Answers To The Hardest Decision-When Do I Sell A Stock?

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Includes: NROM, SYK, V
by: Chuck Carnevale

Summary

The answer to the best time to sell a stock may surprise you.

There are two primary reasons when it makes sense to sell a stock.

What do the best investors think about selling a stock?

Introduction

I'm going to start this article with the same opening statement that I utilized in a previous article I wrote on knowing when to sell a stock. 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." Consequently, it seems to me that whether you are a novice investor or a grizzled old veteran, the decision as to when to sell a stock is considered the most difficult decision investors have to make.

The Power and Protection of Fair Value

Personally, I believe the sell decision is difficult for most investors because of the natural emotional response that motivates them to feel they must do something, especially during turbulent times. In other words, when they are experiencing volatility within their portfolio holdings, they feel a strong desire or even a need to take action. However, more often than not, the best action for investors during volatile markets is to sit tight and do nothing. But the innate "fight or flight response" that is embedded in virtually every living thing is often impossible to resist.

However, if we check in with some of the best investment minds that ever walked the planet, we find that they have disciplined themselves to take a different approach. For example, in the 1996 Berkshire Hathaway Annual Report Warren Buffett stated: "inactivity strikes us as intelligent behavior."

Additionally, in legendary investor Philip Fisher's excellent book "Common Stocks and Uncommon Profits" in chapter 6 titled "When to Sell and When Not To" Philip Fisher gave us this nugget of wisdom: "If the job has been correctly done when a common stock is purchased, the time to sell it is-almost never."

Both of these legendary investors are suggesting avoiding the temptation to do something because they believe that the best course of action is usually to sit tight. At this point, it's important to not overlook the importance of doing the job correctly when the stock is initially purchased. This was a primary theme of my recent article titled "Get Higher Returns And More Dividend Income-In Less Time With Less Risk."

To my way of thinking, doing the job right implies identifying a great business through research and due diligence and then exercising the discipline to only purchase it when valuation is sound, or better yet, at a bargain level. Doing this puts you in the position to be able to walk through turbulent waters with a minimum of risk to your long-term financial future.

However, in addition to doing the job right in the first place, it's also important that investors possess a realistic understanding of how stock prices work in an auction market. In financial parlance, stock charts are often referred to as "mountain charts." The reason is because just like a mountain, a stock price chart that is ascending upward will contain numerous peaks and valleys in between.

Consequently, I have coined a metaphor suggesting that great investors and great mountain climbers share a common understanding. Both recognize and accept the reality that in order to get to the highest peaks you must be willing to traverse the occasional valleys along the way. Therefore, in order to be a successful long-term investor, you must accept the unavoidable reality that there will be short-term periods where your performance will be negative. Even more importantly, these periods of negative performance are unpredictable.

However, there is a caveat with this allegory that relates to doing the job right in the first place part. Once you have been climbing the mountain for a while and are looking for the next higher peaks, it's important to know that you're on the right mountain. However, it is one thing to walk down a valley while on your way to a next higher peak, and it's another thing altogether to walk all the way back down to the bottom because you're on the wrong mountain.

Avoid Selling Just Because the Price Drops

Up to now, I've attempted to establish the principle that selling should be done very sparingly - if at all. Furthermore, implicit in determining when to sell is knowing when not to sell. Short-term market price drops are rarely a valid reason to sell a strong business.

I believe that as long as fundamentals remain strong, a drop in price is more likely to initiate a buy decision than it is a sell decision. I believe this is important, because in my anecdotal experience many investors are inclined to sell a stock if the price drops below the price they paid for it. Admittedly, averaging down doesn't always work out as expected. However, I have seen more people take unnecessary losses by selling a perfectly good stock than I have seen people losing more from averaging down.

The following series of graphs on my personal experience with Stryker Corporation (NYSE:SYK) represent a case in point. I originally purchased the company on July 28, 2008 at a price of approximately $64 per share (see the green dot on the graph). The price had recently fallen from overvaluation based on earnings growth at that time to what I considered fair valuation. However, as illustrated on the graph, the company's stock price promptly fell to approximately $40 a share - representing close to a 38% unrealized loss.

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However, in spite of the fact that we were in a recession, the company's earnings held up quite well, but they did reduce their dividend. I made the decision to hold it, and on May 21, 2010 I had become comfortable that this strong company's business was once again on the upswing and added more to my original position at a lower price of approximately $53 per share.

However, once again the price of Stryker promptly fell almost 20% to just over $43 per share before beginning to recover by year-end. The dividend was increased, and the company's earnings growth returned to double-digit levels. Therefore, once again I continued to hold for the long run because I believed in the company's fundamental health and strength.

