When To Sell

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Includes: DIA, DIS, IWM, QQQ, RGC, SCSS, SPY, STAG
by: Cory Cramer

Summary

This article discusses when to sell stocks that were purchased with a short-to-medium-term time horizon, and discusses three reasons to sell them.

Reason 1: Stocks have met pre-established price appreciation goals.

Reason 2: The thesis, or theses, have played out.

Reason 3: Time is up.

Introduction:

This article will focus on stocks that are purchased with a short-to-medium-term time horizon, and that also contain one or more short-to-medium-term theses that layout why the investor thinks the stock will appreciate in value over that time period. If there isn't a thesis, if the investor has no particular price appreciation expectations, or if every stock purchase an investor makes is for the long-term, then this article isn't going to be very useful. I'm not advocating for one style of investing over another (I use several depending on the account), but these selling approaches won't make a lot of sense for a long-term investment, which I consider to be an investment that is intended to be held for longer than five years. I have previously written about "When to Sell Successful Medium-to-long-term Investments", and I will probably write about explicitly long-term investments at some point in the future.

Prerequisites:

Without a doubt, some of the best stocks are those that have a total return of 20% annually for 10+ years. Stocks that you can hold "forever". Unfortunately, these are extraordinarily difficult to find. And when they are found, it is difficult to make an oversized investment in them because most people to not have piles of cash sitting on the sidelines and the guts to invest in something everyone else thinks is rubbish at the time.

So, while I much prefer stocks that have long-term potential, there are more stocks available that may at least have medium-term potential. The key is to determine which category a stock falls into before it is purchased. This will help eliminate the urge to hold on for larger gains from a stock that simply isn't suitable as a long-term holding.

There are lots of reasons a stock might not be suitable long-term. For example, it may be in a cyclical industry or it may be in a rapidly evolving business like technology or bio-tech. Eliminating a stock from becoming a long-term hold before it is purchased means that one can then focus on how much the investor anticipates the price will rise in 'X' amount of time and why.

An example that includes price appreciation goals:

A several weeks ago I noted that thought Regal Entertainment was a better medium-term Star Wars bet than Disney. Disney (NYSE:DIS), if purchased at the right price (which, for me, is probably somewhere under $90 per share), would be a good medium-to-long-term investment, while Regal (NYSE:RGC) simply doesn't have the stellar fundamentals that I require to consider it a long-term investment. Nevertheless, I thought in the short-to-medium-term, money could be made with Regal. So far, my thesis with regard to Star Wars' success and Regal's outperformance compared to Disney is off to an accurate start, though they are both down with the S&P 500 since then.

SPY Total Return Price Chart

SPY Total Return Price data by YCharts

My basic selling guidelines for a short-to-medium-term investment are to sell if it rises over 10% in 3 months, or 20% in 6 months. (Not coincidentally, those are also the expectations embedded into the theses of these investments when I buy them. Each investor should set their own price appreciation guidelines, of course.)

That doesn't mean I sell after exactly a 10% gain. Usually I watch the momentum when it gets close to 10% I make a judgment call when to get out. But, assuming the thesis is still intact, I wouldn't sell until the price had moved above 10%. If the thesis was longer than six months, I want roughly 20% gain.

These percentages are not entirely arbitrary. For investors dealing with larger sums, there are tax considerations on short-term investments, and for smaller investors there are fee considerations. Additionally, I'm not always going to be right. My long-term goal for all of my individual investments is a 12% total return net of taxes and fees over rolling 5-year periods. (Yours, of course, may be different.) Twelve percent, for me, is a challenging goal, yet a goal that is not so high that I have to stretch too much to obtain. It allows be to be perfectly happy selling stock like Regal for a 10%, 20%, or 12% gain (depending on how long I hold it), and not care what the stock does afterwards. I would never second-guess myself if I met those goals on a stock I didn't think was a good long-term investment. So, if I am able to sell Regal with over a 10% gain in the next six weeks, that would be a 100% successful investment for me, even if after I sold it, the stock kept rising another 50%.

