Here's a question that came my way recently: Why should anyone ever own an overvalued stock? At its face, it just sounds like a bad idea to entertain. After all, why would anyone consider keeping something that is worth $5 if someone is willing to pay you $10 for it? While I'm steadfastly against the idea of buying an overvalued stock, I have fewer objections to the idea of holding an overvalued stock. While I am at peace with investors who advocate always selling an overvalued stock, here are five reasons why an investor might consider holding on to a stock that is overvalued:
(1) Emotional Intrinsic Value. i.e. "My daddy gave me these 250 shares of Coca-Cola (KO) right before he died and they only make up 0.5% of my total portfolio." The emotional satisfaction of maintaining such an investment could offset the potential to make more money. For the most part, an investor should try to keep "emotional intrinsic value" investments to an absolute minimum. If they ever become a meaningful part of the portfolio, an investor is putting himself at a serious risk of getting burned.
(2) Familiarity with the stock. Maybe someone who has owned Colgate-Palmolive (CL) for 15 years knows the company cold--he can name the management, all the products, the expected growth in each product area, all the potential setbacks facing the company, etc. As long as the company continues to grow dividends and earnings satisfactorily in accordance with the investor's goals, there is no need to let go of a company that an investor is very familiar with in favor of an investment that is either out of the investor's comfort zone or does not offer commensurate earnings quality.
(3) You have to pay taxes. Maybe you've been a long-term holder of Procter & Gamble (PG) and you're currently sitting on a $100,000 capital gain. Let's say that someone who sells has to pay 15%, or $15,000, in taxes. Any new investment idea has to be superior to Procter & Gamble in a way that it can compensate for the fact that the initial investment will have $15,000 less working for it than the Procter & Gamble investment.
(4) You can't find a better place to go. Unless a company is at risk of deteriorating fundamentals that could result in a permanent capital loss, it can be wise to heed John Templeton's advice to always know what you're going to do with the money available from the sale of a stock. You might want to stick with the company you've already got until you can find the arms of a new stock to run into (note: this is not relationship advice). If you can't find a better place to go, it can be best to sit tight with the stock you already have.
(5) You measure an investment's success by sustained income growth. You bought 100 shares of Wal-Mart (WMT) for $60. It provides a nice income stream. It has a record of growing that income stream at a double digit rate. It's one of the only stocks in the market that offer such a combination of high earnings quality and the promise of double digit income growth. The performance of Wal-Mart as a company that pays out significantly higher dividends each and every year satisfies your objectives as an investor.
I am not intending to recommend the greatness of holding overvalued stocks, but rather, I wanted to present some circumstances that might lead to such a decision. And I do think this might be helpful to keep in mind: from 1980 to 2012, Johnson & Johnson (JNJ) compounded at about 12-13% annually. Over that period of time, shares of Johnson & Johnson were both undervalued and overvalued. Maybe an investor who sold when the shares became overvalued could have done better. But do not forget: even if he held through the periods of overvaluation, he still reaped a 12-13% annual return.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.