When to sell
This has always struck me as an easy question, so the amount of handwringing over it has always left me nonplused. To be fair, many of the top value investors, people I admire, have said it is a tough question, so perhaps everything I write in this post will be wrong. But, judge for youself.
It’s my impression that people use the wrong mindset when deciding to sell. They seem to drop their value investing roots and start to try to guess what the market is going to do in the short term. If you try to do that, then yes, it’s hard to decide when to sell. It’s my opinion, backed by a lot of evidence, that no one can determine short term market movements. If so, if you try to do it all you are doing is speculating. It’s no more correct to speculate on the sell side than on the buy side.
Okay, so how do you decide to sell? Well, the most important thing to understand is that money has no memory. For example, say you buy a stock, some bad news comes out, and it drops 20%. Let’s say it is really bad news - a fundamental shift in the outlook for the company. In this case it makes no sense to just hang on, hoping to eventually make up the 20%. You sell, take the loss, and put the money into a better company. Your $800 doesn’t know it used to be $1000, and that company is not going to increase in value just because you invested in it and took a paper loss. Always, always, always put your money in an investment with the best rate of return.
So, we use that simple rule to decide when to sell. The rest of this argument is going to be phrased as if you are buying another stock, however, the argument still works if you are going to take the money and put it in a sock drawer or buy a boat with it. Why? Because money has no memory. It doesn’t know if it was used to buy a new stock, or a new boat, or whatever.
Okay, since money has no memory, don’t bother looking at your account and saying “I have 10,000 shares of XYZ”. You do have them, but that knowledge doesn’t affect the sell decision. You certainly don’t say “I bought 10,000 shares of XYZ at $10.00″. That also doesn’t affect the sell decision.
Pretend you have $100,000 to invest. In the entire universe of stocks, what stock or stocks would you buy? The very best stock you know of.
How you make that decision depends on your version of investing, and I won’t go into that here. But obviously you will be looking at FCF, multiple vs yield, your expectations of the future, and risk/reward.
Let’s say ABC is selling at $5 and you think it is worth $10. XYZ is selling at $10 and you think it is worth $13. Both have equal risks and uncertainty. In this case, forgetting for the moment that you own XYZ, you’d definitely buy ABC. Well, how do you get that 100K to invest in ABC. Well look! You have $100K worth of XYZ in your account. Sell it and buy ABC.
That’s extremely straightforward. Just own whatever you think are the best bargains out there. If that means you have to sell something, so be it. Every time you sit down to review your portfolio, figure out what you want it to look like, forgetting what you own now and the paper profit/loss on those. Then, do whatever you need to do (buy/sell) to make your portfolio look like it should.
A few complications: The US government taxes you differently based on your holding period. 15% vs 30% or whatever your effective tax rate is. There are dividends, currently taxed at 15% unless you have an MLP or somesuch. Etc. Natually, you have to factor those into the equation, but they are pretty simple. In this case you could argue the problem gets a lot harder, because you are deciding between selling today at a known price vs next year at an unknown price. Here I pretty much assume no changes in prices, which is a bit conservative given that over time markets rise. You could look at beta, but I think that’s a bit of voodoo.
Another issue related to taxes. Say you bought XYZ, and it dropped 20%. You love this stock, and the price drop was irrational. Normally you’d back up the truck, right? Well, let’s say ABC is equally depressed, and you love ABC just as much as XYZ. In this case, sell XYZ, take the tax write off, and buy ABC. You have the same dollar amount in stock as before, the future is equally bright in ABC vs XYZ, but now you have a juicy tax write off!
The final thing I might think about is delaying the tax bill. If I am figuring out what to sell and it is Nov 30th, I may just wait until the next fiscal year to sell my stock, merely to push the tax burden out a year. But this only works if you aren’t filing quarterly. If you are managing serious money, you are probably filing quarterly.
This post implies a lot of selling/buying. I hope that isn’t the takeaway point. If you bought Berkshire in the 80s and love it, why sell for a few extra percentage points? You know Buffett, presumably you agree with his investment and business philosophies, why go to somebody untried? But that should be part of the decision of “what do I want my portfolio to look like”? Me, I want some solid, indisputable performers like Berkshire, and then some higher risk, but world changing returns like ATP. That way if my risky buys don’t work out, I still have a comfortable nest egg. If they do work out, I’m not just comfortable, I’m very well off. But, here we are veering into buy decisions, which is a different topic.
So, my advice is pretty simple. Figure out the optimal portfolio for you, and just make it happen, not worrying about what you currently have in your portfolio. But don’t give Uncle Sam too much extra money if you can avoid it.
Disclosure: I own ATP, I don’t own Berkshire. They were just chosen as examples of different risk/reward profiles.
August 21st, 2009 at 12:54 pm
rlabbe,
I want to thank you for your blog. I find your writings to be very insightful and helpful. I was wondering if you ever employ options (leaps or otherwise) in your investment strategies? In the case of a stock like ATP where there are obvious catalysts, do you think options are merited, or do you think other unforeseen market factors make them too risky? One of your favorite investors, Greenblatt, is certainly a proponent of the use of leaps in certain situations.
