A lot of time and effort must be put into finding the right business to invest your money in. And endless literature is available on picking stocks and analyzing businesses which helps educate the investor. Waiting patiently for the right time to buy into the business is important also, to ensure you give yourself a large enough margin of safety. But there seems to be much less effort devoted, and much less reading available, in regards to selling. So when do you sell? It is a great question, and one not easily answered.
Warren Buffett has famously said that his favorite holding period is forever. But throughout his career even Warren Buffett has sold many positions and bought others when it has made good sense to do so. And though some companies, such as Coca Cola, may remain great companies for generations, all companies have a finite life, particularly in regards to their growth phase.
Firstly, if you have a stock or 2 in your portfolio that you accumulated because of a hot tip, or from an uneducated guess that the shareprice might go up, or from any reason other than the business is a quality business with sound prospects and the buy price represented good value, then you need to seriously consider selling without delay. This is especially true if the share price is well above the Intrinsic Value as calculated by USAStockValuation.com, or another reputable source.
We at USAStockValuation.com love quoting Warren Buffett. We find his words both enlightening and humorous. With regards to holding poor quality businesses in your portfolio, 2 of Warren’s quotes ring true to us:
"The most important thing to do if you find yourself in a hole is to stop digging."
"Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."
A popular and valuable tool we recommend our subscribers adopt is to keep an investing log book or diary. At the time of purchasing shares in a company, list the reasons why you want to buy a part ownership of that particular business. What makes it worthy of your hard earned money? If at any time in the future you are considering selling, review those buy reasons – if they still ring true then the business is probably still in good shape and a sell consideration may be unwarranted. At the time of buying it is important also to list the risks or threats to the underlying businesses. Re-assess the risks regularly for as long as you own the stock.
For example if you identified a risk to a retail business to be the possibility that their online shopping platform will not compete with other online vendors, and after holding the stock for a period of time you discover that their online sales are not growing, then you may want to consider selling. Another example might be a defense contractor that you invested in and you identified the risk that the US military’s budget will be cut in the future. You accepted that regulatory risk when you bought into the company. But if after holding for a while you discover that indeed the military budget is being cut, you may need to conduct some analysis on the implications of the budget cut – will it be temporary? What area of the military will the budget cuts apply to? Will it affect the company’s earnings? If so by how much? Is it a temporary challenge that the company is likely to work through? If you assess that the implications on the business are considerable and permanent then you will need to sell.
Sometimes a regulatory change that seems at first to negatively impact a company, may actually make the company stronger: If the company is a big player and has a strong balance sheet, chances are it may be able to buy out some of its weaker competitors during an industry wide downturn, making the company even bigger, stronger and better placed to capitalize on the next industry upswing. And during an industry wide downturn, shareprices fall offering attractive opportunities for investors. So you need to do your research on the individual company in question.
Some other reasons to consider selling:
Management begins to make some poor decisions, or other indications point to a deterioration in the quality of Management
The quality Management that was in place has resigned
Regulatory or macro-economic forces are acting negatively on the business, deteriorating its long term performance or competitive position
You need the cash! Of course we don’t recommend selling and using the cash to go on holiday at the expense of your investing and financial goals. But if the holiday sits within your overall goals, not at the expense of them, then enjoy!
A better opportunity has come to exist (be careful on this one – see the example below!)
The shareprice has risen above the Intrinsic Value – perhaps a good time to sell and lock in your profits
As a rule, you should never sell on market panic. If the company’s economics are still sound, there is no reason to consider selling. Selling after a bad quarter or after a profit guidance downgrade is typically a bad idea. Conduct your own research – is the profit downgrade a sign of things to come, or is it due to a temporary occurrence?
Of course, selling creates a capital gains tax liability. One must have a high degree of confidence when selling in order to invest in a better opportunity, that the new opportunity will provide a better return that the existing. If the new opportunity is not better than the existing, let’s say it is exactly the same, the difference can have a compounding effect. Let’s look at an example:
Let’s look at Christina and Anna. Christina and Anna both have investments that they purchased a few years ago for $10k and they are now worth $20k. Both investments are making a 15% annual compounded return. Christina decides to sell her investment because she reckons she can make more than the 15% return elsewhere. As it turns out, Christina was wrong, and her new investment produces just the same return – it also makes 15%. Using a capital gains tax of 20% for both, not considering brokerage fees, let’s compare their situation 10 years on:
Sells at $20k for a $10k profit, and she pays 20% capital gains tax on the $10k profit. Tax = $2k
Buys a new investment with her $18k returning 15%
After 10 years her $18k compounded at 15% is worth $72.8k
Keeps her investment worth $20k returning 15%
After 10 years her $20k compounded at 15% is worth $80.8k
Anna is clearly better off than Christina in this situation, simply because she held. The above example is amplified if Christina buys and sells frequently (i.e. “trading”) while Anna simply holds. The difference in returns can be significant. The above example is something that all investors should be aware of and it goes a long way to explaining why Buffett’s favorite holding period is forever. If you are invested in a good company that is making you, say, 15% per year, you need to be very sure that another opportunity is a truly fantastic one before you switch.
If a company’s competitive position is deteriorating, you need to sell out ASAP. Websites such as yahoo finance or seekingalpha.com etc that provide you with information on the company in question are invaluable – you can keep a close eye on each of your holdings. You can get news releases on your stock holdings delivered to your inbox for free, and you can view immediately on your phone or at your computer. Many people each day look at the share price of their holdings: “oh wow XYZ’s shareprice is up almost 1% today”! But what they should be looking for are any announcements or news articles on the business or industry conditions of the underlying company.
Some people say that the question to ask if you are not sure on whether or not to sell or hold is “would I be willing to buy into this business if I didn't already own it?” We at USAStockValuation.com believe that while this strategy has merit, we don't agree with all of it. We like to buy a great company when it is trading at a discount to Intrinsic Value and sell when it is trading at a premium to Intrinsic Value. There is a window in between where the stockprice might be trading for example at about its Intrinsic Value where we would not be interested in buying into the stock, but we would be happy to hold. But as mentioned above, keeping an investing diary and regularly revisiting why you bought into the company in the first place is valuable and important.
And remember that knowing when to sell is far more difficult than knowing when to buy, and you will make mistakes. Focus on making informed, rational and well thought out decisions.