My experience has been that properly categorizing the stock before hand makes a world of difference psychologically when it is time to sell. It's easier to sell if I know from the outset that the stock probably isn't a great long-term hold.

Please note, that all this assumes that the original thesis remains intact. There may be events that diminish or enhance the thesis as time goes on and it is very important that the investor be honest about those developments. In the case of Regal, the thesis is progressing exactly as predicted so far, and there is even a slight tailwind in that January ticket sales for films other than Star Wars have been higher than expected. With Regal stock still down, this is a time to buy more, not to sell. The next test will be earnings. If earnings are good then the short-term thesis will be proven correct, and I would then hold on to see if the medium-term thesis begins to play out as well, which includes a strong line-up of 2016 films and two more Star Wars films in less than 18 months. If at some point during that time the stock increases over 20% I'll be looking to sell. My price appreciation goals will have been met.

Usually there are multiple parts to any thesis if it spans the medium-term, and sometimes one part plays out and another doesn't. That can also be a time to sell.

Example of an endangered thesis:

Now let's look at a different example that turned out slightly differently. Back in October I thought that Select Comfort (NASDAQ:SCSS) was set up for a very good earnings report and that it had a good short and medium-term catalyst. Select Comfort posted excellent earnings a few days later and the next day opened 15% higher. In a follow-up article I noted a potential danger going forward was that they were experiencing difficulties integrating their new computer and delivery systems (this concern had been brought up in the comment section of my first article). At the time I thought the problems were likely manageable, but later a commenter noted some specific complaints of Select Comfort's customers. One of them was that delivery times were 7 to 8 weeks, which was far longer than management had anticipated. This possibility put my medium-term thesis in danger even though the short-term thesis had been proven correct, and so the risk/reward favored selling and waiting to see how big of a problem this turns out to be for Select Comfort. I was able to book over a 6% profit in a two week time period. Only time will tell if I sold too soon, but I was sticking to my thesis, and my thesis was threatened, so I sold. If Select Comfort disappoints at the next earnings report, the sell-off in the stock that is sure to come afterward will not have been avoided because of dumb luck or market timing, it will have been avoided because there was a medium-term thesis in place, and that thesis had been threatened, causing me to sell until the risk/reward shifted back in my favor.

It is important to note that the current price of Select Comfort will not determine whether my decision to exit was good one or not.

SCSS Total Return Price Chart

SCSS Total Return Price data by YCharts

The stock price is down nearly 10% since I sold, but what I really want to know about is how their business last quarter was, and whether or not their deliveries are back on schedule. If they are, I would consider buying again, all other things being equal.

Time is up:

Each thesis ought to have some reasonable time frame established before buying. There is always a bit of flexibility around the edges, but some kind of time frame helps one know when it's time to sell. When I suggested shorting STAG Industrials (NYSE:STAG), it had a very specific time frame that ended just before the December Fed meeting. If one would have kept shorting they would have continued to make money, but for me, that would have required a new thesis with a new time-frame. A time frame helps one become more independent from momentum and short-term swings in the market. It helps you be proactive, rather than reactive to the market, the media, and your own emotions.

If we go back to Regal and apply the same thinking there, if by mid-2017 all my theses were correct and the stock still isn't 20% higher, it's time to sell anyway. I will just have to admit that the market doesn't see things the same way I do. If that is the case, time will be up on the stock and it is simply time to find a different investment.

Conclusion

There are three questions one needs to ask before selling short-to-medium-term investments. The first needs to occur before the purchase in made, and that question is "Does this company have long-term potential?" If it doesn't, then you can define how much gain you're looking for over the short and medium term.

After your thesis is developed, roughly set the goals for your expected gain over both the short and medium terms. If the stock thesis works, and it meets your goals, then sell, take your profits, and be happy. If the thesis has completely run its course, even if it didn't quite meet your goals, then take your profits or losses. If the thesis become threatened or broken, sell, figure out where you went wrong, and move on to something else.

Disclosure: I am/we are long RGC.

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.