On Selling – Some Thoughts on When to Fold ‘Em

by The Graham Investor on March 5, 2010

Much is made of stock buying strategies, but the truth is nobody makes a dime from their investments until they sell. Selling stock is easy – knowing when to sell maybe not so much. Or is it?

It certainly should be.

Ben Graham variously suggests keeping stocks for 2 years, and/or selling 50% of a holding. Warren Buffett hardly ever sells, if ever. Buffett is no ordinary value investor in that he buys entire companies, not just hundreds or thousands of shares of stock. For the majority of individual investors, there are probably only a handful of selling strategies in use, most of which are more or less random depending on their emotional state.

  • Sell after X amount of time.
  • Sell when I need the money.
  • Sell when I’m in profit and the tax consequences are minimal.
  • Sell to record a tax loss when you file your online tax return.
  • Sell this stock because I don’t like it anymore.
  • Sell because my original investment is 10 percent, 50 percent, even 90 percent gone. Ouch!
  • Sell because EPS missed estimates by one measly cent.
  • Sell because today is as good a day as any and my gut says so.

And so on. You get the picture, more often than not there’s precious little logic involved.

A simple finance course in one of the many online colleges could be of help to many of these “by the gut instinct” investors.
Or, they could find some help in an investment basics article.

Then there is a selling strategy that starts with the process of buying and is built into an overall goal for your portfolio. As you analyze XYZ stock for purchase – because you have determined it to be undervalued and with an adequate margin of safety – before you even pull the proverbial trigger you wonder out loud: at what price will I sell this stock?

The simple answer might be: when it reaches fair value. But life is never simple in investing. When will XYZ get to fair value? Will it ever? Will I still be around when it does?

A better answer might consider the fact that you have a set target for your entire portfolio to make an annualized return of, say, 20% per annum. You can then give each of give your individual purchases a set amount of time to make a profit, say 20% each in any one year period. Suppose you buy 5 stocks at the beginning of the year, investing one fifth of your portfolio in each. If 3 of your 5 stock purchases should make a tidy 50% gain in 6 months (the other two staying flat) and you sell them at that point, you can afford to lose 25% on your other two purchases by the end of the year and still meet your portfolio’s annual 20% percentage gain goal. Should the other two purchases remain flat through year end, your portfolio gain for the year is 30%, comfortably beating your target.

I like to think of maintaining my personal CAGR or Compounded Annual Growth Rate over the years. This means I pay attention to annualized gain and sell early winners, or at the very least lock in profits with trailing stops. That, in turn, means I can give the laggards more time.

If a stock gains 20 percent in a year thats the annualized gain for the year. If the 20 percent gain happens in the 30 days after buying, the annualized gain is way more than 20%. We can extrapolate to find the annualized gain from our 30 day period gain as follows:

((1 + Rate of Return)^1/N) – 1

N = Number of periods

Since our gain happened in 30 days, we calculate N as 30/365= 0.08219178

(( 1 + 0.20)^(1/0.08219178)) – 1

(( 1.20 )^12.1666667 ) – 1

9.19119181 – 1

8.19 or 819%

The longer we get to a full year, the lower the annualized gain becomes. That 819% will diminish exponentially unless the stock continues to gain at the same rate.

In simple terms, sell after 2 years any stocks that have gone nowhere or contributed less than your target CAGR. Lock in profits on those that go up steeply, or sell a percentage such that your remaining stock is free. Or sell if they have already reached fair value and you have found something else that’s undervalued.

What about stocks that go down? If you calculated your margin of safety well, you shouldn’t have too many of those, and your personal CAGR should be boosted enough from the winners and good years that you can ride out any losers while maintaining that minimum rate of return.

{ 13 comments… read them below or add one }

1 Bob April 2, 2010 at 9:12 pm

Hey Mate,
i like your website. I also do some security-analysis and have put up an website about it. If you
ever need some Information on German Stockmarket or European Stock Market feel free to shoot me an email. If you like we can also talk about some collaboration. Cu around.
Bob

2 Chrisfs April 4, 2010 at 2:54 am

Hi,

Thanks for the neat website. As I go to more investment sites on the web, I tend to think that much of it is simply not useful or outright wrong. I appreciate your spreadsheets. And also this post about selling, because many popel recommend stocks, but few people talk about when to sell.

