When Should An Investor Sell a Value Stock?
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When should an investor sell a value stock?
Warren Buffett once said that you make your profit when you buy, not when you sell. When you buy you select the price-value spread that you’re willing to accept and, ultimately, the amount of profit that you can realize from a given investment.
Some investors are happy to leave it at that and just focus on purchasing great investments but you still have to sell your holdings to realize any profit at all. It’s no wonder then that the question of when to sell is one of the most commonly asked questions.
Selling: An Investor Evolution
I never really had a set sell strategy for most of the time that I’ve been investing. At times I would look at the charts of my firms displayed on Google Finance and salivate over the profit I had made. At other times I would look at a holding that just wasn’t going anywhere and finally decide to dump the stock.
But both the mistakes I made and recent big wins caused me to sit down and think of the best possible sell strategies for deep value investors.
Unlike some pundits, I don’t think that there is a single set standard that investors should be using to set their sell decisions – investing is more dynamic than that. When it comes down to it, there are six main reasons why you would sell a stock. More on those ahead.
Should You Use Sell Rules?
Benjamin Graham certainly thought so. Here’s one he wrote about in The Intelligent Investor:
“The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase--say 50 to 100 per cent--and a maximum holding period for this objective to be realized--say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market.”
- Benjamin Graham
If Graham thought we should have sell rules, who are we to argue? Buffett also implements sell rules, though his are heuristics and much more qualitative than Graham’s.
Now on to those 6 solid sell rules. Let’s cover these first three positive reasons to sell a stock before moving on to the negative reasons.
Positive Reasons To Sell A Value Stock
1) The Price is at Unsustainable Levels
The basic concept of deep value investing is to purchase a dollar for 40 cents to allow for a margin of safety. Once that margin has eroded and the price of the stock has reached your estimation of intrinsic value it is time to sell.
If you don’t sell and haven’t lifted your estimation of intrinsic value then you are moving into speculation rather than investing. Your upside is likely limited and the downside is in jeopardy, a dangerous place to be.
Super investor Seth Klarman quipped that the intelligent investor has to sell when the birds are chirping. Klarman would sell just before a stock reached fair value to make sure he could lock in the gains.
A stock shooting towards fair value can entice other investors to get in on the action, increasing volume. As the stock approaches fair value this volume can fall off and the stock could even crash back down to bargain basement levels. So much for your profit.
That’s not to say that a stock won’t go up even after you sell it at fair value. This happens often enough to frustrate investors and cause them to doubt their own investment strategy.
As value investors, though, we use well-proven techniques based on mean reversion and price-value discrepancies to profit in stocks. Holding on past fair value means abandoning what’s worked so well in favour of …something else -- momentum, charting… greed.
2) There Are Better Opportunities Elsewhere
Selling for positive reasons is by far the easiest to deal with. This can take two forms, either there is an investment offering a better return or, the stock has done what the intelligent investor wanted it to do and has become fully valued.
Take Home Depot, for example. Back in the dark days of 2009 I coached my dad into buying Home Depot at just under $30 per share. At the time investors were busy dumping shares and stocking up on canned foods. The last thing they wanted was to own a mega cap home improvement stock during the middle of America’s largest housing busts and a looming financial market meltdown.
Looking at the numbers, home sales dried up and new housing starts were at a level not seen since the 1990s. Home Depot was facing some serious headwinds and this was depressing the stock quite a bit. Even acknowledging the frothy market from 2003 to 2007, the company had very solid earnings over the last 10 years and was clearly undervalued.
At the time I calculated Home Depot’s value to be somewhere around $60 per share. That meant that one of America’s premier businesses was trading at a 50% discount to intrinsic value – a very rare event in my lifetime. Unlike net net stocks, which often trade at less than half of net high quality assets, good companies rarely dip down to these levels.
Fast forward a couple years and Home Depot rose, as expected, up to fair value. At this point it would have been a wise decision to get out of the stock. Once a holding reaches your estimate of fair value, your investment thesis has played out. Unless you have a new estimate of intrinsic value arrived at through very solid reasoning and data then you’re best off selling the stock.
More Reasons To Sell A Value Stock
We covered the positive reasons for when an investor should sell a stock, but investing is not all sunshine and rainbows. Here are three negative reasons why you would want to sell.