Thanks again,
Ian
August 21st, 2009 at 1:17 pm
I do, though I am still pretty cautious with them. I’m working on spreadsheets to model different ideas. I’m particularly interested in LEAPS, as you get the tax benefit of holding them over a year, and while they are still a long ways out the time component doesn’t play a big factor - they react just as the stock does, but multiplied.
I do have some options in ATP currently, but only because of the number of catalysts coming up in the next few quarters. ATP doesn’t have LEAPS, so you have to be pretty happy about their short term prospects. Normally not something I would do. however, I thought the $5 Jan calls were pretty attractive several days ago.
So far, I only put money in options that I’m willing to lose - which is entirely possible.
I have some cheap 2011 Pfizer $15 strike LEAPS. My thinking there - Pfizer is a very good company trading at a large discount. It’s almost certainly going to increase in price in the next two years (and so far it has - I’m well in the green on these options). Rather than throwing $15/share at it, I spent well under $3. If I lose a bit of change by betting wrong, so what? And, if I get it right, it’ll be a multibagger. It’s attractive from a risk/reward perspective, and lets me keep a cash hoard to respond to truly unusual events in this stock or others.
But, I’m still in flux with these - sometimes I find truly undervalued options prices, but more often they seem to be priced about right.
A bigger issue is their lack of liquidity. I already buy obscure stuff like ATP - toss options on top of that, with a huge bid/ask spread, and you really don’t want to be trading these in and out. I got caught that way a few times - needing money, having to sell options at an unattractive price point.
Those are just my current thoughts. Later, as the market becomes fair priced, I’m sure I’ll be selling puts heavily, but right now it makes no sense when the fair value of a stock like ATP is around the 3 digit range.
August 21st, 2009 at 2:47 pm
Good post. I still think it’s the most mentally challenging aspect of investing though. Especially when there are so many potential investments out there. Personally I have to remind myself of my strategy to sell at fair value and move on. So far I have been sticking to my guns but it’s always easier for me to buy in this market then to let anything go. I usually reread a Berkowitz interview (selling cheap to buy cheaper) or notes on Klaraman and then put in the sell order. I think it’s interesting as I so strongly believe in my value investing strategy but always have the urge to squeeze a couple percentage points extra out of a position that’s already above my fair value estimate. I know it’s now become speculation and I’m selling at a profit to buy something cheaper but it’s still a battle for me. Of course there are worse things to bitch about then taking profits…….
August 22nd, 2009 at 6:54 pm
One of the psychological barriers to seelling is lack of confidence that there’ll be something else just as compelling to buy with the proceeds.
Another more obvious one: what if you sell at (say) $20 only to see the stock at $30 a few months hence?
Put these two together and you see where a lot of the worry comes from Value stocks tend to move to fair value slowly at first. If I sell BCD at $20, buy FGH at $20, see BCD at $30 and FGH still at $20 [or $19 or $18], I’d be prone to getting frustrated.
August 23rd, 2009 at 7:55 am
Well, from my point of view, okay, Buffett’s point of view, if you don’t have something as compelling, hold. I recognize I’m kind of mixing his philosophy of buying businesses with the more common approach of maximizing profits, so I guess it isn’t quite as trivial as I make it sound. I guess I’m not the kind of person to hand wring over these decisions. I know I can’t predict short term movements, so I don’t even try. It goes from $20 to $30 after I sell? “So, how would I have known” I think.
My current position is that I want to buy a lot more stocks than I have money for. Thus, every buy must be associated with a corresponding sell. That makes the decision pretty easy for me. After all, it’s a buy decision, not a sell decision: do I like XYZ or ABC better? The question and answer is the same regardless of whether I already own XYZ or not.
I guess I can see how just selling something without having anything to put the money into could be harder, psychologically. I mostly just ask myself, if I had the cash, and didn’t own the stock, would I buy it today at this price, given all my other options. If it is a great company run by great management, such as MCF, trading at 90% of my estimated worth I’d probably say yes. If it is some no-name microstock that I bought as a net-net which subsequently ran up to around 90% of my estimated worth, the answer would be no.
I’m not as strict as Buffett, in that he wants every stock he buys to be a business he’d like to own forever. To me, a basket of net-nets (which for about 6 months you could actually buy) is very worth owning, even though you will take a total loss on a few and will probably not own any of them in 2 years. Unlike Buffett, I am not trying to attract company owners to sell their business to BRK, so I don’t need the reputation of holding forever.
So, I blend it a bit. Some great companies that I don’t have to worry about (too much - you always have to watch) to create a core position, and then some sexier stuff that I can afford to get wrong (because of the core position) but hope to get right.
Right now my core is my 401K, which is so boring it’ll drive you to tears, and the sexy stuff is my “play money”. If a couple of stocks in my play money hit like I think they will, some of that money will get turned into core positions as well. But for now, in this market, I’m swinging for the fences with all new purchases. Within that context, buy/sell is pretty easy.