When To Sell A Stock?

by: Bram de Haas

Summary

At my request, readers are sending me their toughest investment questions.

The question most often asked: when to sell a stock?

As a Dutchman, I don't operate under the same tax system which complicates the decision a great deal.

Tell us about your procedure and keep the questions coming.

Hi Bram,

In my opinion, the hardest investment decision would be when you have to sell a stock. I know very well when stocks are undervalued or when they're worth buying. If I realize that buying a certain stock was a mistake, I will sell it on the spot. However, it isn't so obvious when a stock has reached its full potential, or when it begins to be overvalued but it could still grow.

I hope your answer to my question could be useful for other value investors as well.

Thank you,

Sorin

Selling is a tough decision. I'm going out on a limb here because, as a Dutchman, I'm dealing with a different tax code. Ultimately, I'm probably taxed at a higher take rate so no need to feel envious. However, tax considerations don't play a role in sell decisions, which is a blessing, simplifying the matter greatly and because of it, I can be that much more whimsical about it.

Because of the tax you incur when you sell, ideally you don't want to sell.

Both Warren Buffett and John Malone have made this into an art form. Buffett rarely sells and John Malone is constantly working behind the scenes to make corporate transactions happen to ensure his portfolio is positioned well and he doesn't need to sell. Cable Cowboy is a great book talking in detail about his business dealings and the empire he built by optimizing the tax efficiency of his deals.

You are still better off selling when:

  1. You want to use the money for something else.

  2. You have a better opportunity after considering you'll incur taxes.

  3. The stock is soon going to underperform; you have to weigh potential losses against the value of further deferring taxes.

  4. The risk of holding on to the position (at this size) is too great.

You'll have to consider all of this while keeping in mind your tax losses that you could potentially use to offset any profits. These tax losses are like a joker or a get out of jail free card.

Identifying better opportunities is easier when you don't have a lot of capital gains. It's easier to sell stocks you have only booked modest gains on. This is probably one of the reasons Buffett so rarely sells. He is sitting on such massive gains that the hurdle for him to sell is quite steep.

Under the U.S. tax system, it seems to be a mistake to sell a stock that has run up when you've made a mistake. You first want to identify whether one of the conditions 1-4 apply before selling.

When a stock has reached its full potential, you definitely shouldn't be inclined to sell it unless one of the conditions 1-4 apply.

If a stock is clearly overvalued, you probably don't want to sell it unless one of the conditions 1-4 applies.

This question is also sometimes posed to me in terms of what incites me to review a stock whether it should be sold.

One of the important drivers for me to re-evaluate my holdings is competition by new ideas. If I like an idea a lot and don't have any liquidity, I'll need to sell something and I'll review the portfolio for the weakest link.

There are also events that trigger an instant review. If there is a CEO or CFO change or a change of creatives at a company where that's an important part of the company's product. If these execs don't leave but are otherwise in the news (it's rarely positive), it's also something I want to review. Often it doesn't result in a sale but I think it's important to think about it.

Earnings calls are a moment where I reflect on progress and if the original story is still intact. For me without tax considerations when my original thesis turns out to be wrong it's time to bail. Disappointing progress happens often, but it's not really a deal breaker for me.

News from competitors can also make me sell. For example, if there is a new entrant into a market, that's something I don't like at all and it's a great reason to bail on an otherwise fine idea. A recent example is Google (NASDAQ:GOOG) (NASDAQ:GOOGL) coming out with a version of the Amazon (NASDAQ:AMZN) Echo. This probably isn't great news for Sonos.

Bad news like the emission scandal around Volkswagen (OTCPK:VLKAY) or the Philidor issues around Valeant (NYSE:VRX) would definitely make me rethink a position although I'm opposed to any default response.

I don't have price targets but do have a "stale" number on the intrinsic value of the companies I hold. When it approaches the stale number of intrinsic value, that's often a trigger to re-evaluate unless it's very obvious to me the intrinsic value number must have gotten away from the stock price quite a bit over the same time period. For example, if a stock you hold appreciates 20% but you've also seen the press release where they contracted a new client for the next five years and it increased their revenue by 30%, it's unlikely your thesis has deteriorated much.

In summary, I'd say when in doubt, don't sell, so make sure you have a great reason.

Disclosure: I am/we are long GOOG.

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.