When to Sell Stocks - a value / fundamental perspective

Sunday, Feb 12 2012 by
6
When to Sell Stocks  a value  fundamental perspective

A couple of weeks ago, we looked at the thorny issue of when to sell stocks, looking at the use of stop-losses and focusing on the telltale signs suggested by Bill O'Neill that a growth stock may be getting toppy. As should have been obvious, this approach suits a growth-focused investor like O'Neill who's looking for rapid breakout, momentum stocks and wants to bail out of non-performing turkeys as quickly as possible. It's less clearly applicable in the case of value investing, where one is deliberately investing in companies that are ignored or misunderstood by Mr Market with a long-term view about the underlying intrinsic value and using a Margin of Safety. To illustrate this contrast, Warren Buffett hardly ever sells - indeed, his philosophy is that a lower price makes a stock cheaper and a better buy, although admittedly he's mainly dealing with entire companies, rather than parcels of shares.

A View from Philip Fisher

Although himself more a growth investor, Philip Fisher has laid out a more useful set of selling guidelines for value folk in chapter six of his book, "Common Stocks and Uncommon Profits". He argued that there were three general conditions which suggest that a stock should be sold:

  1. The investor has made an error in his/her assessment of the company.
  2. The company has deteriorated in some way and no longer meets the purchase.
  3. The investor finds a better company which promises higher long term results after factoring in capital gains.

One thing that seems to be missing from this list is when the company's stock price reaches intrinsic value (although that could be part of point 3). Interestingly, gut feelings or worries about a potential market decline are not reasons to sell in Fisher’s eyes - and rightly so, given the inherent difficulties of market timing. He explains:

“When a bear market has come, I have not seen one time in ten when the investor actually got back into the same shares before they had gone up above his selling price.”

Should value investors use stop-losses?

This is a very interesting question for value investors. As blogger TurnAround Contrarian notes, stop-losses are something of a taboo subject among value investors:

"The reason being EGO... Value investors including myself spend hundreds of hours researching a company. I like to think my work, which includes digging deep behind the numbers, gives me a good perspective to place a fair market value on a company. My due diligence includes not only financial analysis but also an exhaustive amount of work speaking to competitors, customers, ex employees and analyzing the psychological profile of the management team".

Value investors tend to take the view that this work means that they don't need the protections of stop-losses -there's no need to worry what the market does because: i) they understand what they are buying, iii) prefer companies with low leverage (lowering the risk of bankruptcy), and iii) they want to take advantage of volatility, not chase momentum.

While it's certainly true that the whole premise of value investing is that the market often drives the price of unloved stocks absurdly low before recovery begins, it may still be sensible to have some rules - or semi-automated procedure - for recognising losses because...

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You won't always be right

While we all hope that the market will come to recognise what a bargain our latest investment was, there are two distinctly unpleasant alternatives. It may be that you've bought in far too early and from a return perspective, any future realisation of value will be far too distant to justify tying up your capital that long. Alternatively, you may got it wrong altogether and the stock may simply be a value trap - a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value because of a fundamental change in their business prospects. Again from TurnAround Contrarian:

"How many value investors purchased the home builders after they had fallen 50%. Only to watch them fall another 80% in many instances. Having operated turnarounds, I know how quickly industry dynamics can change and how those changes can quickly impact pricing, cost structures and a companies competitive position in the marketplace. An investor needs to realize cash flows can decline very fast".

With that in mind, it's worth considering implementing two selling-related rules in your investing:

1) Stop-Time, not Stop-Loss?

An alternative to selling merely because the price has dropped is to consider a specific time-limit for loss-makers. Ben Graham suggested selling either after a price rise of 50%, once the market capitalization matched the net asset value, or at the end of 2 years

Sticking to a similar "stop-time" may be useful in automatically taking you out of dodgy investments. The specific time-frame of 2 years is of course somewhat arbitary but the idea is that too short a time period may not be enough time for management to turn a company around, whereas allowing more than, say, three years is likely to cut your compound returns to unacceptably low levels.

