The stock market’s recent surge to a new record high may tempt some investors to sell vast swathes of their portfolio. They may determine that the current bull market’s recent rise is unsustainable and that equity markets are headed for a sharp decline in the near future.
However, this could lead to an inefficient allocation of capital. Certainly, selling shares that have become overvalued in the current bull market is a logical move. Their lack of a margin of safety may mean further upside is limited. However, selling them just because they have risen in price could be a mistake. Indeed, they may continue to offer sound financial performance and could even trade at a discount to their intrinsic value.
Moreover, sellers of high-quality stocks will need to either hold cash or find other shares to buy. They may end up holding companies that have weaker fundamentals and worse prospects than the businesses they have sold.
Holding onto losers
Similarly, it may be tempting to hold stocks that have delivered relatively low returns in the hope that they eventually recover. This may be a sound strategy if their underlying financial performance and fundamentals are sound. It may provide more time for investor sentiment to improve and for their investment appeal to ultimately be reflected in a higher share price.
However, holding shares in companies that are struggling to grow profits or cash flow may represent a significant opportunity cost. Other businesses could offer stronger financial prospects that translate into higher returns.
Indeed, not all recovery opportunities ultimately return to their previous levels of profit or share prices. As such, selling them and buying shares in businesses that offer stronger fundamentals and better financial prospects could be a logical plan – even if they trade on higher valuations.
Buffett’s view
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has previously highlighted his aversion to selling stocks that have risen based on strong financial performance and a dislike of holding shares in struggling companies.
“Our favorite holding period is forever," he said. "We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.”
As mentioned, this viewpoint may be particularly apt in today’s investing environment because of the stock market’s recent gains. However, it could be prudent to regularly reassess the financial performance and valuations of portfolio holdings in all market conditions to determine which stocks are worth holding or selling.
After all, sound businesses not only offer greater scope for gains in bull markets. They may also be more capable of overcoming economic challenges that can prompt bear markets. As such, holding the most appealing businesses, while they trade at fair prices, and selling underperforming businesses, even if they trade at cheap prices, could represent an efficient use of capital across all stock market conditions.