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My patience and judgment was further tested in 2011 when Stryker's stock price swooned again to levels below both of my previous purchases. But once again, fundamentals remained strong, the dividend was increased again and I added to Stryker a third time at a price of approximately $51 per share. By now I was in the middle of my fourth year of owning the stock, and my returns up to that time based on price action were meager, to say the least.

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Fortunately, it did not take long after my third purchase for Stryker's stock price to embark on a steady and sustained advance. The good news is that my faith in Stryker has turned out to be a very profitable and rewarding investment. But importantly, it wasn't blind faith, instead it was faith based on strong operating performance. The bad news is that I am now faced with the dilemma of now holding an overvalued stock. Later in the article, I will discuss my thought process on why I continue holding a moderately overvalued stock like Stryker.

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Permanent Fundamental Deterioration

However, as investors we are human, and being human means that we can make mistakes, and often we do. Consequently, my primary reason for selling a stock is when I recognize that I made a mistake.

Comprehensive research and due diligence goes a long way towards keeping mistakes at a minimum. Nevertheless, mistakes will be made. The mistake I'm referring to here is investing in the wrong company. Sometimes what once was the right company suddenly becomes the wrong company. This is what I refer to as permanent fundamental deterioration. The respected investor Marty Whitman of the Third Avenue Value Fund put it this way:

"Unrealized Market Depreciation occurs when the market price of a publicly traded security declines. Permanent impairment of capital occurs when the Fundamental values of a business are dissipated with the consequent long-term adverse consequences."

For that reason, my primary reason for selling a stock is once I have determined that a permanent deterioration in the company's fundamentals is potentially leading to a permanent impairment of capital. I offer the following F.A.S.T. Graphs™ on Linn Energy, LLC (LINE) as a representative example of a permanent impairment through deteriorating fundamentals. Although I personally never invested in this company, I believe this example tells an important story regarding the potential devastation of deteriorating fundamentals.

In approximately January 2015 this company cut their dividend significantly. This was preceded by two consecutive years of collapsing earnings. Consequently, shareholders had ample time and reason to be concerned with this company's long-term prospects. Although the company's stock price was in a freefall during 2013 and 2014, the dividend cut should logically have been the final straw.

The calculation on the graph shows what happened to Linn Energy's stock price following the dividend cut. It is based on a hypothetical $10,000 investment that would eventually fall to just a little over $500 before the company's eventual bankruptcy. Taking action after the company's dividend cut would have still resulted in a loss. However, as the old adage goes, usually your first loss is your best loss.

Furthermore, although this example is extreme, I caution that it is often difficult to distinguish between a temporary interruption versus a permanent impairment. Nevertheless, I believe it's imperative to pay attention to how your business is performing on an ongoing basis. However, once you have determined that a company's business is permanently impaired, it becomes a legitimate reason to sell, regardless of current price.

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Dangerous Overvaluation

In my previous article published on December 18, 2013 titled "How Do I Know When To Sell A Stock" I presented dangerous overvaluation as my second primary reason for selling a stock. However, I attempted to make a distinction between simple or moderate overvaluation and dangerous overvaluation. In my most recent article on fair valuation referenced above, I discussed fair value from the perspective of making an initial purchase. Although I will not buy a stock that I consider even moderately overvalued, moderate overvaluation will not automatically initiate a sell, as I will discuss later in this section. I make a distinction between a buy, sell or hold decision.

Dangerous overvaluation on the other hand is an entirely different matter. Investors should always recognize that Mr. Market can be quite irrational at times. The key is recognizing extremely irrational overvaluation when it is occurring. I recently came across a stock through an article I read that I had never looked at before which I believe represents a quintessential example of dangerous overvaluation occurring during 2006 and 2007.

Clearly, as depicted by the earnings and price correlated F.A.S.T. Graph below on Noble Roman's, Inc. (OTCQB:NROM), price rose significantly above the company's earnings justified valuation. With this example, I hypothetically calculated selling the stock approximately in the middle of this dangerous overvaluation time frame. Had you sold the stock at that time you would have given up some significant short-term gains. However, over the longer term you would have saved yourself from eventually losing almost 75% of your investment based on that sell decision.

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As previously promised, the following series of graphs on Visa Inc. (NYSE:V) illustrate an example of overvaluation that does not immediately initiate a sell. The following examples are my personal investment decisions with Visa. I originally purchased the stock on May 18, 2011 at a price of just under $20 per share and a P/E ratio of 17.4, which is below the company's high earnings growth rate fair valuation of 21.8. (Note: when earnings growth is above 15% per annum, I apply the P/E ratio equals earnings growth rate formula as an assessment of fair value.)

