“Knowing when to sell allows you to lock your gains in when you are right, limit your losses when you are wrong and, most importantly, avoid selling for a small gain when the stock has the potential to double or more.” - Sven Carlin
In chapter 11 of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” author Sven Carlin discussed not only the importance of selling at the right time, but also how to find that right time.
As the author noted, there are many different variables that affect sell-hold decisions: interest rates, earnings surprises, sectoral problems and recessions. So, Carlin decided to explore five of the most common strategies for selling stocks.
First, always remember why you originally bought the stock. Consider the case for selling Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) in 2010:
- The price-to-book value was 1.35.
- Chairman Warren Buffett (Trades, Portfolio) had promised to buy back shares at a 1.2 price-book ratio.
- You have committed to selling when price-book reached 1.5.
This chart shows that information in another form:
The share price hit its sell target of 1.5 times book value in 2015. Following the strategy above, you would have sold then, bought back in 2015 after the price dropped and sold again in late 2016 when the stock again became overvalued.
Why would you sell? Carlin argued it is a matter of comparing “how the fundamentals have changed in relation to the stock price.” That might involve metrics such as revenue growth, dividend yields, price-earnings ratios and more. He called it “a selling strategy that imposes discipline and limits risks.”
There might be other reasons to sell, such as a positive or negative catalyst. Suppose a company introduces an important new product, but the market for that product is not receptive (remember New Coke?). In such cases, you should accept a loss and sell the stock: “the circumstances have changed and consequently the intrinsic value is lower.”
Second, you might sell as a result of portfolio rebalancing. This often happens after a sector or stock has become quite popular very quickly and, as a result, the risks in the portfolio have changed. To get back to your original asset allocation strategy, and your original risk exposure, you need to trim some of your winners.
For example, in a portfolio of 10 stocks, each would have a weighting of between 5% and 15%. If a stock on the high end of that weighting were to double, then it would represent up to 30% of your portfolio. In that case, you would take your profits and disperse them among the other nine stocks, especially if the stock price had gone up but the fundamentals remained the same.
Third, there may be something better available. As value investors, many of us have wish lists of stocks we like but lack a margin of safety at current prices. If a wish list stock hits a suitably low price, then we might be tempted to sell an existing stock and buy it. But if we’re not careful in such cases, too much selling and buying could lead to higher transaction costs that nullify potentially higher profits.
Carlin’s solution? “I’ve found the best strategy related to this issue with the famous John Templeton. He would replace one holding in his portfolio only when another holding was 50% better than the first one.”
For example, imagine two stocks that are believed to have a “true” value of $100.
- The one you hold is trading at $50.
- The other stock you like is trading at $40.
- Dividing the price difference of $10 by the cheaper stock, $40, results in a 25% advantage.
- If the second stock were to fall to $30, then there would be a difference of $20 and it would be 66% cheaper than the stock you hold. It may be worth selling the stock you sold and buying the second stock, all else being equal.
A simple rule such as Templeton’s helps us stay cool and maintain our discipline.
Fourth, stop losses and trailing stop losses. Their use is not recommended by or for value investors, but Carlin has included them for the sake of discouraging their use. Setting a stop loss or trailing stop loss means setting an automatic sell signal with your broker, and your stock will be sold as soon as it hits the trigger price. Such tools obviously can limit larger losses—at least in a theoretical sense.
There are number of problems associated with such stops, however. One is selling and buying back too often, what’s known as “whipsawing.” Also, if the market panics, there may be no one willing to buy your stock at the price you set and your stock will continue to plummet, finally hitting bottom where a value investor buys it at a nightmare (for you) price. Trailing stop losses are more flexible, but still have their disadvantages.
Buffett and Seth Klarman (Trades, Portfolio) have both slammed the use of stop losses and trailing stops. Carlin described Klarman’s thinking on stop losses this way: “According to Klarman, it’s irrational to sell a holding when its price falls. If an investor bought the holding in the first place, based on proper value analysis, a new decline in price only means that it is a better bargain and averaging down will increase one’s return. Letting the market decide when you should sell is totally crazy according to Klarman.”
Fifth, you have fulfilled your goal. This is what Carlin called his favorite reason for selling, particularly if you reached your savings objective. This may be true of investing to buy a house or take a trip, but he does not explain what this means for retirement—and saving for retirement is the biggest objective for the majority of investors.
In addition, Carlin does not explain what investors should do if one stock in their portfolio hits its target. Presumably, they would sell and buy something else, but if nothing else is available, should they sell and hold cash or continue to hold? More advice on such questions would have been helpful.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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