Investors usually try to figure out what is the right time to buy a certain stock. Over the past three years, I explained how I build my optimal sector allocation, how I screen for stocks and how I analyze candidates for my dividend growth portfolio. An investor who follows me should understand by now an important part of my methodology.
In the previous article I discussed goal setting, which of course has a lot to do with screening, and investing in quality companies. However, achieving your goals requires you to have an exit strategy from stocks that do not perform well. There are many theories and strategies that offer insights about selling stocks.
Selling stocks is another crucial part in the strategy of the investor. An investment strategy must include an exit strategy from stocks in your portfolio. In this article I will share several popular exit strategies among investors. I will explain why I do not use them, and their disadvantages. In addition, I will also present my exit strategy from certain stocks.
The concept of selling stocks
I am looking at stocks from an investor's point of view. Unlike traders who sometimes see stocks as a commodity, investors see stocks in a more traditional way. Stocks are part of businesses that have decided to raise money from the public by offering them a tiny piece of the business. Therefore, owning a stock is owning a part of a business -hopefully a successful business.
When I buy stocks, I am buying businesses. From my perspective, there is no difference between buying a stock and joining a partnership in a local pub. Each deal gives the investor a certain percentage of ownership in a business. The stock market allows small investors like me enjoy the success of the most successful businesses in the world.
From my perspective, selling a stock means that you believe that the business you own doesn't perform according to your expectation. It means that if you own a bar and the bar is successful, you keep your stake in it. If you own a common share, you should keep owning it as long as it performs according to your long-term expectations.
Therefore, an investor should only sell his stocks when he believes a business has failed him in achieving its long-term goals. When you own a pub, you set the long-term goals yourself. When you own a common stock, the management sets the goals, but you set your expectations. My expectation is to enjoy a growing free cash flow which will be translated to growing dividends.
I am not trimming
Some investors will sell their stake in a company when a certain position exceeds more than a certain percentage of their portfolio. I disagree with this approach, because as I said before, I want to sell my stocks in a company when the company disappoints me. If a company reaches a certain percentage of my portfolio, it means that the stock price has surged, usually because the company is performing well. This is not a good reason to sell. You will be selling one of your portfolio's winners.
Boeing (BA) is among the best performers over the past two years. If an investor chose a random percentage of its portfolio to allocate to Boeing, he would have sold many shares when the stock price more than doubled itself. That investor sold one of the best performers and left in his portfolio stocks that didn't perform just as well. He sold the successful business, and not a business that has failed him.
I am not timing
Some investors sell when the price is "too high" or a company is "at the top of the cycle". They are trying to time the market and figure out whether a company still has room to grow and enjoy additional price appreciation. Again, these investors sell their successful stocks, as they are the ones that reach the top or reach a very high price. This is again a scenario in which we punish the successful companies, instead of punishing companies that have failed us.
Apple (AAPL) is an example for such company. I made this mistake myself when I sold in the fall of 2012 the shares for $100 (split adjusted). I thought that the shares have reached their peak, and for a while I was correct. There was a correction, but since then the shares have recovered, and I later bought shares in Apple for a price that was higher than my selling price.
I am not punishing for success
Selling a successful company because I have achieved a certain return that is "sufficient" is another bad idea in my book. It usually happens with smaller positions of smaller companies. A company becomes very successful, and investors suddenly gain a very impressive return. To secure this return, they will sell the position, and again they will punish a successful company, and stay with less successful companies.
Nvidia (NVDA) is an example of such a company. Bought for less than $25 a little over three years ago, an investor who sold it even after an amazing return of 100% or even 200% missed even higher returns. You may say that it's easy to know in retrospect, but again this sell didn’t make any sense. The sell eliminated a position that was growing due to improving fundamentals just because the company achieved a certain return. The return is a random number that has nothing to do with the situation of the company and therefore shouldn't be taken into account when deciding to sell.
I am punishing for failures
The growing dividend policy is the long-term vision of a blue chip. It symbolizes the fact that the management is working to achieve long term growth in the top and bottom line to fuel free cash flow and dividend growth. It shows the management's company in the business as it raises the dividend even when earnings decline in the short or medium term.
I will sell my position immediately after a company cuts its dividend. From my point of view, it means that the management failed to deliver and execute. The company failed to deliver long term growth or needs to take extreme measures to sustain future growth. In both cases I am not interested in holding a position in this company. If the management failed to understand the situation of the company and its business environment that led to the dividend cut, how would I trust it?
Personally, I had to sell shares in several companies that cut their dividends. I did it immediately and without analyzing it. Sometimes we are disappointed when a position we love fails us. As investors we should stick to our strategy and have no emotions towards any position. You failed us, and therefore you are out. I sold my shares in General Electric (GE) and National Oilwell Varco (NOV) as soon as the cut was announced. Since then the stocks have struggled, and still haven't managed to return to growth.
I am not vindictive, and I don't hold any grudge towards companies that cut their dividends. I am willing to reconsider adding them back to my portfolio as soon as their growth story is back on track. For example, I sold my position in Kinder Morgan (KMI) after the dividend cut, and I initiated a new position in the company this year. The growth story looks promising, and I am willing to give the company another chance.
I am a great believer in having a specific strategy and methodology that should be executed consistently. I am executing my strategy when I buy stocks, and when I sell stocks. Having an exit strategy from a bad investment is crucial to avoid your capital being allocated to poor investments. Every investor should have his exit strategy, because chances are that you won't succeed in every investment you make.
Personally, I am against selling positions in successful companies. I only sell companies that failed me. As a dividend growth investor, failure has to do with dividend cut, but investors with different strategies should define failures in different ways. If you manage to hold on to your successes and good stock picks and get rid of failing positions, you will be able to promote your goals.
Disclosure: I am/we are long AAPL, KMI. 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.