Sometimes stock price corrects very quickly, and at other times we see that overvaluation leads to an extended period of poor performance.
Consequently, this should also illustrate that dealing with overvaluation is a little trickier than we might think. Moreover, it should also be clear that perfectly timing a sell is an unrealistic expectation. Mr. Market can be very befuddling which can cause our minds and emotions to play tricks on us. At the end of the day, I believe that all the prudent long-term investor can hope for is that their buy, sell or hold decisions are sound. If you embrace that reality, your decisions, as imperfect as they may be over the short run, will serve you well over the longer run.
Cisco Systems Inc (CSCO): Insane Valuation 1999-2000
Home Depot Inc. (HD): Three Years of Collapsing Price Due to Overvaluation in 2000
Clorox Co. (CLX): Dangerous Overvaluation in 1999 - Quality Premium Valuation Today
Cintas Corp. (CTAS): Overvaluation in 2000 Resulted In Years of Awful Performance
Medtronic Inc. (MDT): After Overvaluation in 2000 Agonizingly Persistent Flat Performance
The Worst Reason To Sell A Stock
An article on when to sell a stock would not be complete without some discussion about what I consider to be the worst reason to sell a stock. Ironically, this reason may actually be the one that is most commonly implemented by investors. Personally, I will rarely, if ever, sell a stock just because the price has fallen. If I've done my initial homework correctly, then a falling stock price would represent a great buying opportunity, not a rational reason to sell. If I buy a stock at $20 per share that I believe is worth at least $20 per share or more, then it seems logical to me that I should love it at $15 per share. Of course, this is only true if the fundamentals remain solidly intact.
Consequently, for the above reason and more, I personally eschew strategies based exclusively on short-term price action. I especially shun mechanical strategies such as stop losses. For starters, I believe it is never wise or prudent to sell an asset for less than its True Worth™. Therefore, if I bought a stock at its true fundamental value or less, I would hardly be motivated to let someone take it from me at a lower price. I feel this way because I have great confidence in the notion that a stock gets its value from the earnings and cash flows that it generates on behalf of its stakeholders.
Moreover, I believe that True Worth™ is something that the discerning investor can calculate within a reasonable range of accuracy. In contrast, guessing what short-term price action might or might not do is simply too unpredictable. To me, volatility is simply the price investors must be willing to pay for the liquidity that owning a common stock provides. Therefore, when I see one of my wonderful businesses selling for less than my calculation of its True Worth™ I do not see this as a loss, instead I see it as a currently, and temporarily, illiquid holding.
Summary and Conclusions
In truth, I feel this article only scratches the surface on discerning when to sell a stock. However, I believe I've laid a solid foundation that investors can build upon when attempting to make those important decisions. My associate, Eli Inkrot recently penned what I consider an excellent article that I believe provides additional insight and clarity to this important subject found here. I suggest that anyone who would like to gain additional insight into the proper strategy of when, if ever, you should sell a stock, take a look at Eli's article.
But perhaps most importantly, I believe that investors should accept the reality that a perfect sell is not a practical expectation. Investing is not a game of perfect. However, I believe that when it is approached based on sound principles of business, economics and accounting, that long-term success can be achieved, and risk greatly mitigated.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long IBM, ADP, CSCO, CLX, MDT at the time of writing. I am long IBM, ADP, CSCO, CLX, MDT. 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.