2) Always Write down Your Investment Thesis

It's well worth writing down at the time of purchase the specific thesis that underlies the investment and any metrics for tracking this. This allow you to monitor how future events have impacted that thesis objectively, without getting caught up by hindsight bias or issues of loyalty/saving face. One approach - advocated here by Greg Woodhams - is that, should the thesis be (materially) compromised, the holding should be sold immediately and one should avoid allowing new reasons to justify retaining the position. 

Recognising Failure is Hard

Selling out at a loss is not easy - this is both due to the well-documented tendency/bias of "loss aversion" and because loyalty and a desire to save face can get in the way emotionally. You may feel compelled to stick with the company you've come to know and love (only rats jump ship etc), even when the rational thing is to walk away. For that reason, although a stop loss may not suit your investment style, it's still worth establishing some other clear guidelines / procedures for disposing of your investments before it's too late.

Further Reading around the Web


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4 Comments on this Article show/hide all

anahin 14th Feb '12 1 of 4

Note that while Buffett was a Graham student, he seems to follow Phil Fisher when it comes to selling.

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UK Value Investor 15th Feb '12 2 of 4
2

I've always found the 'sell side' of things interesting.

I think stop-losses are the complete antithesis of value investing. The whole point of value investing is that Mr Market is there to serve you, not guide you. So if the share price falls 50% and your investment case holds, then why would you sell? It makes no sense to me. If the investment case has changed then fair enough, but that's something else entirely.

What I would call 'active' selling is where you basically ask yourself "is there something materially better I could be doing with this capital?". If the answer is yes then it might be time to sell and put it into the other opportunity, if not then stay put. The crux of this is how each of us defines 'materially'.

Another approach is 'passive' selling which is what I mostly do and what Graham was doing with his net-net 50%/2 year strategy. You basically set a rule at the strategic level and then stick to it regardless of everything else,i.e. you passively follow your strategy.

Which is best probably depends on each individual investor.

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emptyend 15th Feb '12 3 of 4
1
there were three general conditions which suggest that a stock should be sold:
  1. The investor has made an error in his/her assessment of the company.
  2. The company has deteriorated in some way and no longer meets the purchase.
  3. The investor finds a better company which promises higher long term results after factoring in capital gains.
One thing that seems to be missing from this list is when the company's stock price reaches intrinsic value (although that could be part of point 3).

I'm bound to say that I have never (in nearly 13 years) found that any of the conditions 1-3 applied for my main stock holding.  The additional point (intrinsic value) applied only once....very briefly....for two days....but I convinced myself that there were good enough reasons to continue to hold - and the share price is now roughly half that level (mainly due to the macro market conditions of the last three years rather than anything to do with the company concerned).

The question I occasionally ask myself is whether, with the benefit of hindsight, I would do anything differently - and the answer is, broadly, no.  Of course I regret the loss of value (and of course it would have been prudent to top-slice) and of course I have seen other opportunities come and go and provide handsome returns in the meantime......but I don't think there is anything much I would have done differently, other than perhaps take 20% off the table in a top-slice.

It is all too easy to look back and say "if only" - but one has to be very careful to separate out such vague wishes from decisions that one might reasonably have considered taking, based on the facts evident at the time.

ee

 

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lightningtiger 15th Oct '13 4 of 4

I do use stop losses successfully. What is the point of letting a stock fall by 50%. A 10% stop loss saves you losing that extra 40% in the first place. If you make a mistake, like the pawnbroker recently, this saves you a lot of money. I have used charts for many years. A simple strategy for me is , If it has been going up steadily and still going up buy it. If it has good potential , but going sideways, watch it. If it is going down & passing the stop loss sell it. Cut your losses and get out, and let your profits run. This works well for me. Cheers from Lightningtiger.

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