"Our favorite holding period is forever," Warren Buffett has famously said. But even the Oracle of Omaha sells stocks at times. He has even expressed regret in not selling his beloved Coca-Cola stock when it became wildly overvalued in the late '90s. In reference to its wild run-up, Buffett confessed his mistake in the 2004 Berkshire Hathaway letter to shareholders:
Berkshire's results would have been far better if I had caught this swing of the pendulum ... I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.
So what is the best practice? Should you let your winners run? Or should you cash out when your stocks become overvalued?
For investors in Tesla Motors (NASDAQ:TSLA), these are serious questions and merit thoughtful exploration. Up more than 500% in less than 12 months, Tesla's valuation is getting ahead of itself. But what should shareholders do?
There is no black and white answer on when an investor should sell a stock. There are, though, the two extremes:
- Sell stocks when they become overvalued.
- Let your winners run as long as your investment thesis remains intact.
However, as is the typical problem with extremes, they may be too extreme. Let's examine both approaches.
Letting your winners run is helpful in minimizing capital gains taxes. Even more, it reduces portfolio turnover and means your portfolio may not require as much attention. And probably the best of all, it enables your best stocks and their underlying businesses to outperform your expectations. Why pick the flowers in your garden when you should be watering them and pulling the weeds instead? Finally, it could even be argued that having such an extreme mindset could evoke superior analysis and wiser investment decisions since you could be holding the stock for a very long time.
The biggest problem with Selling overvalued stocks, of course, is that you may find yourself frequently selling your best-performing businesses much too early, missing out on nice gains. But the problem with this strategy goes deeper than that.
To assert that a stock is overvalued, you're going to need an estimate of the company's intrinsic value -- and this isn't easy. Selling overvalued stocks, therefore, introduces a greater need to keep tabs on a company's intrinsic value. To make matters more difficult, that value changes over time.
Before Tesla's first quarter, for instance, the company's ability to significantly ramp up production on its new Model S was nothing but a hope for investors. After it reported first-quarter earnings, however, the story totally changed. And soon after, intrinsic value looked better again as the company paid off a massive government loan and raised about $1 billion in new capital. Clearly, keeping tabs on intrinsic value is hard work.
But there are benefits to selling stocks when they appear to be overvalued. Mainly, it allows you to free up cash invested in overvalued assets, reallocate that money into undervalued stocks, and thus boost the total intrinsic value of the assets in your portfolio. Easier said than done, of course.
A middle ground
Why not find a middle ground between both approaches? Why not hold your slightly overvalued, excellent businesses, but sell your grossly overvalued stocks?
Value investing guru and blogger Greg Speicher explored this same dilemma and eloquently highlighted a compelling middle ground:
I am a strong proponent of patient business-like investing for the long-term. This is a proven way to create wealth. However, at a sufficiently high price, all assets -- no matter what their level of quality -- should be sold.
He goes on to suggest that investors should put "a premium on hard work, exceptional research, and following a rational investing process with great discipline," and cash out on their grossly overvalued stocks.
But what is grossly overvalued? When the company's price "exceeds all reasonable estimates" of its intrinsic value, he says. This answer still leaves a lot of gray area. What is the highest reasonable estimate for Tesla's intrinsic value? For me, it's below $190 -- and that's why I've recently sold the stock. I laid out what I believe to be a reasonable best-case scenario for Tesla's business -- 500,000 cars per year in five years and a 30% gross profit margin -- and I found even this bullish scenario is already priced into the stock. But thanks to so much gray area between different selling philosophies and estimates for Tesla's intrinsic value, you'll be better off making the final decision based on your personal research and opinion, not mine.
Whatever you decide about Tesla stock, the scenario serves as an interesting case study. After examining both approaches and being forced to make a decision with my real-money portfolio, I believe the best approach is found in the middle: Invest with the intention of holding for decades and let your winners run -- but not too far.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola and Tesla Motors. The Motley Fool owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.