Before You Buy A Stock, Know When You'll Sell

by: Cory Cramer
Summary

Most investors agree that deciding when to sell a stock is more difficult than deciding when to buy.

I've found that thinking about the conditions under which one would sell a stock before buying it, helps with the selling decision.

This article covers several reasons an investor might sell a stock, so they can better think about those potential scenarios ahead of time and have a plan.

Sold sign

Source: Pixabay

Introduction

This article is the third article of a new series I'm writing called the "Before you..." series. The first article in the series was "Before You Buy, Watch for Super-Cycles" and the second was "Before You Copy Great Investors, Know Your Differences". The reason I decided to write the series is that I've noticed that a lot of writings on SA have become more sophisticated and technical over the past couple of years (and I think that's a good thing), but I worry that new readers and newer investors coming to the site to share ideas about investing might be a little overwhelmed at first. I specialize in cyclical investing and rotational strategies, and I know that my own investing strategy has become more intricate and sophisticated over the years. And again, I think that's a good thing. But it can be hard to discuss some of the basic assumptions I'm making about my investment ideas and strategies in a 2,500-word article, while also getting in the specific analysis I want to highlight in the articles as well.

So, the "Before you..." series is intended to take one small piece of what I look at before making an individual investment, or before making adjustments to my overall investing strategy, and sharing my thoughts on that subject in a series of (hopefully) concise articles. While the "Before you..." titles may be interpreted by readers as being directed at them, I want to note that they are equally directed at me, as a series of reminders of the lessons I've learned on my investing journey.

I don't expect everyone to agree with each article, but each article should at least offer something to think about. My basic approach to investing is a value approach, mixed with a little bit of growth-at-a-reasonable-price approach. Someone with a very different approach might not find my thoughts on various issues useful. That's fine. I think there are many good strategies out there. But my focus is on cyclical value and medium-term rotational portfolio strategies, so these articles will all broadly be from that perspective.

When to sell? The hardest decision.

Let me begin by noting that I chose conciseness over accuracy with regard to the title of this article. A more accurate title would be "Before you buy a stock, know the conditions under which you plan to sell", but that's kind of a mouthful, so I went with a shorter version. When to sell is only one of many potential conditions one should think about ahead of time when it comes to selling. The 'ahead of time' part is what I really want to emphasize here. I expect every investor's conditions under which they plan to sell to be different and tailored to their individual investing approach and circumstances, and just as importantly, tailored to the individual stock in question. Let me also note that one can intend to buy-&-hold 'forever' and never sell. That is a perfectly legitimate investment approach, even if it is not one I practice. With those caveats noted, let's move on to why I think selling decisions are so hard.

You will find it commonly noted by many very good contributors on SA that deciding when to sell is much harder than deciding when and what to buy. I agree with this sentiment, and I think I know the reason why selling is harder than buying. Once we already own a stock, we lose the ability to take a 'pass' on it, the way we can take a pass before we buy it. As Warren Buffett has noted, "There are no called strikes in investing". I've also heard it said by a very good investor that at any given time in the market, 85% of stocks are too hard to make a buy decision on, 10% are buys, and 5% are shorts. If either of these market observations is close to being correct, once we buy a stock, about 85% of our options are taken away after the purchase because we can no longer call the stock "too hard" and "take a pass" on it. That's a major reason why selling decisions are harder than buying decisions. Layer on to that tax considerations and also that one has to decide what to do with the proceeds after the sale, and selling decisions become harder yet.

With all that said, now let's cover some of the major reasons an investor might want to sell a stock. This won't be an exhaustive list, but I'll try to broadly cover several potential situations one should think about before they buy a stock.

Reasons to Sell

Off the top of my head, I can think of six major reasons to sell, though there are probably more.

