As a value investor, two key decisions make or break your investment
success. You have to know when to buy a stock. You also have to pick the
right time to sell the stocks
you own. Both these decisions can be fraught with self doubt if you
still seek validation from the market behavior to justify your actions.
Generally, what may stop you from buying into a great undervalued
opportunity is fear. You will worry that there is a reason unbeknownst
to you for the stock to be beaten down so much. It takes a history of
taking counter market positions successfully to finally ingrain the self
belief and confidence in your own analysis. Contrary to popular belief,
the market is not always right.
Still, there is only ever one reason to buy. Valuation. There are however, multiple reasons you may chose to sell a stock
We are often told that there are only two valid reasons to sell a
stock. Either the stock has become over valued (hopefully it is via
stock price appreciation, not intrinsic value
erosion), or you are able to replace this stock with another one that
offers a more compelling value. This is true in theory. In reality,
things are not as black and white.
When to sell stocks and when not to? Let’s consider some scenarios
The following presumes that you spent time forming an investment
thesis before you purchased the stock. This involves figuring out the
intrinsic value of the stock and determining the level of
undervaluation. This also involves understanding the business, forming
hypothesis around the future possibilities and scenarios under which the
value can be realized, running a host of what-if scenarios to see the
impact on the business and your investment, listing sources of business risk,
looking at the baggage the company carries that may become a factor
later on (pending lawsuits, tax losses, looming senior management
retirement, etc). During the initial assessment, before you purchased your first shares,
you would have decided on the price you would sell at if the business
evolves the way you expect. I refer to this as a target sell price.
Price has appreciated above target and the business is performing as per expectation
This is probably the easiest sell decision to make. The only thing
you need to overcome is greed. When the business is performing well and
the stock price has risen, it is mainly because the stock has seen a lot
of new interest from other investors. The skepticism that used to
surround the stock has likely been diluted or in some cases, removed. It
is very easy to convince yourself that the good times are likely to
continue and the media will generally support your fantasy. However, if
you concern yourself with valuations and not the stock price, the
reasons for holding the stock are no longer there, so there is no need
to continue holding the stock.
Price has appreciated above target sell price and the business is performing better than expectation
This is generally a hard choice for most investors to make for a
simple reason that they have no idea what their expectations are/were.
Suppose that you bought the stock when the business was unprofitable and
now it has strung together 4 quarters of profitability with over 20%
earnings growth. The stock price has responded as well and has gone
above your target sell price. Should you continue to hold, sell, or even
buy some more?
As you can imagine, there is a value in the future growth prospects.
Majority of the time, this value is hard to quantify with any reasonable
confidence. What is likely to have happened is that if the business has
performed better than your initial expectations, the balance sheet is
much stronger now. In this case, a reasonable valuation judgment can be
made to support holding the stock or even purchasing more in some cases.
In cases where the market has become very excited about the growth, it
is likely that the stock price appreciation has been faster than the
improvement in the business fundamentals, eroding the value argument.
When a stock starts to be treated solely as a growth stock, it is often
time to sell.
Business has deteriorated
When business goes from bad to worse, the stock price often follows.
The knee jerk reaction is to sell the stock to protect against further
losses. The rational decision might very well be to purchase additional
shares or do nothing. It all depends on the specific conditions and your
own read on the situation. We will break this down in 3 separate cases.
Case 1: The value remains and there is a good possibility of a turnaround
In this case, you have likely seen the stock price decline more than
the decline in the intrinsic value of the stock. When you are confident
that the turnaround will take hold, you should purchase additional
stock. Keep in mind that a turnaround plan when announced is still an
intangible and does not do much to remove the risk. You need to be able
to see some positive results once the plan is put into operation to make
a rational decision. If you worry about “it might be too late to buy if
you wait” then you are not investing but speculating. In investing,
risks need to be minimized.
Case 2: The value remains, but you are no longer confident that the value will be realized
Sell the stock. You may turn out to be wrong and the stock may end up
performing really well, but the risk is not worth it. There is a rule
in investing that is almost never talked about – make a decision, make
it fast and stick to it. Over time, you will become much better at
making these decisions and you will learn to trust your business
instincts as they become better developed. Dithering on the decision
will almost always result in ugliness. You cannot win in this case in
the short run, but in the long run this will instill correct decision
making behavior which will more than repay you for the short term
losses.
Please note that indecisiveness is NOT the same as patience. Patience
is a conscious choice, while indecisiveness is a lack of choice.
Blackberry (BBRY)
is a case in point where some investors are confident of a turnaround
while others are more pessimistic. The company has enough assets and
intellectual property to justify a greater share price. The future stock
price though depends on whether the company is able to turn itself
around, which in turn is dependent on its current CEO John Chen. Most of
the investment thesis for Blackberry right now boils down to how much
confidence you have in the new CEO.
