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 have a few black marks against them, 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.
The discomfort can start when the price of a stock you own moves significantly higher. Until you’ve actually sold, those gains are mere 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% 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 finally be 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
Fortunately, 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 (ie at a big discount to your estimate of their fair value) and the rest will take care of itself.
Assuming that you are diligent about your search process and are only buying the most extremely undervalued stocks in the market, the chance is very great that whenever you decide to sell, the valuation discount will be less than it was when you first bought the stock. (If not, then no one is forcing you to sell.) In fact, when you first buy a stock, you could simply throw a dart at a calendar and use that as your target sell date. As long as your purchase decision was sound, that strategy should work out just fine in the long run.
The “Sell By Date” Strategy
For those with a dramatic flare, this is how this selling strategy might work: When you buy a stock, pin up a calendar covering the next couple of years and throw a dart. Mark the date it lands on and when that fateful day arrives, sell your stock and move on to the next great, undervalued opportunity. What you’re doing is buying undervalued companies and assuming (hoping) that that the gap between what you bought the stock for and what you thought it was worth will narrow over time, providing you with market beating returns along the way. Some investments will see the valuation gap shrink only marginally, some will see the price move from being undervalued to being egregiously overvalued and some will whipsaw back and forth between the two extremes. The pattern of this movement has been likened to the route a drunkard takes staggering down a city street. It can be thought of as a random walk and there is no sense in trying to predict how it will play out. The key is not in betting which way the drunkard will stagger next, it is in jumping on board for the ride when he strays too far off the beaten path (to the undervalued side of the street).
A more methodical variation of this strategy is to sell at a fixed length of time after you buy. A year would be the obvious choice. Or, for our tax constrained, American friends, a year and a day. Or you could set the limit to 18 months or 2 years. (On average, after a couple of years, the initial tailwind from the valuation gap starts to subside as valuations revert to the mean.) The point being that you set an arbitrary holding time period to let the story play out and to give the stock a chance to narrow the valuation gap you identified initially. After a year (or two) has gone by, sell the stock, regardless of the price, and move on to the next great undervalued opportunity.
The advantage of this selling method is that it completely removes all indecision, angst, fear and subsequent regret from the equation. It also keeps you disciplined and ensures that you are always cycling from less undervalued stocks to more undervalued ones.
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!
This mechanical selling strategy would work well for those with limited time to devote to the investing game. You could plan to do your buying and selling all at once at specific times of the year. However, if you have the time to monitor your investments more closely, I would advocate a slightly more hands-on approach.
Sell When You Buy
A more nuanced selling strategy and the one I would suggest to most new investors is to focus the bulk of your time and energy on your buying activity (ie your search for undervalued opportunities) and let your purchasing dictate your selling. Spend your time hunting for new, undervalued opportunities. Try to keep a nicely diversified set of 10-12 companies in your portfolio at any one time. When you find a new company that you want to buy, look at your existing holdings, make a fresh determination of each stock’s fair value using the most up to date information, and then sell the stock that is the least undervalued (or, if you’re lucky, the most overvalued).
Again, 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 underlying over or under valuation of a stock to drive your selling decision, not on the actual stock price movement. The stock market doesn’t know or care where you bought a stock. Whether the price is up or down from where you first bought in is absolutely irrelevant to your selling decision. Likewise, whether the price has been drifting lower for months or years or shooting to the moon also has no bearing on the sell. Consider only where the price is right now in relation to the underlying value of the company. Then sell whichever stock is the least undervalued.
(One psychological trick I use: I don’t record the price that I buy a stock at in my portfolio tracking spreadsheet. 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.)
Sell At Fair Value
While I think the “sell when you buy” strategy makes the most logical sense, I have to admit that I tend to follow a somewhat different approach. 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 the sleeves and get to work. Without this incentive, the temptation would be to get out and enjoy the sunshine instead of staying in and toiling away in front of the computer screen. So, it’s human frailty that makes me adopt this modified selling approach, not cold, hard logic.
Any of these three selling strategies, though, I think would provide excellent returns and over the years I have experimented with all of them. (Including selling at a fixed schedule of 1 year after I bought in.)
Once again, if you are buying deeply undervalued companies, the exact timing of your selling doesn’t matter. You could use astronomical signs or tea leaves. You could even use technical analysis. (That’s a dig at technical analysis, in case you missed it.)
All of this is not to say that stock prices can’t go down after you’ve bought in. Frequently, they do. That means either one of two things. If my assessment of the fair value of the company hasn’t changed then that means that the stock price has simply become even more undervalued. In that case, I’ll usually buy more. But not infrequently it means 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 become more pedestrian, lowering the stock’s fair value. There are many reasons why a company’s fair value can drop and typically, the stock price will drop along with it. The challenge then becomes 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 the new information, what do I think the company is worth? And how does the new, lower share price, relate to that fair value? Even though conditions may have deteriorated, if the share price has deteriorated as much or more, the stock might still be an undervalued opportunity. I might even be tempted to buy more. But if the share price has under reacted to this change of events, then the price might no longer represent compelling value and it could be time to sell and move on to greener pastures.
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.
I keep referring to a company’s fair value here as if it is some immutable number that can easily be calculated, but fair value is an opinion based on certain assumptions about future earnings growth. It’s also affected by the overall level of the market. So, it’s impossible to come up with an exact number. The best you can do is get in the rough ballpark. Which is why I wouldn’t get too concerned with trying to hit the exact, perfect selling price. The important part of the whole process is the price you buy at. If you’ve done a good job in the buying department, you can afford to be more laissez faire with the selling.
If you’re always buying at deeply undervalued prices, I don’t think relying on technical signals or trying to time your exit point or taking your initial stake off the table and letting your profits run will necessarily hurt your performance; I just think they’re all needless distractions.
Selling is hard. Keep it simple. Set a “sell by” date when you first buy in or else simply sell your most overvalued stock whenever you find something new you’d rather own. Or, if you’re like me, try to form your own, independent assessment of what a stock is worth and then sell it if it goes too much over that price.
And finally, given my belief that the exact selling price is not that important, I would give yourself latitude to occasionally sell a stock for less well-defined reasons. I’ve sold stocks in the past simply because I’ve owned them a long time, they have not done anything for me and despite them still appearing to be undervalued, I simply get bored with owning them. As long as I’m switching horses to something equally or more undervalued, the only thing I lose by selling is a small commission. 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 too caught up in getting your selling timing down just right. The market will always do the opposite of what you want it to do. If you’re trying to precisely time your exit point, you’ll always be selling too early or too late. Focus instead on finding undervalued companies. If you’re always buying low, you’ve stacked the odds heavily in your favour. Chances are that over time your portfolio will grow regardless of the selling strategy you employ.