Part 6 in a series of tutorials on value investing: Knowing when to sell can be hard. It doesn’t have to be.
Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The Investor’s Toolkit
Part 4: Building a Valuation Framework
Part 5: Hitting The Books
Part 6: When To Sell
Buying Is Easy, Selling Is Hard
Investors often struggle with when to sell their stocks. Psychologically, buying is relatively easy. If you’re buying a stock, you must feel good about its prospects. There’s optimism, hope, excitement. Overall, buying feels good. Even for a contrarian value investor who is often buying companies that would make many people squirm, there is still the hope that you have outwitted the rest of Wall Street and are picking up a bargain.
Buying then, is relatively easy. Selling is harder.
For a value investor, the discomfort can paradoxically start when the price of a stock you own jumps up. Until you’ve actually sold, those gains are merely paper profits. The price of a stock can often move up only to drop again days, weeks or months later. If the price has moved up 30 or 40 or 50 percent from where you bought it, you start wondering if you should sell to lock in those profits. If you do, you might be patting yourself on the back a few weeks later if the price drops back down again. But for every time your quick profit-taking looks like a brilliant move, there will be another time when the share price keeps climbing, sometimes by many multiples of where you sold it at and you’ll be gnashing your teeth in frustration that you sold out way too early.
Likewise, if a stock’s price drops from where you bought it, you can face a similar dilemma. Do you sell out quickly and limit your losses? What if the drop is a temporary dip and you get flushed out of what could have been a wonderful investment? But if you hang on and the price keeps drifting lower, when do you pull the plug? If you wait too long, you might start feeling trapped in this money pit. The fear that the stock may be in the process of bottoming out before making a big comeback could keep you paralysed with indecision. You don’t want to be the sucker who sells the stock right at the bottom but you also don’t want to be the fool that rides the thing all the way to zero.
Just as buying can be associated with positive emotions like hope, excitement and greed (is it okay to call that a positive emotion?), selling is often associated with negative emotions like doubt, fear and regret.
My best advice when it comes to selling? Relax.
Why Selling Doesn’t Have To Be Hard
I believe your selling decision is far less important than your buying decision. It’s the initial purchase decision that drives the bulk of your long-term performance. When you sell is relatively immaterial. Focus on buying companies at rock bottom prices and the rest will take care of itself.
I often look at valuations as following a random walk, similar to the path a drunken reveler might take on their way home from the bar on a Saturday night. They weave this way and that, sometimes moving higher and sometimes moving lower, often without any identifiable reason. (The term “valuation” is just a fancy word for some measure of a company’s intrinsic value. If you’re using the 5 year p:e ratio to value stocks then a low valuation just means a company with a low 5 year p:e and a high valuation refers to a company with an excessively high 5 year p:e.)
When valuations swing too far in one direction, to the undervalued end of the scale, that’s when I buy. From there, I have no control or insight as to the exact path valuations (and the stock price) will take. The stock may quickly rise to what I would consider its fair value or it could spend a fair bit of time meandering along the undervalued side of the street. It could easily overshoot and move into overvalued territory at some point. Maddeningly, it could get to within a whisker of what I think would be a fair price, only to slump back down again. Sometimes there is an obvious explanation for the stock price movements. A disappointing earnings release, for example, or a positive analyst report. But most of the time, a stock price’s fluctuations seem fairly random.
Given this reality, it doesn’t make a lot of sense to tie yourself in knots trying to time the perfect exit point. Decide on an easy to implement selling strategy and stick with it.
Buy When You Sell
The easiest strategy and probably the most logically defensible one is to wait until you’ve identified a new, undervalued opportunity and then sell one of your less undervalued stocks to raise money for the new purchase. Spend your time focusing on what really matters: the hunt for new deeply undervalued stocks. When you find a situation you like the look of then use that opportunity to evaluate your existing portfolio (considering all the latest company developments) and get rid of your least undervalued holding. If you’re using a 5 year p:e ratio as your yardstick of value then simply sell the holding with the highest p:e ratio and replace it with the lower priced newcomer.
If you’re continually updating your stock holdings in this manner then you’ll always have a portfolio that is primed for success. This takes away a lot of the indecision and emotion from the selling process. Let your sells be driven by your buys and always cycle from less undervalued opportunities to more undervalued ones.
The key here is to focus on the valuation of a stock (using a framework like the 5 year p:e), not on the actual stock price movement. The stock market doesn’t know or care what price you bought a stock for. Whether the price is up or down from where you first bought it at should have absolutely no bearing on your selling decision. Consider only what the current value of the company is after taking into account all the latest corporate information. Then sell whichever of your holdings is the least undervalued. Whatever you do, do not anchor your expectations to what you personally might have paid for the stock. Sadly, the universe doesn’t care. Move on.
(One psychological trick I use: I very consciously don’t record the price that I buy a stock at in my portfolio tracking spreadsheet. That way, I can’t be influenced by this arbitrary number. If I have to, I can go back and check my brokerage records, but generally, I only have a vague idea of the price I paid for each stock in my portfolio, especially if I’ve held them for a long time. It helps that my memory is atrocious. It also helps that all my money is invested in a tax sheltered account so that I don’t have to pay any attention to whether I’m generating a capital gain or a loss.)