3 The Graham Investor April 5, 2010 at 9:45 am

Thanks, I will try to post more about selling strategies, but the bottom line is, no one ever went broke taking a profit. On the other hand, many times a big gain can turn into a loss if you don’t take it.

4 Jim Allen April 26, 2010 at 11:18 pm

When to sell a winner is the hardest part of this business as far as I’m concerned. If one is doing a proper job of conservatively evaluating potential investments, insuring a margin of safety, the losers should be few and far between, and none of any consequence in what should be a portfolio of mostly winners.

We have been taught to value a business, buy shares in that business only at a price that insures an adequate margin of safety and hold that until Mr. Market values that business at an absurd price. Of course, sometimes it never gets to that point before conditions in the business begin to deteriorate.

I don’t think there can be a definite objective rule about it, only guidance. Just where to get out is a matter consigned to sound judgment. That’s what I hope I am using as I watch Ashland, Inc. advance from below $6 to over $60 in little more than a year’s time.

Although Graham wrote about selling after a 50% gain or after two years, etc., I think he would be concerned that these hard and fast rules would lead one into a speculative attitude, and hence dangerous.

5 The Graham Investor April 27, 2010 at 9:12 am

Eloquently put. By the way, great to read that you’re sitting on a 10-bagger with Ashland, Inc. Ashland first appeared on the NCAV screen in August 2008 at about $39, and was there most of the way through the downturn – it was still on the screen at $8 and change on 03/23/09. A great company. I know some others have already banked big (100-150% plus) gains from picks off the NCAV screen which is heartening, because it tells me they are clearly able to sell when the time is right.

6 Bryan May 5, 2010 at 9:42 pm

Thanks for the good and timely post. I became interested in value investing after reading Snowball. The approach really resonated with me so I started following the approach – or at least as much as I could decipher from his book and the Intelligent Investor book. I found Ruger (RGR) using stock screeners at around 11 and now it is is over 17. I have no idea of whether it is time to sell, but I am looking at it in real dollars. I have made $500 on the stock and that is enough. The challenge I will face is where to put the money next. Based on what I read about WB and what my stock screeners say, there aren’t too many values out there. And it almost seems like it would be best to have cash ready to deploy on the next correction. Sorry for rambling, but I find it all very interesting and fun right now.

7 Jim Allen May 8, 2010 at 12:08 pm

Do what Warren Buffett does, value the company. What is the value of Ruger (not necessarily the same as the price)? Only then look at the price. If the price and value diverge significantly, act. Don’t get the yips just because you have a nice paper profit. You want to be an investor, not a speculator.

There are various ways of estimating the value of a company, and lots of books describing the various approaches. One of Ben Graham’s approaches for estimating intrinsic value is described here on this site. The key word here is “estimating” as there is no hard and fast “right” answer. There are lots of approaches to value.

If Ruger is still undervalued, why not keep it? Don’t sell just because you’ve made $500, unless the price is close to what you think is the value. Look at the example above of Ashland! It doesn’t always happen like that but why sell a good value with more value left? You have to share that profit with the tax collector, don’t forget.

Don’t fixate on price! Learn to look for value and make decisions based on that, not price. It is harder to do, which is why few people do it, or stick with it.

8 A.N.Other May 11, 2010 at 9:33 am

This is my old, time-tested exit strategy, in summary form. I’ve used this fairly successfully since the mid 90s. I have two different exit strategies, depending on the quality of the business. I’ll start with the one for average or poor quality businesses:

1. What is the minimum fair value of the business, using conservative assumptions? Exit half your position when the price reaches this level.
2. What is the most likely fair value of the business, using normal assumptions? Exit the remainder of your position when the price gets to 90% of this “normal fair value”.
3. If at any point the earnings power or the balance sheet of the business deteriorates substantially, such that fair value is now likely equal or less than the current price, immediately sell the whole position.

I find that most times, the first exit is too soon. That’s why I have a two stage exit. I don’t like to hold on for full fair value, because average & mediocre businesses sometimes have downside surprises, and I don’t want to be stuck in them long-term.

For great businesses:

1. At what price would the business be fairly priced, give its high quality and future outlook for earnings and asset value, using normal assumptions? Sell half once this price is reached.
2. At what price would the business be clearly overvalued, even under fairly optimistic assumptions about future earnings growth and asset value? Sell the remainder of your position once this price is reached.
3. Has the business suffered significant deterioration in its long-term earnings power or balance sheet, such that fair value is likely equal to or less than the current price quote? If so, sell your entire position immediately.

