As the stock market has marched higher over the past few years, I’ve felt a growing desire to start reducing my stake in a few names that don’t seem quite as attractively valued as they used to be. As a result, I’ve spent time trying to answer a seemingly straightforward question: When should you sell a stock? Let me note at the outset that this discussion will focus solely on investments that have worked out as planned (moved higher); the approach to failed investments, while clearly important, is worth its own article at some point in the future.
This discussion is solely related to scenarios where the stock price has reached or passed your estimate of intrinsic value.
Starting from a purely quantitative perspective, I’ve noted in the past that I buy securities when I believe 12% to 15% annualized returns (or more) are attainable for a period of five-plus years (I’ve been guilty of compromising on the low end due to limited success finding investments that met those return requirements in recent years). From a starting stock price of $100 per share, 12% - 15% a year implies a price of $175 to $200 per share five years into the future.
I would normally start selling some of the position as the expected forward rates of return fall into the mid-single digits. From the numbers discussed above, let’s say the stock jumped to $160 per share over the first two years; relative to my original expectations, the expected return for the ensuing three years has now been reduced to a mid-single digit percentage (annualized). While this decision would largely depend on the opportunity cost of the capital employed and taxes, this is a good example of when I would almost certainly start reducing my position assuming nothing has fundamentally changed. Even if I can’t find a replacement that meets my return objectives, I’m unlikely to hold onto a position pricing in ~7% a year for too long; I’d rather move to cash (discussed further in a minute, though I see why some might disagree with that).
But I also approach this decision-making process in other ways that are not purely quantitative.
This might sound odd at first, but I also think that this decision should be made with consideration for one’s emotions. Let me try and explain what I mean by that with an example.
Here are a few questions I’ve been asking myself lately for each of my holdings:
(1) Based on what I know currently, will I be disappointed that I didn’t take the opportunity to sell the stock at current levels if it trades 20% lower a year from now?
(2) Would I be a buyer in size if that 20% decline happened tomorrow?
(3) Will I be indifferent to incremental short term gains if the stock continues to move higher?
These questions have helped me to realize that for some of my holdings, I would need to see the stock price decline materially (at least 20%) before I would consider adding more to my position. Note that over a five year holding period, a 20% reduction in the purchase price increases the annualized return by ~5% a year (changes based upon the return over the measurement period).
If adding 5% to the annual return estimate wouldn’t entice me to invest, I clearly don’t think further price increases are justified (that statement implies mid-single digit returns are priced in, at best); I’d argue that any outsized gains from that point forward are being attained by borrowing from the future. Whether or not outsized gains actually occur in the near term is anybody’s guess. My thinking simply acknowledges that I’m okay with missing out on gains if they reflect a move from fairly valued to expensive.
I think that last point is important because it’s a statement about valuation, not prices. Investors have a tendency to rely on Mr. Market’s opinion in the days after they buy and/or sell a stock to see whether their timing was “right”. That’s a dangerous mindset that I want to avoid at all costs.
As an example, I don’t have any idea where Sysco (SYY) will trade next week, next month or next year. However, some of the things I do know about the fundamentals made me concerned as the valuation approached $25 billion in recent months. These include continued margin pressure, weak organic sales growth, a costly and failed attempt to acquire a competitor, a significant increase in the dividend payout ratio over the past ten years, a questionable decision to increase share repurchases – and financial leverage – in the wake of the failed merger, an earnings / FCF multiple in the mid-20’s, etc.
I asked myself the questions from above, and concluded that I would only slowly start adding to my position in the company (at most) if it fell 20% from where it was trading. The combination of those factors led me to believe that it was best to start selling the position and look elsewhere.
I think the emotional part of the decision relates to how I would react to a material decline in the stock price. I would feel disappointed if I held Sysco from $40 to $32 when I did not believe there was a justification for doing so. This greatly outweighs the pleasure I think I would feel if I got lucky and caught a run towards $50 per share (with the important point being I don’t believe that would be justified).
My fear of potential disappointment played a role in my decision. I’m willing to substitute an equity investment priced for a mid-single digit annualized returns for short term treasuries earning less than 1% a year simply because I’m not comfortable with the drawdown risk associated with sticking to the equity position – especially if I wouldn’t view a material decline from current levels as a chance to buy more (the chart on page five captures drawdown risk and its relation to valuation perfectly). I’ll be happy with the decision even if SYY trades at $50 in six months; how the business performs over the next 5-10 years is the real yard stick.
As I look at my portfolio, most positions pass the “20% decline” test - especially my largest holdings; the few that don’t are within reach of levels where I would actively start selling them.
I think this thought process keeps me grounded. As the market keeps rising, the biggest fear many investors start to have is missing out on continued gains, especially when they look easy (and your friends / competitors are getting rich); fear of actually losing money starts playing second fiddle. As an investor, I think you must question your thinking constantly to ensure you’re not being lulled into a false sense of complacency by endlessly rising stock prices.
I’ll stop here, but I hope that gives you a bit of insight into how I think about this. As always, I’m interested in hearing your thoughts, particularly if you believe that I’ve overlooked something.