James DeMasi's  Instablog

When Do I Sell Stocks? Drawing Wisdom from Buffett to Zuckerberg

Every investor knows when to buy a stock. You buy when you believe that the stock is attractively priced relative to the price you believe is its true value.On the other hand, knowing when to sell stocks can be a little trickier.

Say you buy ABC stock for $25. You believe it will be worth $50 or more in three years. Three months after your initial purchase the stock rallies to $40. This isn't uncommon and it makes many investors very nervous as they wonder, "What should I do now?"

The stock has not hit your intrinsic value target, but you're holding a 60% gain only 3 months into your investment.

This is way sooner than you had expected and this kind of momentum could very well be unsustainable. You might consider taking the gain now and then buying it back when the stock dips, but how big of a dip is big enough?

Will you know? Is $37 acceptable? Should you wait for it to go lower than that? What if ABC never reaches your price point to rebuy? Could you ever possibly buy back in with a comfortable mindset?

As an investor, you've probably found yourself in this exact position more than once, so let's talk about the solution. Forget the market for a second.

The only question to ask yourself here is, "Does selling make sense given everything I know about this company?"

Being able to answer this single question is essential and could quite possibly be difficult, because you might find that you don't know as much about the company as you should.

Let's turn to Mark Zuckerberg to illustrate just how powerful this one question can be.

In 2004, Friendster and an unnamed New York financier each made $10 million offers to buy Facebook (FB). David Kirkpatrick wrote in The Facebook Effect that Zuckerberg, "didn't for a minute think seriously about accepting," these offers.

In 2005, Viacom's MTV offered $75 million, which was also rejected.

In 2006, MTV, Yahoo, and AOL all made $1 billion-plus offers and were turned away.

Michael Wolf, CEO of MTV Networks told Bloomberg that Zuckerberg's response to his $1.5 Billion offer was, "I think it's worth a lot more… I may never have an idea as good as this so I'm not that interested in selling."

At this point you may be beginning to understand why Buffett recommends that you stick to your circle of competence.

No one will ever know more about Facebook than its creator, Mark Zuckerberg. That level of in-depth knowledge brings the clarity and confidence that one would need in order to reject a $1.5 billion offer. He knew what he had and, as he said, he believed it was worth more.

Lo and behold the company now has a $60 billion market cap. If you don't fully understand the business that you're invested in then you will be reliant on the market to tell you what it's worth, because, frankly, you don't honestly know. Being in that type of position never allows for good decision making.

So when will Zuckerberg sell? Never. Buffett has also said that, "The best time to sell is never." He went on to say, "Only buy something that you'd be perfectly happy to hold if the market shuts down for ten years." Buffett is able to find companies that are worth holding onto indefinitely, because he makes sure to fully understand those businesses. This allows him to grasp the company's long-term economics.

When you're researching a possible investment then imagine that you are buying into a private company that will not IPO for at least 5 or more years. What would you want to know about that company before locking yourself into it? You'd probably want to know who the management are, what their qualifications are, what their business model is, what their competitive position is within their industry, what their prospects are, what their strengths, weaknesses, opportunities, and threats are, who their suppliers are, who are their customers are, and the list goes on.

Unfortunately, we cannot all be oracles like Buffet, and we may never know a company as well as its founder. Besides, businesses can and do change over time. As such, an infinite holding period may be more of a dream than a practical reality for most companies, especially as industries evolve at an ever more rapid rate. Therefore, we'll conclude with the lessons of another great investor, Phil Fisher.

In Fisher's book, Common Stocks and Uncommon Profits, he advised that the right answer to the question "when do I sell stocks?" is when one or more of the following three conditions are met:

1. When you realize that your analysis was materially wrong.

2. When, due to the passage of time, the stock no longer qualifies as suitable investment according to his 15 scuttlebutt investment checklist. The most common reasons are management deterioration, managerial smugness, complacency, and exhausted growth possibilities.

3. When there is a better opportunity, BUT you must be absolutely 100% sure of your analysis. Having held your first stock for some time, you know everything there is to know about that company. That is almost never the case with a new investment. Therefore, your analysis must be completely sound and the difference in return must be substantial enough to justify a switch even after discounting the possibility of not being perfectly correct.

How would Fisher answer the original question about what to do with our $25 stock that rocketed to $40? I believe he would hold onto it. He said that selling in that position will make it too difficult to ever get back into it. Besides, if the company is truly innovative then you never know what else the future may hold.

