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.

 

selling a stock (ii): found a better one

A valid reason for selling a stock in your portfolio is that you’ve found a similar one with better risk-return characteristics.

Sounds straightforward:  you own one that you think can go up by 25% and, perhaps by studying the industry further, have found a competitor with a better product that you think can go up by 50%.  So you switch.  What could be simpler?

Strangely (to me, anyway), it’s not what people–even investment professionals–always do.

Consider this situation:

You find a stock trading at $100 a share that you think can go to $120, a 20% return.  You buy it.  Instead of going up, however, it drops to $90, even though the company’s prospects haven’t changed.  So the stock now has a return potential of 33.3%.

You find a close substitute, again trading at $100 a share.  But this second company has the potential to go to $150, a 50% gain.

What do you do?

Decide before you read further, please.

Believe it or not, virtually every securities analyst I’ve ever trained to be a portfolio manager says he’d wait for the first stock to rise to $100, then sell it and use the proceeds to buy the second.

Why is that the wrong answer?

Forget that you already own the first stock.  That’s irrelevant.  You can sell it in an instant at almost no cost.

You have a choice between a stock that can go up by 33.3% and one that can go up by 50%.  Both have similar risk profiles.  You should be holding the second, not the first.

Why do people want to continue to hold the first?  …it’s because their judgment is colored by the fact that they have a loss on it.  They’re more concerned about being right in their initial judgment than they are about making the highest profit.  So they don’t fully process the new information they develop.  The second stock isn’t going to wait at $100 for you to satisfy your ego.  Besides, in a taxable account, a recognized loss has at least some tax value.

selling a stock (i): super-sized position

what is super size in an equity position?

Let’s take an extreme example.  Say an investor does an asset allocation plan in mid-2003.  He decides to put 10% of his equity money into AAPL and the rest into an S&P 500 index fund.  He holds until the end of 2007.

What does his equity portfolio look like then?

AAPL has gone up 2000%;  the S&P has gone up 18%.  So his portfolio has become 65% AAPL and 35% the S&P.  In other words, he no longer has a portfolio of stocks.  He has a position in AAPL (which is giving a big shot in the arm to his wealth) plus bells and whistles.

what’s wrong with that?

The potential problem is that, although a good part of the investing game is to make as much money as possible, another important consideration is diversification–or protecting yourself against achieving a very bad outcome.  Having all your eggs in one basket is okay–unless/until the handle breaks and the eggs fall out.

In addition, sadly, not every stock is an AAPL.  For every AAPL, there are a ton of NOKs or BBRYs.  Suppose you pick wrong.

Also, the reality is that most growth stock rocketship rides last about five years.  After that, either competitive response or technology/fashion change halts their advance and most times sends them plunging back to earth.

The best (a small subset) of these high fliers can reinvent themselves once or twice and thereby add additional time to their fast growth days. AAPL, for example, was the iPod company in the early 2000s and the iPhone company in the second half of the decade.  But eventually even the most creative runs out of fuel and morphs into the equivalent of present-day MSFT, WMT or CSCO.

how much exposure is too much?

A lot depends on an individual’s age, financial situation, risk tolerance and willingness to pay almost obsessive attention to any large positions.

As for my personal approach, I consider myself to be an aggressive investor.  Still, most of my equity money is either in passive products or managed by others.  My largest position is around 6% of the total–and it’s in an industry I’ve been following for over twenty years and is spread over several companies I know very well and whose operations/stock prices I watch daily.

six reasons for selling a stock you hold

Selling an individual stock is either the easiest thing or the hardest thing for any investor to do.

Selling is easy when:

–you’ve found a similar stock to replace it that’s cheaper and has better growth potential

–you bought the stock of a mature company because the price was temporarily depressed.  The share has rebounded and reached the price target you had in mind when you bought it

–the stock has been so successful that it’s reached such a large size relative to everything else you own that the size itself has become a risk

Selling is hard when:

–you become emotionally attached to a stock, forgetting that investing is an economic activity you’re doing to fund your retirement or send your kids to college

–you’ve made a mistake, and are in denial

–you’ve found a true growth company, whose stock has been a rocket ship ride so far.  You know, however, it will come back to earth –hard–when it goes ex growth but don’t know how to identify the transition.

More on this over the next few days.