When Should an Intelligent Investor Sell a Stock?
When should an investor sell?
Warren Buffett once said that you make your profit when you buy, not when you sell. When you buy you select the price-value spread that you’re willing to accept and, ultimately, the amount of profit that you can realize from a given investment.
Some investors are happy to leave it at that and just focus on purchasing great investments but you still have to sell your holdings to realize any profit at all. It’s no wonder then that the question of when to sell is one of the most commonly asked questions.
Selling: the Intelligent Investor Evolution
I never really had a set sell strategy for most of the time that I’ve been investing. At times I would look at the charts of my firms displayed on Google Finance and salivate over the profit I had made. At other times I would look at a holding that just wasn’t going anywhere and finally decide to dump the stock.
But both the mistakes I made with Sears and my quick reaction to former net net darling iGo Inc. really caused me to sit down and think of the best possible sell strategies for investors.
Unlike some pundits, I don’t think that there is a single set standard that investors should be using to set their sell decisions – investing is more dynamic than that. When it comes down to it, I think there are a range of reasons for why investors should sell their holdings and these reasons are generally split into three different groups: positive reasons, negative reasons, and reasons related to opportunity cost.
Sell When the Sun Shines
Selling for positive reasons is by far the easiest to deal with. In these situations the stock has done what the intelligent investor wanted it to do, or some unexpected positive event takes place, causing his stock to become fully valued.
Take Home Depot, for example. Back in the dark days of 2009 I coached my dad into buying Home Depot at just under $30 per share. At the time investors were busy dumping shares and stocking up on canned foods. The last thing they wanted was to own a mega cap home improvement stock during the middle of America’s largest housing busts and a looming financial market meltdown.
Looking at the numbers, home sales dried up and new housing starts were at a level not seen since the 1990s. Home Depot was facing some serious headwinds and this was depressing the stock quite a bit. Even acknowledging the frothy market from 2003 to 2007, the company had very solid earnings over the last 10 years and was clearly undervalued.
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At the time I calculated Home Depot’s value to be somewhere around $60 per share. That meant that one of America’s premier businesses was trading at a 50% discount to intrinsic value – a very rare event in my lifetime. Unlike net net stocks, which often trade at less than half of net high quality assets, good companies rarely dip down to these levels.
Fast forward a couple years and Home Depot rose, as expected, up to fair value. At this point it would have been a wise decision to get out of the stock. Once a holding reaches your estimate of fair value, your investment thesis has played out. Unless you have a new estimate of intrinsic value arrived at through very solid reasoning and data then you’re best off selling the stock.
Sell Just Before Dawn
Super investor Seth Klarman quipped that the intelligent investor has to sell when the birds are chirping. Klarman would sell just before a stock reached fair value to make sure he could lock in the gains. A stock shooting towards fair value can entice other investors to get in on the action, increasing volume. As the stock approaches fair value this volume can fall off and the stock could even crash back down to bargain basement levels. So much for your profit.
That’s not to say that a stock won’t go up even after you sell it at fair value. This happens often enough to frustrate investors and cause them to doubt their own investment strategy. As value investors, though, we use well-proven techniques based on mean reversion and price-value discrepancies to profit in stocks. Holding on past fair value means abandoning what’s worked so well in favour of …something else -- momentum, charting… greed.
Play it Safe and Let it Ride
Professional money manager and net net stock guru Peter Cundill sometimes used to sell enough stock to recoup the value of his original investment when that investment rose to fair value. He would let the rest ride on the stock, taking advantage of further business improvements.
This approach combined safety with the ability to capitalize on future business improvements. Basically, once his original principle was safely in cash again he would have “free” holdings that would continue to increase in value as the business improved. This is a viable sell strategy but investors should keep an eye on opportunity costs, something I’ll talk about in a follow-up article.
The intelligent investor should also have a good reason for holding onto the stock. The reason should speak to some other value assessment, maybe one based on earnings, and investors should also be extremely cautious not to let the stock's price jump shade their view of the situation. Often investors will suffer a positive affect bias and thereby judge the investment to be much more promising than it actually is. One way around this is to come up with a range of possible values before the original investment is made and then stick to that assessment until strong new evidence forces you to reassess the investment's value.
A Mechanical Investment Strategy?
The above paragraph should highlight two of the biggest pitfalls when it comes to investing -- fear and greed. More accurately, people are not perfect number-crunching robots. We're extremely fallible, especially when it comes to investment decisions. The chief drivers for investment errors are ego and the impact that emotion has on our behaviour.
To get around this, investors sometimes adopt strict mechanical investment programs. This is very similar to what Benjamin Graham recommended in his book, The Intelligent Investor. Mechanical strategies can work fairly well to eliminate the impact of emotions, and other biases, on investment decisions.
This brings up an obvious point -- the intelligent investor should sell a value stock if he's following a mechanical investment strategy and specific metrics are achieved which satisfy his strategy's sell requirements. In this case, almost no matter what the reason, holding on to your value stocks would be a bad move.
When it comes to selling a value stock – and a net net stock in particular -- investors will almost never go wrong if they sell as soon as it reaches fair value. As in Benjamin Graham's book, The Intelligent Investor, it rarely pays to hold onto a stock that is priced above fair value. Sure there may be different ways that the intelligent investor can value a stock but the end principle is the same – when your stock reaches fair value it’s a wise move to sell.
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