The “Sell By Date” Strategy
Another legitimate strategy is to simply sell after a fixed amount of time has passed. The obvious length of time to use is one year but in reviewing the past 20+ years of my own investment history, the initial undervaluation that led me to a stock in the first place seems to fuel significant market beating performance for a good 2 years after my initial purchase (on average). So selling arbitrarily, any time within that 2 year window makes sense. Individual results may vary of course. Some stocks will spend years languishing at their lows while other can rocket higher in a matter of months. But it is precisely that random variability that makes a fixed selling date a logical approach.
A while back, I went through my stock picks over the preceding 10 years and calculated what my returns would have been if I had simply bought equal amounts of whatever stocks I owned on Jan 1st of every year and held those stocks for the subsequent year, selling on the next Jan 1st. Using this robotic method of selling, my returns would have been 19% per year as opposed to my actual returns over the same time period of 21%. I went through a lot of selling anxiety to eke out those extra 2 percentage points!
With this strategy, when the sell date arrives, you would sell your holding, regardless of its performance and look for a new, undervalued stock to put your money into. The only exception might occur if you found that the stock remained significantly undervalued when the “sell by” date arrived. In this case, you’d have the option of simply holding onto it for another year. Although, honestly, if you had grown tired of holding the stock, you should feel free to sell it regardless. As long as you’re replacing it with an equally undervalued opportunity, you haven’t hurt your chances at all by switching horses in mid stream.
This mechanical selling strategy would work well for those with limited time to devote to the investing game. You could plan to do your market investigations and subsequent buying and selling all at once at specific times of the year.
Sell At Fair Value
While I think the “sell when you buy” strategy makes the most logical sense and the “sell after one year” would work well for people on a fixed schedule, I have to admit that I tend to follow a somewhat different (and more arduous) approach. When I first buy a stock, I always have a specific number in mind for what I think the stock is worth. This is mostly based off of the 5 year p:e ratio and my assessment of what other, similar companies in the market are trading at as well as the company’s own historic valuation ranges. Coming up with a specific fair value target as opposed to simply searching out the cheapest stocks you can find, requires a broad, in-depth familiarity with the market and the hundreds of companies within it. Which is why I wouldn’t advocate this approach for most investors. However, if you do obsessively follow the markets as closely as I do, having a target sell price for a stock, even before you buy it, has its positives.
As quarterly results come out and developments unfold, I am continually altering my fair value assessment of each of my portfolio holdings. Whenever the stock price reaches that fair value, I sell, regardless of whether I have something better to move the money into or not. Sometimes this means cash can pile up in my account if I am having trouble finding new opportunities. I feel uncomfortable holding cash and seeing it pile up like that is a strong incentive to roll up my sleeves and get to work. Without this incentive, the temptation would be to get out and enjoy the sunshine instead of staying inside and toiling away in front of the computer screen.
Any of these three selling strategies would be effective and over the years I have experimented with all of them.
Best Laid Plans
It’s always a good feeling to see a stock price rise after you’ve bought it. But for value investors who are often buying companies that no one else wants, this is often not the case. Instead, you’re as likely as not to see the stock price go down after you’ve bought in. That means either one of two things. If my assessment of the fair value of the company hasn’t changed, then the stock price has simply become even more undervalued. If the price has dropped substantially, then I’ll usually buy more. But it can also mean that the fair value of the company has deteriorated. Maybe the company lost a big contract, or a competitor has come out with better technology. Maybe a high flying, growth company has stalled out and future growth prospects have dimmed, lowering the stock’s fair value. There are many reasons why a company’s value can drop. The challenge lies in figuring out how the new share price relates to your new estimate of fair value. I’d perform an analysis of this company as if I was looking at it for the very first time. In light of any new information, what do I think the company is worth? And how does the new, lower share price relate to that fair value? Using my revised earnings and growth assumptions (revised to incorporate the new information), has the 5 year p:e moved up or down? If it’s moved down, I’d continue to hold the stock. If it’s moved up then it might be a candidate for a sale.
If you’re following the “sell by date” strategy, you don’t have to worry about any of this. But if you’re basing your selling decisions off of fair value (either selling your least undervalued company to make room for new blood or else selling when a company approaches that fair value), then you need to be periodically reassessing your value calculations.
Other reasons I have sold include diversification: if I end up owning too many stocks of a certain type I will sometimes sell one of them just to lighten up my exposure to a given sector. Or, if a stock has done remarkably well and now makes up an uncomfortably large portion of the portfolio, I will sell part of my stake just so as not to have all my eggs in one basket.
While it is easier said than done, I would try not to get caught up in timing the perfect exit. The market will always do the opposite of what you want it to do. Inevitably, you’ll frequently be selling too early or too late. Don’t sweat it. That’s the nature of the game. Focus your energies instead on searching out new undervalued companies. That’s where the money is. Buy low. If you’ve done your research properly, the selling high part of the equation will take care of itself.
This marks the end of the series. Hopefully, I’ve managed to impart some useful wisdom. You can check out some of the other articles in my Value 101 section for my perspective on some other value-related topics. And if my investing approach resonates with you and you want to see how it might be applied in practice, scroll through the Trading Journal section of this website. For 6 years I documented every trade I made, in real time, and blogged excessively about it. There is some valuable information in those posts for anyone with the fortitude to read through them!