Selling
There’s a time to hold ‘em and a time to fold ‘em.
Philip Fisher summarizes his approach to selling: “If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” (Fisher, 1958,1996)p.113. If the reader hears echoes of Warren Buffett it’s actually the other way round. As I’ve noted elsewhere Fisher was a great influence on Buffett. See Sections 25.20 Warren Buffett and 25.21 Philip Fisher.
Here is a proven list of do’s and don’ts:
1. If your original purchase decision was mistaken, you should sell.
Fisher’s first reason is both the most important and the most difficult to deal with. If the investor has made a mistake in their original appraisal of the investment merits of the company, the mistake must be recognized and acknowledged as soon as possible and action taken.
Fisher points out that the proper handling of this situation is largely a matter of ‘emotional self-control. To some degree it also depends upon the investor’s ability to be honest with himself.” (Fisher, 1958,1996)p.105.
He adds that ego can come in the way and that: “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” (Fisher, 1958,1996)p.106.
The situation here is typically ‘your first loss is your best loss’.
When one buys an unloved stock at a bargain price, one has to be prepared for a fair bit of time to go by before your wallflower becomes the belle of the ball. This is where patience is important. In the meantime, you may have to suffer through many disparaging comments about the company and the sideways glances of acquaintances who know you hold the stock. In these situations, it is a mistake to sell too early.
On the other hand, if your wallflower turns out to be a toad in disguise, one should not hesitate to sell it.
2. The second reason Fisher gives for selling a stock is that circumstances have changed and the company no longer meets the investor’s rigorous criteria.
Fisher points out that this is why it is important to stay in touch with the affairs of the companies in the investor’s portfolio. Fisher notes that management’s former drive and ingenuity may be replaced by smugness or complacency or inertia. Alternatively, the prospects for increasing markets for the company’s products may dim. The company may no longer be taking active steps to renew the company and its products in a changing world.
When the company you firmly believed in starts to lose its way, your psyche can come under siege.
This of course is bit like the proverbial frog in the pan of water on the hot stove. How hot does it have to be before it will jump? We looked at the behavioral biases at play in Chapter 12. Short Term Thinking and our Flower Garden. The biases at work may be Sunk Cost Fallacy, Confirmation Bias, Disposition Effect, Endowment Effect, Anchoring and Narrow Framing.
The rule is simple. When a company no longer fits your high standards or the business has lost its edge or you have lost confidence in management – sell immediately. Don’t wait for a rally. This is a gap-to-edge rule.
We need to make a distinction between losers and losses.
If the rule were simply that a reduction in the price of the stock by a certain percentage should trigger a sale, the advice is wrong.
If the price of the stock goes down and the investor concludes after careful thought that the company is no longer a sound investment, whether because of a change in circumstances or because the investor realizes the original assessment of the company was mistaken or for any other sound investment reason based on the business of the company and the value of its shares, the shares should be sold. The company has become a loser.
The sale is triggered by the company becoming a loser, not by the shares showing a loss.
3. Fisher’s third reason for selling a stock is to take advantage of an attractive opportunity
It won’t occur very often. That is because ‘opportunities for attractive investments are extremely hard to find.’
The dilemma is that they may be found when the investor has limited funds available for investment. In theory the investor’s portfolio will always be composed of superb companies that the investor knows well. Mistakes and changed circumstances will already have been pruned.
John Templeton offers his Maxim 17: “The time to sell an asset is when you have found a much better bargain to replace it.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.153.
Warren Buffett weighs in on this subject: “Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better. We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be “You can’t go broke taking a profit.”)” (Buffett, 1998, p.65)
Buffett’s ideas can usefully be compared with Fisher’s set out above. Buffett is prepare to sell a holding to invest in another that is ‘still more undervalued or one we believe we understand better’, whereas it seems Fisher might not.
4. Selling to generate cash to live on
The investor should look at their return on investments as a total return, inclusive of dividends and capital gains, whether realized or not.
If one cannot live from dividends alone and one is forced to sell some equities to produce the cash to live on, so be it. If the investor is using a discount broker the commission cost to sell a few shares from the portfolio on a regular basis is minimal.
Some advisors recommend holding sufficient cash to cover living expenses for, say, two years. This is foolish. It either sterilizes a substantial portion of the portfolio or causes investors to pick a time to sell that may or may not be at a good time (timing the market is bad).
