Knowing How And When To Sell

by: Roger Nusbaum

A few comments came in over the weekend asking for my take about when to sell a stock. This is a multi-dimensional topic with a lot of variables for each dimension but I will try to cover a lot of ground. Keep in mind this is what we do for client accounts, you may want to do things very differently. I can't say what is right for you, only what we believe is best for our clients. Most of these will be examples of trades we've done and why.

The easiest (for me) one first. If something we own gets a takeover offer or goes up a lot because the market thinks a takeover is coming we are selling the stock. The best example from modern times is Yahoo (NASDAQ:YHOO). We owned it for several years and it had some good runs and not so good runs then a few Mays ago it got a takeover offer from Microsoft (NASDAQ:MSFT) that Jerry Yang notoriously turned down. We sold it that morning in the pre-market.

We have twice sold Caterpillar (NYSE:CAT) for top down cyclical reasons. When the economy goes into recession and subsequent bear market, volatile industrial stocks tend to be hit very hard. We sold just as the financial crisis was starting to be a possibility and we were able to buy it back much cheaper. We sold it again last summer before a big drop, on recession concerns, but it did not drop as much as I thought it might and has since recovered without us.

Over the years we have had several partial sales after parabolic moves up; Statoil (NYSE:STO) twice, Vale (NYSE:VALE) once and most recently GLD. We still have positions in all three and we bought Statoil back in late 2008. With all of these sales there was clear and obvious euphoria around the stocks. With the Statoil sales, oil had gone up a lot in a very short period of time and the stock went up above $40. The GLD sale was just last August. The night we got back from Yellowstone I flipped on Squawk Box Europe and gold was just above $1900 for the first time and knew I would be a seller in GLD the next morning. Part of this type of sale may be frustrating to read but occasionally I get some sort of moment of clarity to sell and so I do, even if just a partial sale.

Another reason to sell is when you turn out to be wrong about some aspect of the position. One example for us might be Partner Communications (NASDAQ:PTNR). It is an Israeli telecom stock with a very high dividend yield that was well covered when we owned it. We bought and the stock just sort of hovered for a while before starting to erode. It was not a spectacular flame out but it was a disappointing hold. You may or may not be able to figure out why you were wrong. But when you suspect that you might be wrong, it makes sense to reassess the holding and possibly sell. Every investor will get some wrong, this is guaranteed to happen. Part of owning stocks is to continue to monitor them. No longer being able to figure the stock out is probably a good reason to sell.

Being wrong can manifest itself in several ways. The stock might simply underperform its industry or sector. The thesis for why you bought may turn out to be wrong or maybe you bought too early for the market to care about your thesis or you bought too late and things started to change. Although we never owned the name, people who bought Netflix (NASDAQ:NFLX) above $250 appear to have been late, as an example.

In past posts I've talked about buying stocks or ETFs to bring certain attributes to the portfolio; things like yield, volatility, correlation and so on. For a long time we owned Plum Creek Timber (NYSE:PCL) for the low correlation to the S&P 500 and the high yield. As time went on, it seemed to me the that low correlation effect was going away (meaning the correlation to the SPX was increasing).

There was nothing wrong with the company, but one of the reasons to own the name was going away, which was a reason to reconsider. The stock seemed to become increasingly popular, which might explain the correlation. So I was left with a low vol, high yield name in a sector (materials) where increasing volatility was becoming attractive. The yield and volatility characteristics were easily obtained in other sectors while things in the materials sector looked to be heating up. In that light, owning a low vol name in a sector you think will do well may not be the best strategy.

Quite a few years ago we owned Advanced Auto Parts (NYSE:AAP). Our timing was lucky and the stock went up much faster than any expectation I could have reasonably had. If something you think should be a slow grower goes on to skyrocket then either you were lucky or wrong about the stock somehow but either way revisiting the thesis makes sense.

A change in the story can be a reason to sell. Although from before I was a portfolio manager, I owned AOL (NYSE:AOL) when the merger with Time Warner (NYSE:TWX) was announced. This struck me as a profound and meaningful change in the stock I owned, that being AOL. They were buying a bigger, slower growing company. I did not know the name would implode, I just knew the story had changed meaningfully.

A similar example was Bank Of America (NYSE:BAC) purchase of Merrill Lynch. This seemed immediately insane to me because had they waited until the next day they could have paid 50% less. They may have been coerced (I don't remember it that way) but coerced or not, they were grossly overpaying.

The above examples obviously make no mention of strategies like putting an 8% stop loss under every holding as some people like to do. The reason I don't do something like this is that 8% means different things to different stocks. An 8% drop in Procter & Gamble is a different thing than an 8% drop in Research In Motion (RIMM). Another drawback I see with this type of strategy is presumably when you buy something you think it is the best choice for some market segment. If you get stopped out, are you then going to buy what you previously thought was second best? Are you going to wait for the stock to go down more and then buy the same name back? What if it doesn't go down? What if the entire market goes down 8%? If the market was down 8% I'm not sure that a stock that dropped in line with the market should be a sell--maybe it should, but the 8% drop is not itself enough information.

Occasionally the story for a stock changes, occasionally the fundamentals change (this can be positive to the upside like the examples above), occasionally you will be more right than you expected and occasionally you will simply be wrong for whatever reason. The job of managing a portfolio means paying attention to the holdings and being prepared to occasionally take action. How does big news that is good change things? How does big news that is bad change things? Many of the decisions we make are influenced by top down cyclical factors.

One last example is relatively large positions in employer stock or stock inherited from family members. If that stock were to go to zero what would it do to your financial plan? The more impact it would have the more important it is that you take action toward reducing it. This has nothing to do with prospects for the stock. If half your portfolio is one name and that one name somehow goes to zero, it stands to reason that you'd be in a world of hurt. Avoiding that scenario should be a priority.

There are other examples, but I think this creates some understanding of how I come at it- which is to look for various types of fundamental changes and use those changes as a catalyst to review and make changes if needed.