I Wouldn't Sell This Stock if I Were You

Back in 1995, when I had much more hair on my head -- but much less investing experience under my belt -- I discovered a promising little company that fit all my investing criteria. Although this company was young, it boasted a strong balance sheet, impressive free cash flow, and tremendous growth potential. Best of all, the company -- I'll reveal its name in a moment -- was run by a dedicated founder/CEO who also happened to be the single largest shareholder.

I happily bought shares, then even more happily sold a few months later, pocketing a tidy 25% profit. It was a textbook value investing success.

It was also the biggest investing mistake I've ever made.

I know what you're thinking
If you've lost money by following any of my stock recommendations over the last 15 years, you're surely wondering: How in the world I could consider a 25% gain the biggest investing mistake of my career? But rest assured, my experience with Dell (Nasdaq: DELL  ) was more painful than suffering a dozen bankruptcies.

That's because after I sold my shares, Dell went on to increase 45 times in value over the next 10 years. Even though the company has been in a slump recently, it still trades at more than 18 times my sell price. That's the kind of multi-bagger return that can make an investing career -- or fund the retirement of your dreams, if you don't share my aspirations of being a master investor.

Fortunately, my Dell experience wasn't a complete waste. In fact, I learned a key lesson that has helped me identify other long-term winners and prevented me from selling them when they still had room to run. But before I get to that, let's examine what made Dell such a success in the first place.

Three keys to a great company
1. Customer Focus:
Founder Michael Dell couldn't afford to build the fastest or most stylish personal computers -- he was operating out of his dorm room! Instead of trying to compete with the big boys, Dell concentrated on the one competitive advantage he could control: customer satisfaction. Thanks to its direct sales model, Dell could better understand its customers' wants and needs, and provide the PC that was right for them.

The great corporate leaders that I've met over the years, from Coach's (NYSE: COH  ) Lew Frankfort to Southwest Airlines' (NYSE: LUV  ) Herb Kelleher to Amazon.com's (Nasdaq: AMZN  ) Jeff Bezos all share an unrelenting focus on delighting their customers. Coach conducts over 40,000 one-on-one customer interviews each year to make sure its handbags meet its customers' needs. Southwest only hires employees with a sense of humor, a creative streak, and a passion for helping passengers. Amazon prides itself on low prices, cheap shipping, and exceptional customer service.

It's no secret why these firms have been so successful -- and why I believe their success will continue in the future. They are willing to go above and beyond to delight their customers in ways the competition simply can't match.

2. Strong Financials: Of course, the greatest customer service in the world won't matter if the company doesn't have enough cash on hand to cover its electric bill. Although Dell's tremendous growth potential was apparent, I waited for the company to generate consistent free cash flow before I bought my shares. I was happy to sacrifice a slightly higher purchase price for the downside protection that comes with a proven cash generator.

In addition, Dell had a sound balance sheet, with a debt-to-equity ratio of about 20%. I don't mind when companies take on a little debt -- in fact, I think it can actually help executives invest their limited resources in the best projects. But too much debt can have the opposite effect, forcing execs to adopt an unhealthy short-term focus.

Just look at Chesapeake Energy (NYSE: CHK  ) , which was forced to sell valuable assets during the credit crisis to shore up its balance sheet. Chesapeake may own a number of attractive shale positions, but its levered balance sheet makes it too risky for my liking. To avoid a similar fate, I generally steer clear of companies with debt-to-equity ratios in excess of 100%.

3. Insider Ownership: Last, but certainly not least, I was encouraged by Michael Dell's significant ownership position. I've found that high insider ownership is one of the most reliable indicators of stock market success. Founders and managers with high levels of ownership have their own wealth riding on the company's performance.

Michael Dell was the company's single largest shareholder, with an approximately 9% stake. Of course he was going to make decisions with shareholders' best interests in mind!

To see how many shares an executive owns, simply open up a company's latest proxy filing (also known as SEC Form 14-A). As a general rule of thumb, I like to see CEOs of small-cap companies own at least 5% of the outstanding shares. I'll relax this ownership restriction for larger companies (we can't realistically expect Rex Tillerson to own $15 billion worth of ExxonMobil (NYSE: XOM  ) shares, can we?), but I still like to see execs of large-cap companies maintain an ownership stake of $10 million or more. Tillerson's $68 million position in his company, combined with his 35 years of experience and reasonable salary, gives me confidence that he will continue to serve ExxonMobil shareholders in the future.

Please bear in mind: High insider ownership does not always translate to stock market success. Ken Lay and Jeff Skilling both owned large amounts of Enron's stock, and look where that got shareholders. But when an executive owns a significant stake and has a history of shareholder-friendly behavior, the investing odds are stacked in your favor.

