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Diversity Investment Group
"Deciding When to Sell"
from the BetterInvesting Official Guide
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Famed investor Warren Buffett has a theory on the best time to sell: "Never."
This may be an extreme position, but without question, amateur investors are
more likely to sell too soon than to hold their stocks too long.
How likely is it that a decision to sell will prove profitable? Consider that
with each sell action you must make not one, but two, right decisions. First,
you must decide to sell stock A. Then, you must find its replacement. And stock
B must offer less downside risk and greater upside potential than its
predecessor in order to justify the action.
Consider Costs
The decision is not limited to share price. You can't forget commission,
either. A low estimate of the commission involved is 2 percent to buy and
another 2 percent to sell. Plus you must add the additional federal and state
taxes you and your fellow club members will have to pay on your profits, further
eroding your "gross" profit. You may be startled to learn that, on average,
after both commissions and taxes are taken into account, a new stock must
register a 37 percent gain before you even begin to make money!
Reasons To Sell
What are legitimate reasons for selling stocks? Certainly, one is to reap the
rewards of years of successful investing and withdraw funds for a new house, a
child's education, or other major expense. The other is to improve your
portfolio.
You should sell:
- Because of an adverse management change. New management is not necessarily
good management. It might be difficult for you to assess the ability of brand
new management, but you can consider the opinion of investment professionals,
who are probably familiar with the individuals' track records.
- Because of declining profit margins. This is a leading indicator of
corporate problems. Keep in mind the Wall Street saying "There is no such
thing as one bad quarter." The company may be in for a year or more of
depressed earnings.
- Because of a deteriorating corporate financial condition. If a company has
taken on too much debt, it may face serious trouble meeting interest and
principal payments in a slowing economy. Keep up to date on changes in the
company's capitalization, and check the impact of leverage, as you learned to
do in Chapter 4.
- Because competition is affecting profits. Nobody has a monopoly on a good
idea. When others see the potential for a product or service and enter the
business, price-cutting, earnings erosion, and even bankruptcy may follow.
Although the company's earnings may continue to advance, they could decline in
P/E ratio if the EPS growth rate slackens.
Don't follow the crowd and chase "in" industries. Think for yourself, and look
at the ability of management, not the glamour of the business. An example: RPM
is a specialty chemical company making adhesives and coatings. "Not a very
exciting business," you might think. Perhaps not, but RPM has chalked up
increases in sales and earnings for 47 straight years! And we all know that
price is related to earnings.
- Because of dependence on a single product. In the 1960s, Brunswick
Corporation was viewed as a growth stock. When the automatic bowling pin
machine was introduced, bowling lanes throughout the country and abroad made
sure to buy it. However, once every bowling facility had the equipment, the
growth slowed. This was product growth, contrasted with the growth that stems
from good management. At Minnesota Mining and Manufacturing, the company has
traditionally garnered a quarter of its sales from products not on the market
five years before. Such a company will probably show slower growth than that
of a shooting star, but the growth is longer-lasting.
- Because a stock's quality will change as economic circumstances change.
The quality of a stock comprises many factors. To name a few: size, financial
condition, consumer acceptance, market share, effectiveness of research, and
depth of management. But say raw materials triple in price. The stock's
quality attributes are still good, but the changed economic situation has
changed its quality as well.
- Because securities that have proven to be cyclical and that have a recent
history of low growth should be sold when the economy peaks. Buy cyclicals
during the trough when P/E ratios are relatively high and the market is
predicting their earnings recovery. Don't buy when the multiples are
relatively low and the stocks seem to be a bargain, as this indicates that
earnings are headed for a decline.
- Because it's important to maintain balance by company size in your
portfolio. Remember our recommendation: Keep 25 percent of your holdings in
companies with $2 billion or more in sales, 25 percent in small companies with
sales under $400 million and with rapid growth rates, and 50 percent in
medium-sized companies.
Selling Don'ts
Set these rules for yourself concerning selling:
- Don't sell just because the price hasn't moved. One of the cardinal
requirements for successful investing is patience. Don't concentrate on price
as a trader would; rather, focus on the fundamentals as a long-term investor
should. If the basics remain attractive, over time you need not worry about
price.
- Don't sell because of a paper loss. You might think it's smart to sell out
when a decline in price of 10 or 20 percent is posted. But a stock well worth
keeping can go down that far in a declining market.
- Don't sell because of a paper profit. You might be tempted to sell when a
stock doubles, yet many stocks post gains of 2,000 percent, 3,000 percent, or
even more over a ten-year span. Think how much you'd miss out on if you sold
in the first year! Again, concentrate on the study of fundamentals. As long as
the stock meets the criteria you have established, hold on to it.
- Don't sell on temporary bad news. A perfect example is Metromedia, which
once enjoyed an earnings gain of 40 percent in a quarter when newspapers in
two of its major markets-New York and Los Angeles- were on strike. Advertisers
flocked to Metromedia's TV stations, and management pointed out that earnings
probably would be less in the same quarter a year hence. Sure enough, they
were. And the price of the stock fell sharply, even after management's caveat.
But, as management had also predicted, earnings resumed their upward trend,
and so did the stock price.
- Don't sell just to take action. This is sometimes appealing if you feel
frustrated that something isn't happening quickly enough. Be patient and wait
out the market.
- Don't sell a stock that has fallen so far that your remaining downside
risk is minimal compared to the upside potential.
If you are unsure about whether to sell, why not hedge your decision? Se1l part
of the holding and keep the rest. You'll be diversifying your portfolio, which
can be especially important if a single issue has become too large a part of
your holdings. In a small portfolio (under $100,000 in size), a single issue
should not account for more than 20 percent of total value. In a large portfolio
(at least $100,000 in size), no single holding should represent more than 10
percent of the total value.
To sum up, selling may be the most difficult decision you face as an investor.
Take full advantage of the Portfolio Management Guide and PERT. If sales and
earnings gains continue to meet or exceed your minimum requirement, and if the
pre-tax profit margin is rising, consider selling only if the price multiple
exceeds one and a half times the historical average high price-earnings ratio.
And even then, you may find reasons why you should continue to hold the stock.
Don't sell too quickly-remember Warren Buffett.
Starting and Running a Profitable Investment Club [Chapter 15], by
Thomas E. O'Hara and Kenneth S. Janke, Sr. (1996, New York: Random House).
If you have questions or comments, write to:
DIGnet@mindspring.com.
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