Someone who reads
sent me this email ([email]email@example.com[/email]):
1) For a layman, when should one sell a stock?
For when to buy stocks there are so many formulas and
screens: AAII screens, CANSLIM,
When to sell a stock is complicated.
A) Benjamin Graham said when the stock appreciates 50%, or
B) Magic Formula says rebalance with highest earning yield
and highest ROI at the end of year.
If I don't watch my stocks for a year, if the fundamentals
deteriorate in this year I might lose (fundamentals change every
quarter). I asked this question to Validea and AAII. They said
rebalance every month.
For the Benjamin Graham screen, rebalancing every month is
not following what he said. For the
screen, rebalancing every month is not following what he
What is the simplest time and condition for a non-techie to
sell a stock?"
Sell when your original idea has played out. Or when your
original idea has been undercut. Never sell a live idea unless
you need the cash to buy a better idea.
Never sell a live idea just because it's been a long pregnancy.
If you bought a stock a year ago because you had a good, valid
idea and that idea is as good and valid today - but the stock
price is no higher - that doesn't matter.
The gods of finance do not reward patience. Nor do they punish
it. They are indifferent. The world doesn't care. It doesn't care
if you are getting bored. The lack of action that's making you
itch to sell is inside of you. The guy who buys your shares from
you isn't going to feel that itch. For him, it's a new stock. The
mental process reboots.
Don't let that happen. Don't sell a real thing from the outside
world - a stock that might have a lot of value - just to scratch
some mental itch. When deciding to sell a stock - it shouldn't
matter whether you bought it a day ago or a year ago.
So don't relive your experience of owning the stock. Relive your
experience of buying the stock. When you think about selling a
stock - start by restating your reason for buying the stock. Then
forget the time that has passed. That time is gone. All that
matters is your past idea and the present reality.
The key to selling is knowing why you bought. If you don't know
why you bought - you can't know when to sell. So, if you want a
formula for selling - you need a formula for buying. If you trust
the formula for buying - like Validea or AAII - then trust them
for selling. I don't trust them. I do my own buying and selling
for my own reasons. And for the rest of this article, I'm going
to talk to people who do that too.
I'm going to use something a blogger wrote as an example. Why?
Because bloggers do the work all investors do. They just do it on
paper. We can see their thoughts. And we can revisit their
reasons for buying something.
In October, the blogger who writes
Student of Value
National Western Life Insurance (
At the time he wrote the post, he did not own the stock. It was
"on his radar." But since he was thinking about buying the stock
- his post works just as well as what someone who did buy that
stock might have been thinking.
Here's what he said about the company's value:
"National Western is selling for 40% (of) book. Life insurers
at the start of the year were selling for 0.7x book on average,
according to Damodaran's data. Based on my analysis so far, I
would think National Western is better than average. On top of
this, the average is currently depressed. Assuming only the first
part gets adjusted and the company trades up to par with the
average life insurer equals a 75% price increase."
We can boil down his argument into two ideas: 1) National Western
is an above average life insurer. 2) National Western trades for
a lower price-to-book ratio than an average life insurer.
This is the gap he wants to close. This is his idea. And it's a
live idea as long as nothing happens to ruin his reasoning. If he
realizes NWLI is not an above average life insurer - then his
idea may be ruined.
If the average life insurer falls in price while NWLI rises -
that may kill his idea. But that's the point. He wants the idea
to die by seeing that gap close. Once that happens, the idea will
be dead. And the stock should be sold. Hopefully, at a profit.
Something like a 40% drop in all stock prices - including the
price-to-book ratio of the average life insurer - could kill his
idea without a profit. That would close the gap without NWLI
going up in price.
When he wrote this article, NWLI was trading for 40% of book
value. So, he saw 75% upside. Or we could flip that and say he
saw a 43% margin of safety. That's because the multiple paid for
the average life insurer could fall from 70% of book value to 40%
of book value (a 43% multiple contraction) and NWLI would still
be cheap. It would still be a better than average life insurer
trading for the price of an average life insurer.
So, when should this blogger sell NWLI? When it rises 75% to 0.7
times book value. Not exactly. He didn't say 0.7 times book value
was some magic number. It wasn't a target set in stone. It was
just the price an average life insurer was trading for. So, it's
not right to say he should sell at 70% of book value. Instead, he
should think about selling when NWLI - which he thinks is an
above average life insurer - trades for the same price-to-book
ratio as an average life insurer.
Maybe NWLI will rise 75% and other insurers will rise 30%. Maybe
the average price-to-book ratio for a life insurer will be 0.9
times book value at some point. At that point, maybe he should
keep NWLI even if it trades at 0.7 times book value.
Because we have to keep his reason for buying in mind. His reason
for buying was that NWLI is an above average life insurer. If he
is right about that, then NWLI should not trade for less than the
average life insurer does.
So, when should he sell NWLI?
He should sell NWLI when his idea plays out. His idea was that he
was buying an above average life insurer for less than the market
was paying for an average life insurer. As long as that's a live
idea - he can stay in the stock. Once that idea is dead - he
should think about selling.
But that's just the upside idea. Student of Value is a good blog.
And like any good blog it doesn't just look at the upside. It
looks at the downside.
What is the risk in NWLI? What's the downside idea?
Here's what he said about that:
I came across news from late 2011 of Brazilian insurance
regulator attempting to impose a $6 billion fine on the company.