There are two benefits to selling shares in smaller amounts on a regular basis. Most investors are aware of the concept of dollar cost averaging in buying shares. Over a working lifetime investors do this naturally whether they plan it or not. Money is saved each month or year and regularly invested in the slowly building portfolio. This tends to smooth out the peaks and valleys in the market.
When one retires, the regular sale of shares to generate money to live on is what one might call dollar price averaging. Regular but small sales tend to average out the prices obtained over an extended period of time. It tends to smooth out peaks and valleys in the timing of buying and selling.
A second benefit to selling shares in smaller amounts on a regular basis is that one can use these sales to gently rebalance the portfolio using the selling principles discussed in the Motherlode.
5. Selling when individual position too large
I have a general rule that I will not let a stock become larger than fifteen percent of my entire portfolio.
If one of my stocks advances to this level I will sell it back to ten percent. My concern is about catastrophic idiosyncratic risk. I think here of situations like the oil spill in the Gulf of Mexico experienced by BP. It came completely out of the blue and caused a massive loss to shareholders. Such a risk is present in all companies. Consumer products can become contaminated by vandalism. A rogue trader can destroy a bank.
My comfort level is at about ten percent of my financial holdings in any one position. Between eleven and fifteen percent I become increasingly concerned.
6. Selling when the company makes a big acquisition
The question is whether management is engaged in ‘disworseification’ (to use Peter Lynch’s expression) or foolish empire building. Many acquisitions end poorly. Your company can over pay for a reasonably well chosen target. This would be poor capital management and dilute your interest.
But, there is no rule that says you should sell when the company makes a big acquisition. What you must do is reassess your investment in the company. It is something you should turn your mind to immediately.
Sometimes a company’s stock price reacts quite badly to an acquisition. This is not a signal to sell. On the contrary. It may provide an opportunity to buy more shares.
7. When the company is to be acquired by another company
What is referred to here is when a takeover bid is made for all of the company stock.
The finer question is whether to wait for the bid to close and take the cash or shares offered or whether to sell into the market when the share prices goes up close to the bid price.
There is no definitive answer. It depends. If the closing is some time away and the investor has a good alternative investment to place the money, then selling into the market at a modest discount to the bid price can make sense.
Or, perhaps there is some doubt as to whether the bid will close. It may be better to sell into the market and move on.
There may be times when the investor likes the company offering its own shares to pay for his shares in the company being acquired. In such a case the investor may choose to continue to invest in the acquirer.
8. Selling when company changes its business model
When the company’s business model has changed there is every reason to fundamentally re-examine the investment. It is not reason, by itself, to sell.
9. Selling when balance sheet turns for worse
If the company’s balance sheet is deteriorating it is time to reappraise the investment. The first question, of course, is to ask why. The company may be investing in the company’s business for the future growth. The company should have been earning a sufficient return on invested capital to have more than enough cash to invest for the future. But, the company may have to take on a one time large amount of long term debt for a special capital investment. This needs to be assessed.
If the added debt is the result of an acquisition you certainly have to assess whether the combination of the acquisition and the added debt mean the company no longer meets your rigorous investment criteria. You may decide the company has taken on debt it can easily pay down to take advantage of an outstanding opportunity.
Or the company may have decided to leverage its balance sheet to improve its return on shareholders’ equity. This may or may not be prudent. Again, a fundamental reappraisal is called for.
10. Stock price rockets up in short time period
Just because the stock price has run up quickly is no reason to sell at all. This applies even if the stock’s price becomes fairly rich. Really wonderful companies will often get overpriced and selling means losing a position in a first rate company. It may be different if the price is really rich and you have another wonderful company you want to invest in available at a good price.
11. Commodity sector
Philip Fisher’s and Warren Buffett’s approach to evaluating companies can only partly be applied to mining and oil and gas companies. Because of their cyclical and commodity nature and because they can be extremely volatile, I tend to lighten up on these stocks once their stock prices get well beyond their Net Asset Values and be a buyer when they can be bought at cents on the dollar to Net Asset Values.
12. When controlling shareholder sells some shares
What should one do when a controlling shareholder sells some of his shares? The first thing to find out is how many shares they continue to hold after the sale.
If they continue to have a major personal common shareholding it may not be a concern. One can sympathize with a founding shareholder with all their net worth tied up in the company’s common shares. It may simply be prudent for them to lighten up while still holding a major stake.
I regularly monitor the shareholding of directors, officers and controlling shareholders. I have sold entire positions if I felt that the directors and officers were losing their commitment to the company.