In conclusion, legendary investor Joel Greenblatt said it best.

"Ideally, your decisions to buy or sell stocks should be based solely on the investment merits."

Of course, you have to be brutally honest with yourself and your analysis. If after all that, you are sure that you own a great company that you understand and feel confident in then be like Zuckerberg and don't settle. Remember, it takes time for those 3, 5, or 10+ baggers to evolve and for wealth to be created. Happy investing and may good fortune be forever in your favor.

Visit Seraphin Group at http://seraphingroup.com/ or follow on Facebook at http://www.facebook.com/SeraphinGroup

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I recently read an article on Seeking Alpha entitled 10 Low Debt Tech Stocks With Strong Corporate Governance.  The article screened stocks with low debt to equity ratios that were also ranked as low risk according to Institutional Shareholder Services (ISS).^[1]  I have read many research articles showing a positive correlation between strong corporate governance and strong stock returns, but I have never looked into the services of a company like ISS to do the work for me.  Their scoring process made me curious.  I wondered if using such a service would be an effective way of finding great market performers, as the Seeking Alpha article implied.  So, I decided to examine this further.

I began by doing a Google (GOOG) search for the ISS website.  In the search results, I found a research report paid for by the ISS to show the correlations between their scoring process and stock returns.^[2]  One thing in the report immediately bothered me.  It was a phrase in the fine print that was being used over and over again.  Next to many of their tested factors the fine print said, "Becomes positively (or negatively) significant... when Spearman Correlations are used."^[2]  I am not a statistician, but when I'm reading about a statistical process and it is described as, "Becomes significant," then I skeptically wonder if the data is being manipulated in order to produce the results that are necessary to sell their service.  Naturally, my next question was, "What are Spearman Correlations?" Another quick Google search resulted in an example explaining Spearman Correlation:

As an example, let us consider a musical (solo vocal) talent contest where 10 competitors are evaluated by two judges, A and B. Usually judges award numerical scores for each contestant after his/her performance. A product moment correlation coefficient of scores by the two judges hardly makes sense here as we are not interested in examining the existence or otherwise of a linear relationship between the scores. What makes more sense is correlation between ranks of contestants as judged by the two judges. Spearman Rank Correlation Coefficient can indicate if judges agree to each other’s views as far as talent of the contestants are concerned (though they might award different numerical scores) – in other words if the judges are unanimous.^[3]

In other words, Spearman Correlation ranks perceived governance among companies of the same industry and can be called, "a correlation coefficient between the ranks."^[3]  Does it make sense to use this type of ranking system?  
For example, if I would like to know the strength of Dell's (DELL) corporate governance policies then what I am obviously seeking is to learn how their policies compare to a set of defined best practices.  I am not interested in knowing if Dell's governance system is better in relation to an industry competitor, like Hewlett-Packard (HPQ).  What if both companies had weak governance policies, but Dell's, while still bad, were better than a more atrocious situation at Hewlett-Packard?  At best, Dell's higher governance score would be utterly worthless, because the system is simply giving the better score to the lesser of two evils.  At worst, the score would be misleading because it instills a sense of false confidence in the company.  (This is a hypothetical example and not a valid opinion of either Dell or Hewlett-Packard's actual corporate governance systems.)

To make matters worse an article out of Stanford revealed that these governance watchdog companies, like ISS, do not even have direct contact with the companies that they are assessing.^[4]  The ratings are constructed quantitatively.^[4]  This begs the question, is it possible to rate a governance system without actually speaking to the company?  David Larcker, codirector of the Rock Center for Corporate Governance at Stanford and the Stanford Business School’s James Irvin Miller, Professor of Accounting, said that, “There’s an industry out there that claims you can. But for the most part, we found only a tenuous link between the ratings and future performance of the companies.” ^[4]  In their independent study, the Stanford researchers examined 15,000 ratings of nearly 7,000 firms from 2005 to 2007 and found that in all cases that the ratings provided by the corporate governance rating agencies showed very weak correlations that, "did not appear very useful."^[4]

To conclude, always be skeptical of research until you have personally verified it to be sound and objective.  Moreover, do not rely on corporate governance ratings unless there is evidence that the rating agency has actually had contact with the target company's managers and directors and have reviewed the company's policies themselves.  It is my opinion that such a rating cannot be measured on a purely quantitative basis.  It appears that investors will still have to evaluate governance systems for themselves by examining publicly available documents and by contacting shareholder relations in an effort to identify the implementation of best practices.

Disclosure: I am long GOOG.