The hope of profits and the joy of ownership make buying stocks a fairly simple decision, especially in comparison to the tormented hair-pulling that's often associated with selling.
When to jettison a stock is a difficult decision, so we won't pretend there's a one-size-fits-all formula. However, guidelines can make selling decisions easier. At Motley Fool Million Dollar Portfolio, the following are four key factors in any sell considerations.
The most cited reason to sell -- a fairly valued stock -- is also the most difficult to nail down.
We estimate the fair value of a company before plunking money down to buy, determining intrinsic value by digging into financial statements, analyzing business prospects and free cash flow, and making conservative assumptions about future growth.
Buying undervalued stocks, we wait patiently for a price that's close to our estimate of fair value, reassess at that point, and then ruthlessly sell if the stock looks fairly priced.
One challenge is overcoming your attachment to the stock -- everyone loves a winner -- and the dream that it will go up indefinitely. You may love the same store sales growth, rapid store openings, and debt-free position of Chipotle (NYSE: CMG ) , as our team of analysts does, but at nearly 40 times free cash flow, the valuation says sell anyway. Million Dollar Portfolio sold its shares based on an unfavorable risk-benefit trade-off in its valuation models.
That said, decisions based just on valuation can mislead you sometimes. Netflix (Nasdaq: NFLX ) has looked rather expensive for years, but it continues to reward shareholders. If valuation on a leading business is perplexing you, you may consider selling just some of your shares (to lock in profits) or protecting your gains through other means (including options), and then consider other factors that may influence a sell decision.
2. Fundamental change in the underlying business
Companies are always undergoing change -- sometimes for the better, oftentimes not. As patient investors, we're willing to tolerate minor, fixable hiccups along the lines of a weak quarter or delayed product launch. We're not so forgiving of major blunders -- think acquisitions that undermine the core business, getting surpassed by a competitor, taking on unproductive debt, or a string of failed new product attempts. Whenever a business undergoes a significant change, you need to put on your thinking cap and reassess.
Palm has underdone organizational changes and management shakeups, lost its early lead in handheld devices, and taken on debt, all in the past handful of years. Not surprisingly, it didn't create shareholder value before it was finally acquired by Hewlett-Packard.
3. Challenges to your investing thesis
When you make a buy decision, you should write down your reasons and keep them handy. Knowing the most important drivers behind your buys, you can reassess your decision if any part of your thesis is challenged.
Because valuation is part of any thesis, threatening changes can include dividend cuts, deterioration of margins, weakening free cash flow --- or economic shifts. If you'd bought Lowe's (NYSE: LOW ) or Brookfield Homes (NYSE: BHS ) before 2007, believing a housing boom would continue, you'd have followed housing news closely and may have seen your thesis falling apart -- forcing a timely sale. Similarly, if you own either of these stocks today, it makes sense to stay up-to-speed on the health of the housing market. So, what's the thesis behind each stock you own? Write it down.
4. Better places for your money
Sometimes a sell decision has little to do with the holding itself -- you may simply see better opportunities elsewhere and lack the funds to take advantage. Just as a soccer coach will swap tired players for fresh ones in order to win the game, your portfolio can benefit from shuffling some players, too.
In the late 1990s, it was becoming apparent Johnson & Johnson (NYSE: JNJ ) had a better business model than the pure drug companies, including Merck (NYSE: MRK ) . Since 1999, J&J has gained 61% while Merck has lost 48%. That was a great swap.
These are some of the criteria at the forefront of sell decisions at Million Dollar Portfolio. To keep membership manageable, Million Dollar Portfolio will open for a few days this month, the first time members have been able to join since October 2009. Join while you can -- and let us sweat out the tough sell decisions for you. You can get more information about Motley Fool Million Dollar Portfolio by putting your email in the box below.