Someone who reads my articles sent me this email ([email]firstname.lastname@example.org[/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,Stockopedia, etc.
When to sell a stock is complicated.
A) Benjamin Graham said when the stock appreciates 50%, or two years
B) Magic Formula says rebalance with highest earning yield and highest ROI at the end of year.
C) Warren Buffett said never.
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 Warren Buffett screen, rebalancing every month is not following what he said.
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 talked about National Western Life Insurance ( NWLI ) .
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 out?
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 Warren Buffett 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 with.
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 Coca-Cola ( KO ) 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:[email]email@example.com[/email]
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.