13. Don’t sell just to take a profit
Fisher put it this way: “Willingness to take small losses in some stocks and to let profits grow bigger and bigger in the more promising stocks is a sign of good investment management. Taking small profits in good investment and letting losses grow in bad ones is a sign of abominable investment judgment. A profit should never be taken just for the satisfaction of taking it.” (Fisher, 1958,1996)p.277.
14. Don’t sell just because the price has moved above intrinsic value or is overpriced
Fisher canvasses all the arguments. He says that many investors argue they will get back into the stock when the price has come back down. He points out that most investors in his experience will not get back into the stock except above the price at which they sold. His main reason for not selling a stock which has gone up considerably is that he wonders how anyone with even moderate precision can tell what is overpriced for a superb company that meets all his investment criteria. He also points out that capital gains taxes will have to be paid in ordinary investment accounts, which ruins the investor’s ability to let the unrealized gains compound tax free.
15. Don’t sell because the price earnings ratio has gone up
Some strategists say to sell when stocks you have bought because they had low price earnings ratios, low price to book ratios or low long term debt or high return on equity and they no longer have these attributes. This is a variation on the same theme as the previous point. No need to repeat. If the advice is from a broker, you know it will generate commissions.
16. Don’t sell because the stock has reached a price target
Stock brokers often recommend price targets when buying a stock. A price target is a price you determine when you buy a stock at which you will sell it.
This is insidious advice. Brokers will recommend price targets to encourage their clients to sell. This will generate a commission when the sale occurs and another commission when a replacement security is purchased.
17. Don’t sell in anticipation of a market downturn
Fisher was quite clear that one should not sell in anticipation of a possible market downturn. He wrote: “Even if the stock of a particular company seems at or near a temporary peak and that a sizable decline may strike in the near future, I will not sell the firm’s shares provide I believe that its longer term future is sufficiently attractive.” (Fisher, 1958,1996)p.260.
A strategy of selling all one’s stocks when the whole market seems seriously overpriced is considered by Andrew Smithers. He notes that: “Historically, there have been only five peaks in the market’s overvaluation since 1900… The average time between peaks has been 24 years but the average is far from regular and each of the last two swings has taken over 30 years from peak to peak.” (Smithers, 2009)p.78.
After examining the data and calculating the extent to which the stock market can become overpriced without it being worthwhile switching to cash, he concludes that: “only twice has the market become so overvalued that it was worthwhile selling on either of these assumptions [the expected return on equities and the expected return on cash]: the first time being prior to its 1929 peak and the next prior to the peak in 2000.” (Smithers, 2009)p.78.
18. One should move to cash once a true manic stock bubble has been identified
This topic is covered extensively in Chapter 29. Bubbles, crises, panics and crashes of the Motherlode. There is no need to repeat it here.
At a certain point, sooner rather than later, in a true bubble, going to cash or short term bonds is the right thing to do.
Selling and moving to cash or short term bonds does have one negative feature. It puts the investor out of the market for a period of time and the investor will lose touch with the companies they are following. I experienced this in 1998. I sold ninety percent of my stocks and went into two year government bonds. By the time I wanted to get back into the market in 2002 I was out of touch with all the companies I had previously been following. Partially as a result of this, my re-entry to equities in 2002 was not especially smooth.
19. Don’t sell because a stock price has gone down
Stocks lagging in price may fall into one of a number of categories:
The weak price performance may reflect overall stock market conditions. It may be a weak relative price performance that reflects weak industry or sector conditions. It may be some temporary issue affecting the company or a large shareholder trying to sell shares for reasons unrelated to the merits of the company. Or, it may be a sign the company is starting to falter.
Price pullbacks may signal it’s a time to sell or to do nothing or to buy more stock. But, if it is simply the price that is faltering, this alone is no reason to sell.
After reciting the vicissitudes of a particular major American company over a period of years, Benjamin Graham notes: “There are two chief morals to this story. The first is that the stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies’ performance like a hawk; but he should give it a good, hard look from time to time.” (Graham, 1973) p.107.
There will be significant fluctuations in the price of individual stocks in one’s portfolio, but this is background noise. Against this noise the investor must monitor their portfolio to detect signs that the superb companies in their portfolio have not or are not deteriorating in character and quality. Where quality has deteriorated, the investor should not hesitate to sell.
And, as always, what the investor paid for any stock is utterly irrelevant.
Want to read more about the issues raised in this post, take a look at Part 7: Building and managing a portfolio .
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