Case 3: Business has deteriorated and the value has been destroyed
In short, the stock has become overvalued, the management has proved
to be incompetent, and/or, the competition is becoming unmanageable.
There is no real reason to keep this stock in the portfolio. Sell.
You found a significantly better opportunity
It makes rational sense to replace a stock that currently offers 30%
margin of safety with a new stock that offers 40% margin of safety. In a
way, the margin of safety indicates not only your risk, but also the
future appreciation potential (not always, see below). Before you do
this, please remember what exactly does margin of safety represents.
You choose to buy a dollar for 60 cents (40% margin of safety)
because you recognize that your estimate of $1 intrinsic value is
approximate, and in some cases maybe completely wrong. There are many
things you can estimate, few things you can predict and very little of
unexpected future business twists you can yet imagine. Mistakes are also
known to be made by the best of us.
In practical terms, you have no idea which is better when you compare a 30% MOS stock with a 40% MOS stock.
In some cases however, a 30% MOS stock may be better than a 40% MOS
stock because you may know of a catalyst that will accelerate the
realization of the value in a 30% MOS stock much sooner than the other
one. A 20% return in 6 months is better than a 100% return in 5 years.
In cases where these kind of catalysts may not be apparent, I
recommend a minimum of 50% improvement in potential annual returns in
the new stock before you switch out the old stock in its favor.
You have waited too long already
The value may still be intact, but it has been a few years since you
bought the stock and you have not yet seen any reasonable return. If you
were looking at this stock now for the first time, you will rationally
decide to purchase it. But you have wasted all this time already. So
what to do?
About 95% of the advice on this site will tell you to forget the
past. It has no bearing on what you should do now or in the future
(other than the lessons learned). All that matters is the price versus
value equation today.
But there is still an uncomfortable possibility that you may have
made a mistake in the analysis of this stock and might be continuing to
make the same mistake. Or the management is not really working to
maximize the shareholder value – upon which whole investment paradigm
rests. This may turn out to be a value trap. In reality, there is no way
to identify a value trap a priori. All you can do is to break out of this trap when you do realize it.
Whatever the case may be, you should set a maximum time period for
which you will wait on a stock to start showing positive returns. If it
does, and there is a case to be made, you can continue to hold the stock
longer. If it does not, sell and move on. Sure, the stock might double
the day after you sell (most of the time it won’t – believe me, the rare
instances this happens sticks in your mind and makes this seem like a
trend), but the opportunity cost of having your capital locked up in a
non performing asset is too great. You won’t do this in your business
and you should not do this in your investment portfolio. My
recommendation is 2 years.
There are corporate events or changes that you do not agree with
If there is a new CEO and you do not like him/her for good reasons,
sell. If the company makes a business move you feel is counter
productive, sell. If you value ethics above all and feel the management
falls short of the standards you require, sell. The point is that you
need to be able to think like a business owner when you buy a stock. You
should not switch your persona back and forth between a business owner
and a speculator to suit the context. This will just make your thinking
muddled and you will lose the big picture. It is very exciting to try
and hit a home run every time, but what really matters is the long term
average you maintain.
The Market/Economy/Sector is out of favor pushing the stock price down
You bought the stock, you now own the business. As long as the
business makes sense, you continue to own it. You need to know enough to
distinguish between a temporary downturn versus a long term industry
trend. For example, many industries go through cycles and a long term
investor knows this and will make appropriate adjustments in his
holdings (buy more at the cycle down turn, sell once the cycle turns
up). In other cases, entire industries such as buggy whips might
disappear when a better replacement product comes along. If you own
stock in a company whose products are being obsoleted, and the company
has no credible plan to react, it may be a time to exit the stock (also
depends on the stock price/intrinsic value equation). In majority of the
cases, temporary market/industry/sector downturns are not enough to
justify a sell decision as long as the company continues to be well
managed and adapts.
Successful investing is a habit that needs developing
The list above is by no means complete, but covers a vast majority of
the situations you will encounter while making a sell decision.
Hopefully the critical message you take away from this is a buy or a
sell decision is a considered decision based on a set of principles and
processes that you have built and habits you have developed over time.
Any time you find yourself making a transaction as an emotional reaction
to certain events, you are doing it wrong. Sometimes, you will have to
accept that your choices may turn out to be wrong, but over a typical
investment horizon of a few decades or more, these processes, principles
and habits will pay off greatly.
Source: http://valuestockguide.com/valueinvesting/when-to-sell-stocks-in-your-value-investing-portfolio
