"We like to buy. Selling, however, is a different story"
-- Warren Buffett.
This got me thinking. Buffett loves to talk about his methodology for buying stocks, but he spends much less time delving into why he chooses to sell holdings.
We could speculate that it's just the opposite of why he buys stocks. Strong management is important to Buffett, so we could assume if a weaker CEO took over that could be a selling point.
That's, however, far from a good enough answer for me, as I'm sure it isn't good enough for you. That's why I have dug into over twenty years of Buffett's letters to Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) shareholders, and compiled four small gems of information on how Buffett decides to sell stocks.
1. "Seeing an arbitrage opportunity"
Buffett has made famous the philosophy of buying stocks with the intention of holding them forever. In some cases, however, if Buffett sees an opportunity to make a short-term profit he'll buy with the intention to sell.
Arbitrage is, basically, betting on market inefficiencies. For instance, if company A plans to buyout company B for $10 a share, and company B is currently trading for $5 a share, investors could exploit the variance to make short-term gains.
In 1992, Buffett saw a similar opportunity when General Dynamic announced that it was planning a fairly large stock repurchasing plan using a Dutch tender. Buffett would go on to explain, "We've made the same sort of commitment perhaps a half-dozen times in the last few years, reaping decent rates of return."
After further researching General Dynamic, Buffett decided that the company had long-term potential, and nixed any thought of arbitrage.
For the average investor, such as myself, I would suggest leaving arbitrage for the day traders and high-powered computers and stick to Buffett's original advice of buying and holding great businesses.
2. "But the size of that potential was in question"
American Express is one of Berkshire Hathaway's most consistent holdings. It's lesser known, however, that Buffett was very close to selling a large portion of it in the mid-1990s.
In 1991, Buffett had acquired $300 million in American Express Percs. Which Buffett defined as, "essentially a common stock that featured a trade-off in its first three years."
When that trade-off came due, Buffett admitted he was leaning toward selling.
While he still believed in the business, and still had faith in management, he wasn't sure American Express could maintain returns in such an incredibly competitive industry.
Buffett, luckily, decided against selling American Express. However, limited potential due to intense competition is a perfectly reasonable rationale for cutting back or eliminating a position.
3. "I figured if you see one cockroach, there's probably a lot."
In the wake of the financial crisis, Buffett was asked to speak before the Financial Crisis Inquiry Commission (Congress) about Fannie Mae and Freddie Mac.
Before eliminating Berkshire's position in Freddie Mac in 1999, Berkshire Hathaway was the largest holder of Freddie Mac stock.
That led to the inevitable question from Congress: why did Buffett sell Freddie Mac?
To which, Buffett suggested Freddie Mac had become, "Entranced by trying to report increased earnings every quarter. And any financial institution that tries to do that, in my view, will get in trouble sooner or later."
Buffett also noted that Freddie Mac was using U.S. Government credit to buy bonds that had nothing to do with housing. For Buffett, that was one cockroach too many.
Ultimately, it's OK for a company to have a bad quarter or even a bad year. It's those companies that will neglect the long-term health of the business in order to drive quarterly earnings that investors need to watch out for.
4. "To fund these large purchases, I had to sell portions of some holdings"
Buffett has said that when it's raining, investors should reach for a bucket and not a thimble. And after the crashing of the stock market in 2008 and 2009 Buffett saw lots of opportunities.
So, while Buffett still believed in all of his major holdings, he saw even greater opportunity buying fixed-income securities issued by equally strong businesses. The lesson to be learned here is that when opportunity comes knocking, be ready.
How to sell stocks like Buffett
Buffett is much better at buying stocks than he is at selling them. What he teaches us, however, is to hold ample amounts of cash, and be clear in your reasons for why a particular stock is a good investment.
That way if a better opportunity arises, or the business diverts from what you originally liked about it, you know exactly when to sell.
More of Warren Buffett's greatest wisdom
Warren Buffett has made billions through his investing and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. 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.