The best time to sell
The world's greatest investor, Warren Buffett, teaches us that the best time to sell a great company is never. I couldn't agree more. I have seen far too many investors miss out on multi-bagger returns because they missed the big picture and sold a stock due to short-term valuation concerns.

Just imagine if you had sold Microsoft in the 1980s when it was still a small- or mid-cap stock. Those investors with the foresight and patience to hold onto their shares were richly rewarded.

The stock you shouldn't sell
And that, dear Fools, is the invaluable lesson I learned from my Dell experience. When you have identified a company with the three keys to greatness -- customer focus, strong financials, and high insider ownership -- you shouldn't let short-term valuation concerns scare you away from multi-bagger returns.

That's the advice I'd give to investors who own shares of Dolby Laboratories (NYSE: DLB  ) , one of the most successful recommendations I've made at Motley Fool Stock Advisor. Although Dolby has tripled since I first recommended the stock to Stock Advisor members in 2006, I think this audio entertainment pioneer still has plenty of room to run.

Dolby has a rock-solid balance sheet, with $779 million in cash and just $7 million in debt. The company generates strong and steady free cash flow, and it has great growth prospects as countries like China, India, and Russia make the transition to digital technology. And best of all, founder/CEO Ray Dolby owns over 50% of the company's shares.

I am confident that every decision Ray makes will be in his shareholders' best interests. I am also confident that those Dolby shareholders will be glad they held on to their stake in 10 years' time.

To read more about Dolby, as well as the other companies my brother David and I think you'd be smart to own for the next 10 years -- or more -- just click here to take a free 30-day trial of Motley Fool Stock Advisor. There is no obligation to subscribe. You have my word.

Fool co-founder Tom Gardner owns shares of Microsoft. Chesapeake Energy and Microsoft are Motley Fool Inside Value selections. Amazon.com, Coach, and Dolby Laboratories are Stock Advisor picks. The Fool owns shares of Chesapeake Energy and Microsoft. The Fool has a disclosure policy.


Read/Post Comments (28) | Recommend This Article (235)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 22, 2010, at 4:54 PM, jrj90620 wrote:

    Very timely article when everywhere I go on financial boards I read about investors(speculators) trading for the short term.Not an easy way to make money.Get rich quick usually ends up as get poor quick.Better to get rich slow.

  • Report this Comment On April 22, 2010, at 5:06 PM, opedbyme wrote:

    Ya I'll work on not selling the stocks I shouldn't be selling and focus on stocks I should be selling...unfortunately I find it very difficult if not impossi8ble to sell stocks I've researched and then bought.....so all I do is buy and hardly ever sell.....not that I'[m complaining cause my portfolio has been doing great as of late even with about 1/3 of them not making me money.....so please do not emphasize buy and hold but rather emphasize when to sell cause that the rub.

  • Report this Comment On April 22, 2010, at 5:09 PM, footchester wrote:

    "Dolby has a rock-solid balance sheet, with $779 million in cash and just $7 million in debt"

    The company was founded in 1965 (not sure when it went public) and has held a dominant market position for decades. Any chance they'll start spreading a little of that cash around? With that kind of balance sheet, they certainly don't need to stock up on cash for a rainy day; how about rewarding investors?

    (as you recommend, no one should be selling, which makes all of the stock price gains just so much paper; only dividends actually return cash to shareowners.)

  • Report this Comment On April 22, 2010, at 5:20 PM, Fred37bus wrote:

    I find this to present a dilemma: Rebalance my portfolio allocation by selling some of my big winner stock annually vs letting my winners run. One of my big winners had grown to about 45% of my portfolio and that seemed imprudent; I concluded I needed more diversification, so I sold half. Of course, the replacement stocks have not performed as well. Insurance can be costly.

  • Report this Comment On April 22, 2010, at 5:38 PM, guesszoo wrote:

    So where are you putting your STOP order to protect your "triple gains" while continuing to capture any upside?

  • Report this Comment On April 22, 2010, at 6:01 PM, mdtiller wrote:

    Ditto for NETFLIX which closed up $13.27 today. Very tempting to take some profits off the table. But I think I'll let it ride for awhile.

  • Report this Comment On April 22, 2010, at 6:06 PM, Gardnermiles wrote:

    My experience is that if it isn't a dividend stock; what's the sense of owning it?

  • Report this Comment On April 22, 2010, at 6:22 PM, deeandjay100 wrote:

    so where is Nokia heading from here?