My investment worked out just as I hoped it would up through August 2014, with only a couple of minor periods of overvaluation. However, from that point forward the company's price became steadily disconnected from my calculation of Visa's fair value. Nevertheless, I still hold the stock today, but, I am fully aware that it has become overvalued.

Since I invested in Visa at an attractive valuation initially, my annual rate of return thus far has exceeded 31% per annum, representing just under a quadrupling of my original investment. Now, here is where overvaluation gets a little insidious. It is very tempting to sell the stock and lock in the high rate of return I have been fortunate enough to receive. To be clear, this now becomes a risk-based conundrum. Therefore, it is logical to evaluate what I could possibly lose by holding on as I will do next.

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Before I evaluate the potential damage from my Visa holding eventually moving down to my calculation of fair value, I would like to further address the risk element. One thing that investors should be conscious of when a stock they own becomes overvalued is that it simultaneously becomes vulnerable to bad news. Recent reports about Visa facing issues with the retail giant Wal-Mart (NYSE:WMT) in Canada represent an example of a potential catalyst that could change the markets' sanguine view of Visa. In other words, overvaluation is typically associated with optimism. Sometimes that optimism is justified, and sometimes it is not.

Consequently, it makes sense to me to calculate my potential risk going forward. Therefore, I once again utilize the calculator function of F.A.S.T. Graphs™ to calculate what the results would be if Visa were to trade at my calculation of fair value by fiscal year September 2017. This calculation suggests that my annual rate of return could fall to approximately 23% and my principal plus dividends would be worth approximately $36,798 versus the $39,720 it is currently worth (see the pop-ups on the graph).

However, since it is not a certainty that that will happen, and considering that Visa might continue to have momentum at least over the near term, I have decided to hold for now. On the other hand, I am fully cognizant of the current overvaluation and the associated risk. Therefore, Visa is on what I refer to as my sell watch list. Moderate overvaluation does not immediately initiate a sell for me. I'm a long-term investor that appreciates that my Visa bird in the hand might possibly be worth more than two in the bush.

On the other hand, if I happen to come across a compelling stock that I felt offered more future return than Visa, it would represent a potential source of capital to take advantage of that opportunity. On the other hand, selling a popular stock (overvalued) to invest in an unpopular stock (undervalued) will often result in a short-term mistake. The popular stock might continue to rise and the unpopular stock might continue to fall, at least over the short run.

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Summary

In the last article I wrote in December 2013 discussing when to sell a stock, I reviewed several aspects that were not specifically related to investing decisions. For example, I talked about selling stocks to fund an important purchase or a child's education, etc. I also talked about selling a stock in order to rebalance your portfolio or to take advantage of an uncommon opportunity that you might have come across. However, I have recently been asked about the sell decision from purely an investment perspective. Therefore, with this article, I tried to present my views on selling a stock purely as an investment decision.

However, if people are looking for advice on the perfect time to sell a stock, I respectfully submit that no such advice exists. You can never - and should never - expect to sell a stock with perfect timing. In fact, I would suggest that the best you can hope for is to make a prudent decision. What I'm suggesting is that more often than not if you do sell a stock, it is likely to continue rising for a period of time after it is sold. This is especially true if your sell decision was based on a perspective of overvaluation.

This reality often reminds me of a rather profound definition of appreciation that a colleague shared with me. He asked me if I knew what appreciation was, and of course I gave him the classic definition from the financial lexicon. However, he corrected me by offering that the real definition of appreciation was when the other person appreciated what you owned more than you did. So be careful, when a stock is popular, it's important to come to grips with the fact that someone else out there might appreciate it more than you do.

As a general rule, stocks become overvalued because they become popular - or hot, as some people like to say. This type of price action is based on sentiment, and sentiment is virtually unquantifiable. You can make guesses, but you can never predict with perfect accuracy how high is up, or how low is low for that matter.

Conclusions

As I indicated throughout this article, there are valid reasons to sell a stock. However, these reasons are typically only relevant under extreme conditions. I adhere to the investment strategy of being a long-term owner of a wonderful business purchased at a sound valuation. Long-term oriented investors recognize that time in the investment is more profitable than attempting to time your investments. Buy-and-hold is a proven strategy and produces solid long-term results. However, at times it requires patience and courage to implement the strategy successfully.

So in closing, I submit that if you've done your homework correctly, that the best time to sell a good stock is never. On the other hand, like all rules, there are always exceptions. Dangerously excessive overvaluation would be one, and a permanent deterioration of business fundamentals another. But at the end of the day, it's important to fight the temptation of being too active with your portfolios. As the old Wall Street adage goes, a portfolio is like a bar soap, the more you handle it, the smaller it gets.

Disclosure: Long SYK, V

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: I am/we are long SYK,V.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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