The reason for rule 2 is that great businesses often surprise on the upside, and just keep creating value year over year. Many times I have sold stocks when they seemed “fair value”, and then seen them double, triple or more over the next few years due to surprisingly high earnings growth, business deals, exploration finds or other unpredictable events. Effectively, great businesses have a kind of “surprise premium” to their valuation. I therefore prefer to hold half until the price is so high that even with optimistic assumptions, it is still not worth any more than that. This has let me run some excellent growth stocks like AAPL, CMG etc much longer than I would have in the past, and it still protects you from the risk of holding on at crazy overvaluation.

Finally, a catch-all set of rules:

1. Accounting problems = sell
2. Significant lawsuit = sell
3. Genuine risk of insolvency = sell

9 Charles Parker June 13, 2010 at 2:27 pm

I’d like to go back to the comments on Ashland and what I perceive is an over-optimistic view that few of your stocks will decline. I presume any stock selling at 2/3 or less of net-net looks to have an adequate margin of safety, yet Ashland passed the screen and declined to 8. Were we supposed to ride it down? Stocks passing a net-net screen are generally unpopular, but this doesn’t keep them from becoming a lot less popular before things turn for the better (if ever).

I’d like the group’s thoughts on this.

Thanx – Charlie

10 Jim Allen June 15, 2010 at 12:07 am

Ashland was perceived to be an excellent bargain when it came to my attention at around 12, so I bought it. It thereupon got to be an even better bargain, descending down through 7, below which I bought another batch. It kept on declining with the general market, and I admit I was beginning to think I might have to tell my wife I had blown a pretty good slug of money. The low was $5.35. Ashland later reported earning something like $2.70 for the year.

Since this experience, I have read and re-read Graham’s depictions of Mr. Market’s irrational behavior, and all that, and given this a great deal of thought. There is certainly no guarantee that a stock will stop its decline just because you bought it! Thanks to Graham, I know intimately the meaning of the word “disquieting!”

I conclude that as long as you detect no deterioration in the company’s financial position, or prospects, you are justified in continuing to own the shares. I saw that kind of situation recently with Zales, where it had been a net-net play but the financials got worse. When that happens, you will take a loss. Those things are inevitable if you do this long enough. When, however, the business continues satisfactorily, the lower quotations are meaningless, unless you chose to buy more. You do need to be sure of your facts, though, to withstand the apparent loss with confidence.

Warren Buffett reportedly has no quote machine in his office, or in his world. To the extent we continue to price our holdings every day, or even oftener, and allow the quoted price to affect our mood, we are acting like speculators, not investors. Graham/Buffett teaches us to look first at value, and only then at price. If the price is close to value, then maybe doing something is warranted. If price is quite a bit less than the value, sufficient for an adequate “margin of safety,” a buy may be in order. Unless the value changes, or unless the price catches up to the value, do nothing. (The trouble with doing nothing is you are never sure when you are finished!)

Warren Buffett writes that if you can not stomach the idea of a 50% decline in price, you probably shouldn’t be in the market owning stocks. If it were easy, everybody would do it!

Memorize Graham’s depiction of Mr. Market. It will help you sleep.

11 S.Menon June 17, 2010 at 12:11 pm

Interesting to see discussions on ASH, ZLC etc. I was one who DCAd on its way down, all the way from $25 to $6. As Jim has mentioned, it takes a lot to stomach the un-realized losses on the way down, but this was a sound business with a huge margin of safety.
I did sell 25% of my ASH position at $60. There are very few quality net nets to be found these days, but would be interested in studying some of your thoughts on individual value picks…

12 Bill Spetrino July 25, 2010 at 6:50 am

As a person who has made a living SOLELY from building a dividend machine based on Berkshire Hathaway I take profits on NON dividend stocks after a predetermined amount based on a rate of return I feel is sufficient

13 Jim Roberts November 4, 2012 at 6:24 pm

I think trailing stops are a must, but don’t forget to raise them as the price goes up. You can always buy them back later (after the crash) if they continue to show up on the screens. Give it three months to reach rock bottom. Better to be late than early.

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