selling a stock (iii): it’s done its work

To the extent that we, as individual investors, hold specific stocks rather than an index ETF or fund, each stock should have a specific purpose.  Most times, it’s that we think the stock in question will outperform the index.  (That’s not always true.  Some investors, for example, will hold stocks that pay a large dividend.  For them, the stock is a substitute for a bond.)

The rationale for holding an individual stock generally falls into one of two patterns:

1.  the company is mature and slow-growing.  For one reason or another, it has fallen out of favor with Wall Street and is unusually cheap compared with either its breakup value or its future earnings prospects.  This routinely happens with companies whose businesses are highly sensitive to the business cycle.

Here the analysis is pretty straightforward.  You establish a target price and sell when (or if) the stock reaches it.

You might, for example, think that Barnes and Noble has a breakup value of, say, $25 a share (I don’t, but clearly some people think the number is at least that high).  If so, you would presumably have sold it when the rumor surfaced in TechCrunch that MSFT was preparing a bid for the Nook division.

Or you might observe that, say, a farm equipment maker typically trades at 8x peak earnings during an upcycle and that it’s trading today at 5x your estimate of peak earnings.  So you buy in anticipation of a 60% gain–and sell if/when the stock hits your target price.  (That’s typically long before earnings hit their peak level.)

2.  the company is small, fast-growing and, many times, trading at a high multiple of today’s earnings.  Here the sell decision is more subjective and less clear-cut.  At one time, WMT was a stock like this, as was IBM, ORCL, CSCO, MSFT or CHS (Chico’s).

In each case, there’s a qualitative or “story” aspect to the name.  In WMT’s case, it was that it made a ton of money by building superstores on the outskirts of US towns that had a population of under 250,000.  At some point–long before the financials began to signal a slowdown in growth–WMT began to run out of small towns to build new stores in.  That “qualitative” deterioration is usually the time to sell.  The sell decision is a little more complicated in each case, but that’s the general rule.

two notes

Even if you sell at the perfect time, that doesn’t mean that the stock doesn’t continue to go up.  If the overall market continues to advance, that movement will drag just about every stock along with it.  The “losers” will be stocks that don’t rise as fast as the market.  But they too will have higher prices.

The two types of stocks I’ve described above are typically called value stocks (#1) and growth stocks (#2).  You can read lots more about their characteristics by searching for “growth” or “value” on this blog.


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