Much as I like the MF recommendations, I am struck by a lack of an exit strategy. No one at MF seems to realize that there is nothing wrong with saying “Sorry, we made a mistake with this one. Let’s sell it and move on.” I’m not just talking about the stock, but also the company behind it.
Hi Saul,
Saw your post on the Best Of list (most highly recommended posts in the public boards over the past 24 hours).
If you don’t mind, I’ll share an article I wrote for the March release of Stock Advisor discussing selling. It may not address all your points, but it does explain a fair amount of our philosophy and some of the reasons why we’re reluctant to sell (such as underperformance among those who do it a lot).
For those with access, it’s found here: http://newsletters.fool.com/18/coverage/issues/2014/03/21/fo…
Cheers,
Jim
Fool’s Tools: When Should You Sell?
By Jim Mueller
March 21, 2014 - Analysis
You may have noticed that we here at Stock Advisor very rarely recommend selling any of our stocks. In fact, over our past 12 issues, we have recommended selling just 11 in total and three others in part – out of a list of more than 100 individual companies.
You may find that frustrating. Maybe you’ve got a losing position that’s painful to see every time you check your portfolio. Maybe you need to raise some cash to pay for the things that inspired you to invest in the first place. Or maybe you’ve just given up on a company.
A long-term mind-set sometimes means holding on to a stock even when your gut is telling you to sell. But even Foolish investors know nothing is forever. So how do you know when the time has truly come to sell?
Try Not To
First off, we try to avoid it. Here’s how David put it in a recent board post: “The more I invest … the more I realize that selling is almost always silly – for the types of world-beating businesses I’m fascinated by and recommend – unless the company I’m selling has truly broken down.” (Emphasis in the original.) We’re trying to find strong businesses to own, not slips of paper to trade.
In fact, trading is hazardous to your wealth. In 2000, Brad Barber and Terrance Odean published a paper by that name which investigated the activity and results for 78,000 accounts over a six-year time period. During the years they studied (1991-1996), the market averaged annual gains of 17.9%. Those who traded the most had net average returns of just 11.4%, while those who traded the least achieved net average returns of 18.5% per year. Quite a difference!
The authors attributed the large difference to overconfidence on the part of the traders. The new position would do better than the old one, seemed to be the thinking. Unfortunately, that didn’t work out so well.
Warren Buffett has commented that he would have more money today if he had never sold a position. And Tom Gayner, the very successful chief investment officer at Markel (NYSE: MKL), has said that investors make more money from their butts than their brains (as in, sit still and don’t overthink things).
We approach the situation by assuming that we don’t know whether we’re right to sell. After all, the sell decision requires us to be right twice (once on when to sell, once again on where to reinvest the money), rather than just once (leaving the position alone). Plus, we don’t know what the future holds. A quality company that’s struggling could turn it around. It happens – just ask investors who held Netflix (Nasdaq: NFLX) through the bruising fall from $305 to $62 (an 80% drop) in 2011. Shares are now above $420.
Look Forward
David writes, “For me, a lot of thinking about selling a stock is contextual; for a given stock, you have to think of it in terms of whether it’s fulfilling your original or revised expectations of it, and most of all you need to look at the business, not the stock, and at the future, not the past. We’re constantly doing this.”
Our favorite question to ask whenever we look at any of our positions is, “Can this company’s stock outperform the market over the next three to five years?” When Tom recommended selling LabCorp (NYSE: LH) this month, and when David did the same with Southwest Airlines (NYSE: LUV) last October, the answer to that question from all the analysts was no. We answered by looking at the company and its prospects at that moment, not how its stock had fared. From what we understood of their prospects and opportunities, we no longer believed they would outperform.
One of These Things Is Not Like the Others
One advantage of not selling – and holding for long periods – is that big winners will far and away outstrip big losers.
Looking at our entire scorecard (as of Thursday’s market close), Tom and David have made 288 recommendations over 12 years spanning 208 different companies. The worst-performing 10% (29 recommendations) averaged a 63% loss, ranging from Dell’s 44.4% loss for Team David all the way down to Pacific Sunwear’s (Nasdaq: PSUN) 95.6% loss for Team Tom. (If you’re curious, David and Tom also split Nos. 2 and 28 — Satyam Computer Services’ 94% loss and Resources Connection’s (Nasdaq: RECN) 44.7%, respectively.)
