The Most Misleading Words In Investing: You Can't Go Broke Taking A Profit

Includes: BRK.A, BRK.B, CVX, KO, MCD, MO, PM
by: Tim McAleenan Jr.

At Kiplinger Magazine, Kathy Kristof put out this article yesterday titled "Five Lessons From Apple's (NASDAQ:AAPL) Fall." Much of the commentary about Apple was about what you'd expect, but there is one bit of "conventional wisdom" mentioned that I would like to bring to your attention.

In the Kiplinger piece that came out, Rule #3 of the "lessons learned" from Apple's fall from grace is that you should partially liquidate any holding that doubles in value in a short period of time:

"Winners take chips off the table. Unless every stock in your portfolio doubles each year (in which case Warren Buffett would like to hire you), Apple's rise over the past 12 months likely caused it to become a disproportionately large share of your assets. That makes your portfolio riskier and less balanced and is a signal that it's time to sell a portion of that stock, says Lance Roberts, chief executive of Streettalk Advisors, a Houston money-management firm. If a stock doubles, sell half your shares, Roberts advises. That takes your profits off the table, securing a gain and reducing the risk that one stock could jeopardize your overall wealth."

Before we go any further, take a moment and search "The Pareto Principle." If you do not want to do that, I'll explain: The Pareto Principle, also called the 80/20 Rule, states that 80% of the results come from 20% of the actors. It got its name from Vilfredo Pareto's observation that only 20% of Italians controlled 80% of Italian land. A possible corollary to this is that 20% of your investment selections may cause 80% of your investment success. According to this source, 90% of Warren Buffett's success at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) can be attributed to less than a dozen decisions.

This is one of those reasons why it can be hazardous to follow set rules like selling after a company appreciates by a certain amount on the grounds that "you can never go broke taking a profit." In Buffett's case, he could have missed out on a lot of wealth if he divested See's Candies after it only took him six years to extract "internal dividends" from See's Candies that equaled the purchase price. Likewise, if Buffett would have sold Coca-Cola (NYSE:KO) after his $1.3 billion investment after it grew to $2.6 billion, he would have missed out on its price growth to over $17 billion today (and this does not include the dividends paid out over the past 20+ years, which would make the Coca-Cola results even more attractive than what I have presented).

If you are a long-term shareholder of Altria (NYSE:MO) and you bought at any time before the spin-offs of Philip Morris International (NYSE:PM), Kraft (KRFT) and Mondelez (NASDAQ:MDLZ), there is a decent chance that the investment may have been the most lucrative of your life:

If you bought Altria in January of 1990, you would have compounded your money at 16.63%, turning $10,000 into $398,000.

If you bought the company in January of 1995, you would have compounded your money at 18.21%, turning a $10,000 investment into $215,287.

If you bought Altria in January 2000, you could have turned $10,000 into $136,218 by compounding your money at 21.62%.

And if you made your Altria purchase in January 2005, you would have turned $10,000 into $40,010, for a compound rate of 18.13%.

If you decided to cash out your tobacco holding merely because the price doubled, you would have missed out on investing gains that could have singlehandedly make your investing career success. You only have to get rich, you only have to have one successful investment "to make" it, and you could undermine your own cause by cutting the legs off of a company that still has room left to run.

The average Social Security check in this country is about $1,200 per month. If you bought $10,000 worth of Altria (then Philip Morris) in 1990, you'd be averaging $1,568 in dividends per month, assuming optimal tax strategy. This is one of the best case scenarios involving letting your winners run, but we see it happen all the time with other blue-chip stocks in different degrees.

There are other examples in the blue-chip universe where "taking a profit" after a double would not have worked out as well. Today, the price of McDonald's (NYSE:MCD) is over $100 per share and the company pays out an annual dividend of $3.08 for each share that you own. In 2003, the company hit a low of $12.10. Would it have been wise to sell the following year when the company traded between $24.50 and $33? If you sold in 2004, you would have missed another stock price double by 2007. And if you sold after the 2007 double, you would have missed another stock price double by 2011. And that is just talking about McDonald's stock price, without considering the dividend, which has grown substantially over the past ten years.

McDonald's has grown its earnings by 12.5% and dividends by 26.5% this decade (as an aside about the rapid dividend increases: the payout ratio acceleration reflects McDonald's continued shift from restaurant operator to "toll booth" collector as the profits that come to headquarters are the result of 4% sales fees and rents that franchisees must pay to the parent company. At year end, McDonald's "the company" was operating less than 19% of the total stores, most of which are not in the United States).

All it takes is one Altria or McDonald's in your portfolio for the long-term to make your investing career a success.

My problem with the logic behind "you can't go broke taking a profit" is the fact that it is mindless. Ideally, buy and sell decisions should be made within the context of valuation, not just because a company has doubled in a short period of time. When a stock price doubles, you still have to look at the fundamentals of the company, judge the future growth prospects against the current price, and then proceed intelligently with your own opportunity costs in mind. Having automatic sell rules can be an abdication of an investor's responsibility to think and evaluate the fact specific circumstances beyond the change in stock price.

Selling after a stock price doubles is akin to selling a stock because it just hit a 52 week high. Chevron (NYSE:CVX) hit a 52-week high two days ago, yet the company does not seem like a "sell" given 10% annual earnings growth projections, a cash hoard of $21 billion, 4-5% impending production gains, and a company strategy to lower the finding cost per barrel. Considering it is still trading below 10x earnings (typically, the company trades around 10-11x earnings unless oil and natural gas prices are experiencing rapid movements in either direction, in which case the rules change), it seems reasonable to argue that the company is a hold (or even buy) at today's prevailing prices, despite hitting a 52-week high just two days ago.

That is why I would reject the advice in Kiplinger's that you should sell a stock simply because it doubled. That is a mindless rule that outsources your ability to think, and at worst, puts you in the position to automatically cut the legs off of your winners. If you see a stock price appreciate quickly within 12-24 months, it could be a useful time to reassess the company's long-term earnings prospects in relation to the current price. But don't treat it as an automatic time to sell.

Disclosure: I am long MCD. 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.