Value Investing: When to Sell a Stock

When to Sell a Stock by Vishal Khandelwal, Safal Niveshak

Barbara Streisand, an American singer and actress found a new occupation for herself in 1999, during the heydays of the dot com bubble. She became a stock picker.

What’s more, she started managing funds of her close friend Donna Karan, a leading US fashion designer, of the DKNY fame.

Times were so good then, that in just five months of intense trading, Streisand turned Karan’s investment of US$ 1 million to US$ 1.8 million.

Now, for all her dabblings in the risky territory of stock trading, Streisand admitted that the volatility made her nervous.

As she confessed then to a friend, “I can’t stand to see red in my profit-or-loss column. I’m Taurus the bull, so I react to red. If I see red, I sell my stocks quickly.”

Well, for a die-hard fan of Streisand or a stock trader, this rule of selling stocks – whenever they are in the red – may sound like a gospel truth. In fact, some of the smartest and most successful traders would agree to the fact about cutting their losses as soon as possible.

But if you are a long-term investor, selling a stock as soon as you see red can be a dangerous activity. Why dangerous? Simply because you lose out on the opportunity of benefiting from any compounding that that stock can achieve over the next 5-10 years, in case the underlying business has such potential.

“But When Should I Sell My Stocks?”

This is one of the most frequently asked questions I’ve received over the past few months, and is surely a sign that surging stock prices is making a lot of investors edgy.

Now, isn’t it ironical that we all invest in stocks to see their prices rise, and when they actually rise, we get nervous and itchy to cash out?

So, a lot of people, even long term investors who would buy a business promising to hold on for “at least 10 years”, would sell as soon as the stock multiplies 2-3x.

I have been a star at such “price-based selling” in the past. So I would sell stocks as soon as they multiplied 2-3x or if they did not move for 2-3 years. All this while, the only thing I looked at was the price of the stock and what it had done in the past.

Another irony here – when we buy businesses, we are forward looking, and when we sell, we are backward looking.

The lesson I’ve learned from several such episodes of either selling too early or selling due to not seeing action is that I now do not make my sell decisions based on my cost price. In other words, my cost price does not matter when I’m looking to make any sell decisions.

What matters is my expectation from the business over the next 10 years or so. If the expectation is still good, even after the rise in stock price in the past, I continue to hold on.

This is what I’ve learned from what Warren Buffett has said repeatedly…

We never buy something with a price target in mind. We never buy something at 30 saying if it goes to 40 we‘ll sell it or 50 or 60 or 100. We just don‘t do it that way. Anymore than when we buy a private business like See’s Candy for $25 million. We don‘t ever say if we ever get an offer of $50 million for this business we will sell it. That is not the way to look at a business.

The way to look at a business is this going to keep producing more and more money over time? And if the answer to that is yes, you don‘t need to ask any more questions.

Not selling stocks just because the prices have moved up is probably something Buffett learned from Philip Fisher, who had these three simple rules of selling stocks –

1. Wrong Facts: There are times after a stock is purchased that you realize the facts do not support the supposed rosy reasons of the original purchase. If the purchase thesis was initially built on a shaky foundation, then the shares should be sold. More money is lost by people who’ve held on to bad, losing businesses hoping to get their money back some day.
2. Changing Facts: The facts of the original purchase may have been deemed correct, but facts can change negatively over the passage of time. Management deterioration and/or the exhaustion of growth opportunities are a few reasons why a stock should be sold according to Fisher. You must avoid the commitment bias here.
3. Scarcity of Cash: If there is a shortage of cash available, and if a unique opportunity presents itself, then Fisher advises the sale of other stocks to fund the purchase.

If you re-read what Fisher had to say about selling stocks, and combine it with Buffett’s thoughts above, you’ll know that both these men are not talking about stock prices at all while deciding to sell stocks.

They are only talking about evaluating businesses at regular intervals and whether they will remain good for years to come, and then deciding what to do with the stock – to sell or hold.

As far as evaluating the business is concerned, my friend and value investor Ankur Jain writes this on his blog post on when to sell…

We should be asking questions to ourselves about the companies we own before considering selling the stocks.

Is the competitive advantage of the business better than before? Any deterioration in the bargaining power of the business? How are the growth prospects? Any foolish diversification attempted by the management? Can the business continue to scale up and deploy large amounts of capital at attractive rates of return? Change in the competitive landscape? Is it a better, larger and a stronger company now than when I bought the stock?

If the answers to these questions are largely in favour of the company in question, we know that the company is on the right track.

“But What If My Stock Gets Overvalued?”

This is another common question I’m getting these days. Philip Fisher answered this beautifully in his book Common Stocks and Uncommon Profits…

…another line of reasoning so often used to cause well-intentioned but unsophisticated investors to miss huge future profits is the argument that an outstanding stock has become overpriced and therefore should be sold. What is more logical than this? If a stock is overpriced, why not sell it rather than keep it?

Before reaching hasty conclusions, let us look a little bit below the surface. Just what is overpriced? What are we trying to accomplish? Any really good stock will sell and should sell at a higher ratio to current earnings than a stock with a stable rather than an expanding earning power. After all, this probability of participating in continued growth is obviously worth something. When we say that the stock is overpriced, we may mean that it is selling at an even higher ratio in relation to this expected earning power than we believe it should be.

All of this is trying to measure something with a greater degree of preciseness than is possible. The investor cannot pinpoint just how much per share a particular company will earn two years from now or whether a sizable increase in average earnings is likely to occur a few years from now.

He can at best just this within such general and non-mathematical limits as “about the same,” “up moderately,” “up a lot,” or “up tremendously.”

…how can anyone say with even moderate precision just what is overpriced for an outstanding company with an unusually rapid growth rate? If the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 percent overpriced?

That which really matters is not to disturb a position that is going to be worth a great deal more later. If for a while the stock loses, say 35 percent of its current market quotation, is this really such a serious matter? Again, isn’t the maintaining of our position rather than the possibility of temporarily losing a small part of our capital gain the matter which is really important?

If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.

“So, Should I Never Sell My Stocks?”

Well, you should never sell your stocks while looking at the stock price. Instead, look at the business and then decide whether you would want to be its owner starting that day.

In other words, treat each day you own a stock as the first day of owning that stock. And you should decide to keep owning it, or sell it, depending on what you expect from the business starting that very day and for the next 10 years.

But again, please do not sell a stock just because…

• It has gone up 2x since your buying price; or
• It has surged 20%
  

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