  • Report this Comment On April 22, 2010, at 7:48 PM, wintrwman wrote:

    How do you answer the same question regarding GE?

  • Report this Comment On April 22, 2010, at 9:38 PM, OPTIONNUT wrote:

    One should always sell at least a portion of stocks that have run-up. Remember bears make money, bulls make money, and hogs get slaughtered! Never lement a profit even if the stock continues to rise!

  • Report this Comment On April 22, 2010, at 9:43 PM, peters46 wrote:

    You can also have too much insider/founder ownership. Many years ago I invested in an LLP (software). To me as a novice, everything looked good. Months later the founder informed investors that the software was out-of-date and needed an expensive fix. However, it was losing money too fast. So he (owner of 80%) was going to take it private and fix it. Legally, he was obligated to pay shareholders about three cents per share (less than two cents on the dollar invested). Shareholders were willing to put up the $25k needed for the fix, but had no say in the decision. All shareholders lost big time except for said founder. No insider ownership over 40% for me.

  • Report this Comment On April 22, 2010, at 10:43 PM, jackcrow wrote:

    Work your system.

    Tom has worked out his system. He has taken his lumps. Listened to others. Thrown out stupid ideas and been told they were stupid. He has dissected his winners and losers. He now knows what works for him.

    Don't follow or mimic Tom, learn from him. Maybe small cap to multi-baggers will be your thing, maybe not.

    When I first got into buying individual stocks I jumped on the hype and bought AMZN and NOK. 3 months later I sold both for small profits. Years later both have done very well compared to my original buy in price. I don't shed a single tear over my decision to sell because my decision to buy both was stupid eagerness not thoughtful studious purchasing. The right decision was to get out and rethink.

    Buying and not selling WAMU was stupid both ways, not because they made a mess but because I've never figure out how to price financials but I bought one any way.

  • Report this Comment On April 22, 2010, at 10:43 PM, snapcap wrote:

    opedbyme, I would sell the 1/3 of your stocks that are not making money for you, and look for something else that will. Unless of course there is a compelling reason for keeping the losers.

  • Report this Comment On April 23, 2010, at 12:27 AM, penchy1 wrote:

    This is all just retro-think by Tom and all of us. If you are a master investor (WB) then you don't need Tom's advice. TG is not WB and cannot claim to be a great investor until a public stake is driven. However (sheepishly), I have no alternative than follow TMF.

    Mark

    who loves reading the Fools and almost-fools (ala I think Cobra1000).

  • Report this Comment On April 23, 2010, at 7:06 AM, Awebb30 wrote:

    The day that I believe that people are sick of video games, T.V., movies, mobile devices and basically anything else that produces sound is the day that I'll sell DLB. Keep your dividends if that's what you like (VZ looks nice right now) - nobody's trading in their gadgets anytime soon.

  • Report this Comment On April 23, 2010, at 9:24 AM, sept2749 wrote:

    Does not sell =buy? Even at 60.+and no div.

  • Report this Comment On April 25, 2010, at 9:51 AM, dgnokids wrote:

    Where would one see that Ray Dolby owns 50% of the company shares. When I go to the secfiling.com, I see Ray's form claiming he owns 10,000 shares. What am I missing? I desire to have a good understanding and up to date info on insider activities.

  • Report this Comment On April 25, 2010, at 9:01 PM, TMFTenacious wrote:

    Hi dgnokids,

    Ray Dolby owns 60 million shares of the company's class B stock (each class B share carries 10 times the voting power of a class A share).

    For more information, check out Dolby's latest proxy statement by clicking the link below:

    http://investor.dolby.com/secfiling.cfm?filingID=1193125-09-...

    Hope this helps,

    Rich

  • Report this Comment On April 26, 2010, at 12:29 AM, smellcoffee wrote:

    Where does APPL play in all this. It's already shown huge growth but the fundamentals are all there.

  • Report this Comment On April 27, 2010, at 11:13 PM, yippiekiyeh wrote:

    If you thought buying Dell was so great, buying Apple in 1997 was even better!

  • Report this Comment On April 29, 2010, at 6:23 AM, MrBear509 wrote:

    I sell a stock when I don't like the product. I bought a Dell Inspiron last summer. It is the WORST computer I've ever had, and I am 58 years old. I am stunned or laugh out loud out of frustration at the things it does. Dell will help--at a price. So they sell you crap and then charge you to fix it. I'll stay away from Dell-thank you. The chickens always come home to roost.

