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 know when to sell 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, when to sell stocks is not an obvious decision.
Under which of the following situations will you sell stocks?
- The market/economy/sector is becoming out of favor pushing the stock prices down
- You bought the stock at a discount to your estimate of the intrinsic value and the stock price has continued to decline and is dragging down your investment portfolio
- You found a better opportunity that offers a 40% margin of safety compared to 30% you are getting today
Buying stocks online is not complicated
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.
Scenario 1 – Stock 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.
Scenario 2 – 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.
Read more: terms in stock market
Scenarios 3-5 – 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.
Scenario 3 – 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.
Scenario 4 – 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 if you are investing for the long term, know that 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.
Scenario 5 – 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.
Scenario 6 – Consider selling stocks when you find a significantly better investing 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.
Scenario 7 – You have waited too long already to sell the stock
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 stock market 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.
Scenario 8 – There are company 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.
Scenario 9 – 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.
Develop Good Financial Habits to Invest Successfully
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.
Finally, instead of selling stocks and incurring tax consequences, consider donating your appreciated stock to charity. This will take care of your charitable contributions and avoid capital gains taxes at the same time.