National Western has been laconic in its disclosure... From what
I read, the claim is most likely just flexing muscles on behalf
of the regulator. The amount seems highly incredible at 5x the
company's capital. If the threat were credible, it certainly
would have affected both the stock price and A.M. Best's
financial strength rating of A (Excellent) with a stable outlook,
reiterated on May 31, 2012. Yet, Brazil is National Western's
largest foreign market - about the annual size (by premiums and
contract revenues) of the next 3 largest markets... Even if there
is no big effect on the company, the fact that management hasn't
been more open about a seemingly big issue in its largest foreign
market undermines the confidence I had in it."
So here we have another reason why he might sell. He might sell
because the risk played out the wrong way. He might sell because
something changed that made him believe the Brazilian threat was
real. Or because he lost trust in the CEO because of how he
handled this problem.
The key to selling is to always go back to your original idea.
Why did you buy the stock? What upside did you see? What downside
did you see? Has the upside played out? Has the downside played
No. Then has the upside changed? Has the downside changed?
No. Then you should stick with the stock.
If the price-to-book ratio of the average life insurer fell from
0.7 to 0.4 while NWLI's stock price stayed the same - maybe he
should sell. It might feel like a defeat. But so what? His idea
was an above-average life insurer selling for less than the
average life insurer. His idea was not that all life insurers are
undervalued. It was that this life insurer is undervalued
compared to the others.
Before you buy a stock, do what
suggests: Sit down with a pen and paper and say, "I am buying
shares of this company because..." Then put that idea in a
drawer. And whenever you reconsider the stock - read that idea
back to yourself. Is it still a live idea? Have you given it time
to play out?
If you've squeezed all the life out of an idea - either because
price rose or value dropped - then sell it. But if there's still
juice left in the idea - just hang on. Be patient. Never sell a
stock for lack of action.
There is one exception. You can always sell one stock to buy
another. That's different. When that happens, you just compare
the stocks. And you go with the one you are most comfortable
Now that we know the key to selling a stock is revisiting why you
bought it - let's think again about what Buffett and Ben Graham
said about selling stocks.
Ben Graham said you should sell a stock when it rose 50%. It's
easy to see why. Graham said you should buy a stock at two-thirds
of its net current asset value. If you buy a stock at two-thirds
of NCAV and it rises 50% - you now have a stock that is trading
around its net current asset value. That's still cheap. And
Graham knew it. But once you got beyond net current asset value -
you would need to know more about the business to know if the
stock was cheap. That wasn't Graham's style. So he said you
should sell after a 50% rise.
Buffett said the best time to sell a stock is never. Or, at least
he said something - "our favorite holding period is forever" -
that means roughly the same thing. Buffett focuses on quality. He
wants to pick as close to the perfect business as possible. Once
you own a chunk of a perfect business - you don't want to sell
it. So he doesn't. But if he picked wrong - he should sell.
These guys had different specific ideas about selling. But their
general principle was the same. Don't try to guess about things
you don't know. Keep a stock as long as it stays in your comfort
zone. Once it ventures into the unknown - outside of your area of
focus - let it go.
Once your original idea plays out - sell the stock.
Buffett's original idea in something like
is that it's a great business that will stay a great business. As
long as it stays a great business - he sticks with the stock.
Ben Graham's upside idea for a net-net is that it's cheap. It's
cheap no matter how bad the business is. As long as the net-net
is safe it is cheap. It doesn't need any growth prospects. He
didn't worry about whether it was worth 5 or 10 or 15 or 20 times
earnings. He worried about whether it was worth more alive than
dead. Once the stock rose above its net current asset value - he
couldn't be completely sure it was still trading for less than it
was worth. So he would sell the stock.
You mentioned Graham saying you should sell stocks after two
years. I've looked at Graham-Newman's holdings by year - and
haven't seen any evidence he actually did this. Fear of getting
stuck in a net-net was often the biggest complaint Graham got. I
think this is something he suggested amateur investors could do.
It's not something he did in his own fund.
Here's my advice. If you don't know when to sell a stock - the
problem is that you don't know why you bought it. You don't
really know what the idea was you had in mind. And you don't know
if that's still a live idea. So you can't tell the difference
between clinging to a dead idea and just waiting.
Always err on the side of waiting too long. Few investors wait
too long. A lot of folks I know sell too soon. For example, I
know plenty of people who pick good net-nets and then don't stick
with them. They do good work. And they don't make money from it.
Selling can't fix a bad idea. But it can kill a good idea.
The one instance where I am always in favor of selling this
second is when you know you misjudged the risk of catastrophic
loss. If you totally misjudged a company's risk of default,
fraud, etc., go ahead and sell the stock right now.
Otherwise, revisit your original idea. And then decide whether
it's played out fully or not. There's no rule that says you
should hold a stock for seven weeks, seven months, or seven
years. It all depends on why you bought it.
If you bought the stock to flip it at a higher P/E - and it's
seven weeks later and the stock is up 25% - I can't blame you for
selling so soon. But if you bought the stock because you loved
the competitive position and the constant buybacks and the rising
dividend - and you're selling it within a year - I don't think
you've let your original idea play out.
So unless you buy stocks using nothing but a formula, you won't
be able to sell stocks using nothing but a formula. You'll need
to revisit your original idea.
Talk to Geoff about When to Sell a Stock:
Read Geoff's Other Articles
Visit Student of Value
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