  • Report this Comment On April 30, 2010, at 6:02 PM, bertil08 wrote:

    Dolby is totally amazing and unique as I see it. Patents run out, Viagra goes generic. MSFT falls asleep. GOOG becomes "idealistic"

    Dolby does not seem to have any negative user problems. It did drop big in 2009...if you count trough to peak but if you held on you'd be OK, but you never have to call Bangladesh to try to get your dolby working as we all do with Dell, VZ, AT&T, Sony, LG friendly customer service rep...or even worse: have you ever tried to contact Google et al?

    So - here's THE challenge for Tom: (after you throw away the rear-view mirror, of course) -

    ID the next five "DLB" candidates. Right here!!!

  • Report this Comment On May 01, 2010, at 12:21 AM, MikeBobulinski wrote:

    While Tom may have provided a formula and given an example or two, I think a great many folks are missing the point. I think the underlying point here is to not be quick to sell your winners. I can speak from some personal experience.

    I have a very wealthy brother who has been very successful in the Wall Street world. Needless to say, I wish I had even a small part of his business smarts. I once asked him for advice regarding when to sell out of a position. He told me that much of that decision was up to me, but that if he had a choice between selling a winner versus selling a loser, he'd cut his losses quick and sell the loser preferring to let the winner run a bit more. He then went into a bunch of discussion on stops and started to lose me. BUT the message was not run out sell the winners.

    Despite being told by him. Despite reading the same advice in a number of books. I did just that. When I needed to cover a call, I sold a winner instead of a loser. It was a bad trade made on emotion. I had hopes that the winner was going to drop down again, and that the loser might fly at a later date.

    Long story shortened. The winner flew and the loser died. The winner I am talking about? Last year, almost a year ago to the date, I bought a measly 20 shares of Baidu. I am a small investor and that is all I could afford at the time. Like Tom's story, a couple of months after I bought it, I reached my decision point and needed to cover a call. Baidu was up enough that I was going to make a few hundred dollars. For me, that was a big win. Now, a year later...my initial investment of $2500 could have grown to be worth better than $14000....the price of a small car.

    My point...who cares what the next DELL or DLB is? There are a great many opportunities out there. Do the research. Follow whatever rules you feel you can live with. In the end, it is your money...your bet. Place it wisely, and be careful not to jump out of the winners too quickly. You might walk away with some profit, but holding a little to a lot longer and you could walk away with a much larger profit.

    Fool on...

  • Report this Comment On May 01, 2010, at 3:27 PM, elfwin wrote:

    Hmm..I was raised on "buy & hold"- bought Microsoft in 1990, and held it all the way up to 60, then continued to hold it all the way down to 20. For a decade it hasn't managed to pop out of the 30's. I think the days of "buy & hold" are gone- now I'd rather take some profits and have the bird in the hand, rather than hoping for the two that might be in the bush.

  • Report this Comment On May 03, 2010, at 5:00 AM, TheDexter wrote:

    I bought BAC for the sole purpose of flipping the stock. It was an over correction of colossal proportion. Did I consider holding? No. Because when paying $2.00 a share that became $18.00 within the following six months, it served my purposes completely, and in the current economic climate I am not expert enough to know where financials are going to next, much less hold. I sold for what it was worth to me.

  • Report this Comment On May 04, 2010, at 11:03 AM, Vinny42 wrote:

    Explain to me why a company with $ 779 million in cash maintains $ 7 million in dbt ???

  • Report this Comment On February 04, 2011, at 4:43 PM, titus77 wrote:

    <i>Hmm..I was raised on "buy & hold"- bought Microsoft in 1990, and held it all the way up to 60, then continued to hold it all the way down to 20.</i>

    Even with the price being stagnant, when you calculate your return after 8 splits and 8 years of dividends, do you still think it was a bad investment?

  • Report this Comment On August 03, 2011, at 4:25 AM, garifolle wrote:

    I am pretty late in this discussion, I had not read the article before.

    I would just like to understand: taking a 25% profit after a few months cannot be a mistake: you had no more crystal ball then anyone else.

    Running up with a stock up to $60.00, and getting so married with it that one will dive with it down to $20.00, seems a bigger mistake, but it's not the subject.

    Probably many others took their profit on DELL around the price you sold.

    But I just wonder why you did not buy it again, when you saw it was still going up?

    Had you put all the cash from that sell in something else?

    When I read articles on the Fool, it sometimes gives me the impression that portfolios are indefinitely "stretchable": "Never sell this stock", "Buy this one and hold".

    Sure one can reallocate.

    If you portfolio was fully invested, and you saw Dell going up, you could have sold part of another position to jump back in DELL.

    This type of article makes me feel either terribly poor, or think that you live in another world.

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