3) You Have Made a Mistake
Making mistakes is inevitable in investing, but it is important to act quickly and learn from them. This will help you avoid losses before they materialize or grow. If after buying a stock you realise you have made a mistake, you should sell even if that means taking a loss. By following an effective investment process, mistakes can be minimised but you should act decisively if you find your analysis is flawed in any way.
4) The Thesis Has Changed
Sometimes something happens that makes you reassess your original judgement of the firm's risk-reward ratio. Something has either caused you to call your assessment of the firm's value into question or the risk that you're assuming when making the investment. Perhaps your standard for value -- the comparative value of other firms in the industry, interest rates on corporate bonds, etc -- have shifted which tips the balance unfavourably.
On the risk side of the equation, maybe management lets investors know that it's currently holding a lot of questionable mortgage instruments. Maybe sales shift so that, rather than the same 30% seen in the previous quarter, 70% of your housing contractor's sales are now coming from one customer. Both of these substantially increase the risk of your holdings and the intelligent investor may be wise to cash out.
5) Deterioration Continues
It's possible you'll find a great value stock, have a lot of conviction about it, and then after a while watch the gap between price and value close. Unfortunately, the gap closes in the wrong direction -- the intrinsic value of your firm has shrunk to match the firm's selling price rather than the market price of the firm rising to match the firm's value.
Maybe the net net stock was losing its NCAV little by little while the price failed to advance. Maybe the firm has lost a major customer, devastating the firm's income stream. Maybe the company decided to issue a large number of new shares or options, burning current investors in the process. Value erosion happens to the best of us and the only thing the intelligent investor can do at this point is sell the problem holding -- although best avoided in the first place.
6) It's Just Time to Say Goodbye
Sometimes things don't look too bad but the stock price hasn't budged. Your stock is still well below fair value and you just can't understand why.
It may be true that eventually price and value converge -- but sometimes waiting for that convergence can be devastating and bring down your returns. These types of situations are perfect candidates for review and possible sale if your thesis has changed or the fundamentals have deteriorated detrimentally.
A Mechanical Investment Strategy?
A mechanical investment strategy can help overcome two of the biggest pitfalls when it comes to investing -- fear and greed. More accurately, people are not perfect number-crunching robots. We're extremely fallible, especially when it comes to investment decisions. The chief drivers for investment errors are ego and the impact that emotion has on our behaviour.
To get around this, investors sometimes adopt strict mechanical investment programs. This is very similar to what Benjamin Graham recommended in his book, The Intelligent Investor. Mechanical strategies can work fairly well to eliminate the impact of emotions, and other biases, on investment decisions.
This brings up an obvious point -- the intelligent investor should sell a value stock if he's following a mechanical investment strategy and specific metrics are achieved which satisfy his strategy's sell requirements. In this case, almost no matter what the reason, holding on to your value stocks would be a bad move.
When Not To Sell
Sometimes it can be easier to invert the question to narrow down the range of options and to avoid analysis paralysis. There are two definitive reasons why you should not sell a stock.
Firstly, a stock shouldn’t be sold because an unexpected bill arrives or an emergency occurs. Before you start investing you should pay down and eliminate any bad debt, have an emergency fund of at least 3 months expenses and only invest your truly free capital. If you have to sell because of an emergency, you may end up selling at a bad time ensuring disappointing results -- but this would obviously be a better option then taking on debt.
The second is that you shouldn’t sell because you are bored or your patience has run out. The most important attribute for successful investing is patience, patience and more patience. This is a characteristic that the majority of investors do not possess but is vital for long term success.
The stock does not care if you are bored or the penny has lost its shine. Avoid selling because of boredom or a lack of patience at all cost. Otherwise it might be hazardous to your financial health.
Final Thoughts About Selling Your Stocks
When you think about selling a stock – start by restating your reason for buying the stock.
Does this still hold true? Are there any better opportunities available? Has your thesis played out and is the stock trading at intrinsic value?
Selling a stock wont help to fix a poor investment decision but it will kill a good idea. Approach selling with as much consideration as you would buying an investment and have a plan in place before you do.
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Article image (Creative Commons) by 401(K) 2012, edited by Net Net Hunter.
