So far Downside Protection Report has focused on finding good stocks to buy and bringing them to you. We have assembled a portfolio of ideas that has trounced the broader market (see scorecard on page 8). As our featured ideas hopefully make money for you, the question of when to sell becomes increasingly important.
Knowing when to sell a stock that has outperformed is no small task. The danger is dual: We can either sell too early, foregoing future gains; or we can sell too late, giving back the gains we have enjoyed on paper. There are additional wrinkles that complicate the decision to sell, including taxes and broader portfolio considerations.
Selling too early is a common “mistake” of value investors. While we make money on undervalued stocks that become less undervalued, we also frequently “leave money on the table.” Avoiding this predicament is difficult, perhaps even impossible — for it’s the same value-driven mindset that gets us to buy an undervalued company and to sell it when it trades closer to fair value. If we could hold onto a stock as it rises in price from fairly valued to overvalued, we might lack the mindset that allows us to buy the same stock at a bargain price in the first place.
Selling too late is rarer among value investors, but the danger exists nonetheless. We have a tendency to hang onto something that’s been good to us — a winning stock falls into this category. We may become emotionally attached or view a stock as our idea. The pain of selling and then seeing someone make more money from our idea might be too much to bear, influencing us to hold onto a company too long. There’s also the danger of keeping losers around merely because we want to break even. Facts, rather than “mental accounting,” should dictate the timing of a sale.
This brings us to two companies that we’re putting on the sell list this month — PDL BioPharma (NASDAQ:PDLI) and Sierra Wireless (NASDAQ:SWIR). Whether or not to sell is a “good problem” in each case, as PDLI shares have gained 15% since we featured them in our July 13th issue, while SWIR has gained 192% since March 23rd.
In the case of PDLI, while our analysis remains intact, one of the key validations of our work is no longer in place: Seth Klarman’s investment. When a superinvestor like Seth Klarman of The Baupost Group sells a company we own, the question must be, “How confident are we that we either know more than Klarman, or that our judgment is superior to his, or that he was selling for non-fundamental reasons?” In the case of PDLI, prudence requires us to take our gain and move on.
In the case of Sierra Wireless, we have obviously enjoyed a strong gain in a short time, and we hope you have as well. We simply cannot make a no-brainer valuation-driven case for Sierra any longer, even as the company has many other things going for it.
Finally, just as with buying a stock, the decision to sell must be driven by your own particular circumstances. There may be tax or other considerations that make holding onto a stock the correct decision, even if the valuation gap has narrowed.
Disclosure: No positions.