In contrast, the 29th-best performing recommendation is Illumina (Nasdaq: ILMN) from David, with a 274.1% gain. If you’d invested $1,000 in this and each of the four losers above, the $2,741 gained from just this one winner would make up all but $46 of your losses.
In other words, avoiding the temptation to sell can, in itself, protect you from big losses. And if you invest in more winners than losers, as Stock Advisor has (with 213 out of 288 total recommendations in the green), then holding losers ends up being not nearly as painful.
Good Reasons
Still, after all this, we do sell on occasion. But it’s always for a concrete reason. Here’s why we would part ways with a stock:
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The thesis has collapsed. The investment hasn’t worked out as expected, and it’s not likely to based on what is known at the time. This usually means selling after a significant drop because it takes time for the company to show that it’s truly falling short of what you expected. We make a good-faith effort to wait until we’re convinced this is the case.
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The thesis has run its course. You invested for a very specific reason – the company was in the midst of a turnaround, for instance – and that reason has now been met. You got what you came for, so move on. It’s very easy to convince yourself after a big win to stay in and change the thesis; I’d advise you not to do that. Sell, wait a quarter, and then revisit the company as a brand-new investment. Develop a brand-new thesis. The time interval will hopefully dampen your euphoria, allowing a more clinical examination of the company’s situation going forward.
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Your investment thesis is fundamentally wrong. During your research, you overlooked something major or didn’t take something into account that you should have. Adding this new information changes the situation enough that you would not have invested in the first place if you had included it. Don’t be shy about owning up to the mistake, and don’t compound the error by refusing to correct it.
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There’s a sudden resignation at the C-level. Did they quit or were they fired? (“Family reasons” is almost certainly a euphemism for one or the other.) A power struggle at the top will preoccupy those who are left, and having to find a replacement is also distracting. I much prefer smooth transitions.
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The SEC opens an official investigation. By the time this is announced and you hear about it, it will be too late to avoid a lot of pain. Get out anyway, because it often gets worse.
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The company has to restate its books more than once within a four-year time span. Investors absolutely rely upon the accuracy and transparency of the financial statements. If the company has to correct its statements, management could be playing games with the financials. You have better opportunities.
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The stock has reached your estimate of fair value, and outsized returns are less likely. This one is very tricky to get consistently right. Fair value is a fuzzy target at best, and it’s 100% dependent on the assumptions used to estimate it, any of which could be wrong. Further, this type of investing tends to miss the huge growth stories — e.g., Amazon.com (Nasdaq: AMZN) — because those companies almost always look overvalued and may never be purchased in the first place.
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You have a better opportunity elsewhere. This is probably the most nebulous and least reliable reason, as we are all too good at convincing ourselves to do something, coming up with reasons to justify it, and ignoring reasons we shouldn’t. So it’s there – but don’t forget what Barber and Odean had to say about the perils of trading.
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You need to rebalance. Depending on your investment style, philosophy, and comfort level, you might trim from a big winner if it becomes so big your overall returns rise and fall with it. What that plateau may be is up to you (many use 25%), but the idea is to reduce your risk and get back to a level of diversification that lets you sleep at night.
Time to Sell!
Having laid out our philosophy, I am fully aware that most of us invest for a reason, be it to send a child or grandchild through college, or to go on a once-in-a-lifetime trip, or to support retirement. Therefore, one needs to cash out at some point in order to use the money for its ultimate purpose. In Stock Advisor, we do not give guidance on how you should do that or what positions to sell (other than our official sell recommendations), though a few possibilities do spring to mind.
One would be to trim a bit from all positions. Let the remainder keep growing. Or you might work your way up from the bottom, selling those that have performed the worst while letting your winners continue running. Or you might have one or more positions that are significantly larger than the rest, so trimming those would free up cash and lower your risk by rebalancing the portfolio a bit. All of these strategies make sense, and you could very well use a combination successfully.
When you decide to sell a stock, do two things: Write down why you sold, and start tracking what happens over the next three years. If you sold for valuation reasons or to take advantage of a new opportunity, this will give you black-and-white feedback on whether you were right or not. And if you sold because of concerns about your thesis, you’ll want to monitor that, too. Tracking your decisions will help you improve the process of making them, so you can make better ones in the future.
Whatever you do, avoid second-guessing yourself for selling B instead of A. That’s hindsight bias, which will only interfere with your enjoyment of your efforts.