  1. The stock has met the goals and expectations for the thesis of the original purchase. This is the best kind of selling. The profitable kind. And the thesis can be anything from improving market sentiment, an earnings beat, the success of a new product etc. The reasons are endless, but in order for this reason to trigger a sale, you must have a clearly defined thesis to begin with. (Theses work best if you write them down.) And while there is some benefit to not getting too detailed on the thesis, I've found that deciding what key metrics or events will trigger a sale - whether it be earnings growth, valuation, or expected return on your investment over time - is really helpful. What metrics I use vary from stock to stock. But I always try to have a fairly good estimate for what metrics will trigger a successful sale before I buy a stock.
  2. The thesis is busted. This is the flip-side of number one. If you predict, for example, that a stock will beat earnings and be rewarded by the market for it with a higher price, then the company misses earnings and is punished for it by the market for it, that could trigger a sale. The thesis was a bust. This happened to me in 2018 with an investment in Papa John's (PZZA). In January of 2018, I thought their founder was stepping down and moving out of the spotlight of the company and that would be a catalyst for the stock. But it turned out he had no intention of really walking away from the day-to-day operations of the business and was instead secretly running the company behind the scenes. Once that became obvious to me, I sold and took a loss because my thesis was busted. There are other things that could cause a busted thesis like fraud or mismanagement, unexpected competition or disruption in the industry, or changes in secular trends, to name a few. Tracking and measuring those things in some way should be done as a way to measure when one's thesis might be busted.
  3. Time is up. Once again, this usually happens when a stock hasn't fully achieved its thesis. It might not be a losing investment when time runs out, but you might have been waiting for better returns or earnings that never materialized as you expected. My basic default time-horizon is 5 years for most investments before I say time is up, but sometimes I specify shorter time periods. With my 2016 Gilead (GILD) investment, I specified 2 years, and when two years were up, time had run out on my thesis, but the price wasn't where I expected it to be. I could have kept waiting for the price, but I had set a time-frame for the thesis, and it was up, so I sold. Of course, in order for the time to run out on a thesis, one must first have an expected time-frame for the thesis to play out. And, for what it's worth, not having established a reasonable time-frame for a thesis to play out is probably the biggest strategic mistake that I see investors make.
  4. Overvaluation. Most of my investments have medium-term time-frame expectations, but, every now and then, I come across a great buy-&-hold investment at a great price. In 2013, I was able to buy some Apple (AAPL) for under $60 per share and I was recently able to buy some Altria (MO) very cheaply as well. These, when purchased, had the potential to become long-term holds. For stocks like this, I generally will not look to sell unless they become valued over 150% of what I consider to be fair value. So, I'm not buying-&-holding 'forever' because if someday they get really overvalued, I'll take profits, but I don't attach a time-frame to these if they continue to outperform year after year without becoming overvalued. I will sell if they do become significantly overvalued, though. It was dumb not to sell Coca-Cola (KO) or General Electric (GE) back in the late 1990s when they traded for P/Es over 60, for example. If Apple starts trading at a 30 P/E with no new revolutionary products to push it that high, I'll take my profits and find something else. So, undeniable overvaluation, even on buy-&-hold stocks is a good reason to sell. Additionally, don't forget that falling earnings can cause overvaluation as well, not just rising sentiment.
  5. Macro environment changes. This is a pretty big category, but one that I see investors regularly ignore or not pay as much attention to as they should. A great deal of my strategy is focused on individual stock cycles and their relationship to macro-cycles like the business and credit cycles. Changes in where we are in these cycles at any given time could trigger selling in certain stocks or ETFs depending on one's initial investment thesis. But perhaps most importantly, is to take potential changes in these cycles into account for your initial thesis because they might affect your selling decision. The most basic question that I always find myself asking at this stage of the cycle is "What do I expect to happen to this stock in the event we have a recession?" The reason I ask this is I expect my investments to behave differently during a recession than I do in the late stages of the business cycle. Other important macro environment changes might be changes with regard to inflation or deflation, broad sentiment changes, political and regulatory changes, changes in the accessibility of credit, and demographic changes. Changes (or lack of changes, depending on what your thesis is) in any of these major macro environments could potentially trigger the sale of a stock. It's important to think about the big things ahead of time, even if we'll never know exactly what combination of macro-factors the future holds.
  6. Personal finance issues (AKA you need money for something). I think this one doesn't get discussed enough, but it's worth thinking about whether your personal finances are in a position for you not to become a forced seller. Are you borrowing short-term to invest longer term? That could be a problem. Are you likely to get laid-off, fired, or furloughed during a recession? If so, would you be forced to sell your investment in order to pay your mortgage? Having a plan in place in this regard is important. I often read how individual investors underperform the market and get returns of 2-3% instead of 8-9% that the market returns. And it is often assumed that investors are making poor market timing decisions. That might be true. But I think what aren't accounted for are investors who sold their stocks in order to pay for living expenses or debts of some kind and so they needed to sell regardless of price. Investors who weren't timing the market, but instead, simply were paying their bills. (Additionally, one would expect that when times are good, people simply have more money to invest. People are dollar-cost-averaging, paying no attention to price, and when they are losing their jobs, then they aren't doing that anymore. They buy regardless of price at the top and become forced sellers at the bottom. Ironically, Bogleheads, in the aggregate, become market-timers depending on their income-based contributions.) In addition to this, one might simply be in the distribution phase of retirement and part of the long-term plan was that a certain portion of one's holdings would be sold to fund retirement. That is a personal finance reason for selling and it would probably be wise to avoid a more volatile portfolio if there is a chance of forced selling for personal reasons.

Conclusion

Since one of my goals of this series is to be concise, I'm going to stop here for now. Each one of these reasons for selling probably deserves its own article (and I may write those in the future), but my main point with this article is that part of one's thesis for buying a stock should at least contain a rough outline for the conditions under which they plan to sell the stock. The more conditions you can imagine and think of ahead of time and plan for, the less apt you will be influenced by temporary one-time news narratives or short-term price momentum, which are probably the absolute worst motivations for selling a stock.

I have several future articles like this one planned for 2019. If you would like to be notified when I publish those articles, click the orange "Follow" button at the top of the page.

Disclosure: I am/we are long AAPL, MO. 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.