FOOL ON THE HILL
An Investment Opinion
When to Sell Bill Mann (TMF Otter)
November 3, 1999
The stock market is, in the short term, a study of psychology, and as a pari-mutuel marketplace (one in which people, when broken down into the simplest terms, are betting against one another), psychology matters. Why else would eBay (Nasdaq: EBAY) have traded, in a little more than one year's time, from $8 up to $234 then back down to $75 and then rebounding to $160, only to slip back to its current level of $124? It's enough to give the most stout investor a nagging case of heartburn, and I submit that this company has, on the back of shareholder sentiment, blown past its intrinsic value several times now, be it up or down.
No, sir, the general sentiment of the investor is not to be trifled with, which is why I choose to limit its influence in my investment decisions, especially when to sell. I'm going to parrot one of my favorite writers on investing and his advice about selling stocks -- Phillip Fisher. He, like the best writers on the subject, is highly uncomplimentary of the concept of selling any individual holding due to general overall market conditions. In fact, in Fisher's magnum opus "Common Stocks, Uncommon Profits," he dedicates exactly eight pages to the subject of selling a stock holding. In these eight pages he debunks every market-timing strategy, and in their place gives exactly three reasons why one should sell.
That's right, three. (Well, plus a caveat, which I'll address as well).
Just so my position, and Fisher's, is clear on the subject of selling, here it is:
Not never, because never would have had the effect, for example, of following a Bethlehem Steel (NYSE: BS) from the heights of glory and into the slag heap of companies that did not change with the times.
So let's review Fisher's reasons to sell.
Reason 1: When it Becomes Clear that the Original Rationale for Purchase was Flawed
Simple enough, this means that we must be willing to admit and atone for our mistakes. This, unfortunately, is almost exactly contrary to the nature of human beings. We do not like to be wrong. We like even less to admit that we were wrong. But sometimes it becomes clear that even the best, most comprehensive research, that the actual situation for a company is considerably weaker than anticipated at the time of purchase.
I'll give you an example, and I'll use my own boneheaded mistake. You see, I bought Iridium (Nasdaq: IRIQE).
I went through the motions of analyzing this intriguing company and its financials. In the end, my absolute fascination with the potential of the Iridium technology, which allows someone to be connected by phone from almost any point on earth, blinded me to the inherent weaknesses in the business model. What weaknesses, you say? Oh, gee, let's see, how about $5 billion in debt financing before they ever made a penny. Yep, billion, with a B.
Soon after I bought Iridium, the price started coasting downward, as it was beset by one operational problem after another. All of the sudden, that debt began to loom large, and yet I was convinced of my correctness. And for a short while I was rewarded, as Iridium surged back higher as it began operations, hitting a high water mark at $45 per share early last November.
In a matter of days the share prices dropped 30%, to around $31. This is where I made my real mistake, because I can look back and say that I knew that there was a big problem with this company. And yet, I held. Why?
Because I thought I would wait for the price to bounce back to my purchase price and then sell.
I saw the crash coming, but I refused to jump ship. Therein I made my bigger mistake. Fisher states that every investor is going to make mistakes in his or her career, but that the successful investor requires the ability to control their own emotions. After all, in the course of decades, what is going to be the difference between a 20% loss and a 5% gain on any one company? If other money has been invested well, the answer is next to none.
I missed the boat here, and I've got a slew of nearly worthless share stubs to show for it.
Reason 2: A Company No Longer Qualifies as a Top Performer
This reason is fairly straightforward. You have elected to invest money in a company that has passed your tests showing that it has an excellent potential for returns. Over a number of years, the company begins to lose its edge. Maybe the management changes, and in the place of a once top-flight, free thinking management team you have a less desirable group in its place. Perhaps the company has failed to keep up with its competition, or has missed an "inflection point," where the overall atmosphere in which it operates has changed.
Excellent examples of this would be Bethlehem Steel or Woolworth (NYSE: Z) (operating under the name of Venator), two former Dow components. In the '50s and '60s these two companies had a long run of top-flight returns for their shareholders. But starting in the 1970s the wheels began to come off for both companies.
For Bethlehem Steel, the company failed to keep its costs or its quality under control, and was undercut in price by U.S. steelmakers as well as overseas competition. The company failed to give itself any price advantage or differentiation in a commodity business, and the cost of this failure was dear, as the company slumped down to a fraction of its former value.
Woolworth was a similar story, as it failed to change its service offerings or strategy in the face of a changing retail environment. In the 1950s, every small town in America seemed to have a Woolworth on its Main Street, and the company's shareholders were blessed with excellent returns over a lengthy period of time. But as the automobile changed the retail environment and people became less apt to drive downtown for shopping, forsaking it instead for suburban shopping malls, Woolworth's brick-and-mortar infrastructure became a tremendous burden. Outside events changed a retail environment, and the company was unable to handle it, or stave off the competition from such innovative retailers as Wal-Mart (NYSE: WMT) and Dayton-Hudson (NYSE: DH).
When these inflection points become clear, a shareholder must be willing to analyze the general environment and decide if the company is capable to react. This does not necessarily have to be a management mistake, as some companies simply, over the course of time, exhaust their growth potential. In any case, when an investor becomes aware of such a situation. It is time to get out.
Reason 3: There is a Better Place to Put Your Money
Fisher calls this the rarest of the three situations. If an investor has equity in a company and finds another company in which the money will clearly and decisively provide better return, he or she should move to the new investment.
There are a few warnings about this strategy, however. First and foremost is that the investor should be absolutely convinced that the new company is significantly better, as this strategy is not tax efficient. By selling a matured investment one is giving the government a cut of their investment capital, whereas maintaining the capital in the original company does not cause a taxable event. Moreover, you must be even more certain not to make the mistake as detailed in Reason 1, as it is often much easier to understand the weaknesses of a company you have studied for a long time than a newer one.
This is completely contrary to the concept of cyclical investing, of moving based upon the tides of the market. I'd reiterate that you can control the amount of knowledge you have on an individual company, but you cannot control the psychology of the market at large. Why give over power to that you cannot hope to understand?
And Finally, a Caveat
Fisher says that it is always time to sell a stock when you are making a choice of happy living. If you have held a stock for a number of years and it has appreciated and you decide that you would be happier spending a little bit of that money that has accumulated, then this is an acceptable rationale to do so.
But it should be clear that this is contrary to the long-term goal of obtaining the greatest dollar benefit from an investment. But there again, what is it that we are investing for? I know the answer for myself. Do you?