Fool.com: Bad Reasons to Sell (Fool on the Hill) November 5, 1999

FOOL ON THE HILL
An Investment Opinion

Bad Reasons to Sell

By Bill Mann (TMF Otter)
November 5, 1999

For this installment of the Fool on the Hill, I'm going to play lightning rod and put forth a few highly controversial theories on portfolio management. These theories are, by and large, completely in conflict with many of the most widely accepted "truths" in personal financial management. You know what they are:

  • Don't let your portfolio become overweighted in one or two companies
  • Sell when a company becomes "overpriced"
  • Sell in advance of a potential market downturn
  • Sell after the stock just had a huge run-up
All of these rationales ignore a basic function of individual stock selection. That is, a Foolish investor has gone through and tirelessly done research on the fundamentals of the individual company, and has decided that it provides a better-than-average chance for a superior return. Why in the world would the same investor make sell decisions without re-examining the same criteria with which he or she bought?

The answer is, they do it all the time. Heck, EVERY investor, at one point or another, has faced one or more of the above fears.

I'm here to tell you that there have been more potential returns left on the table by nervous investors following one of these sell edicts than there have been losses by people who went over their holdings' fundamentals, decided to hold on, and were wrong.

How much has been lost? In the words of Carl Sagan, "Billyuns and billyuns."

By following these "sell signals," an investor is actually adding additional risk to her portfolio. Why? Because investing is all about maximizing returns over the long term. In order to do so, investors must use certain things to their advantage, but all of these things center on one single factor: knowledge. Knowledge of a company's business, knowledge of financials, knowledge of the potential returns for the company. By using external factors -- that are unknowable -- to determine whether a company is ripe for sale, the investor gives away the one true advantage that she has. That advantage is the knowledge of that individual company, what it does, and how its economics work.

Already the hackles of the short-term traders are up. "What do you mean? You don't look to see if a company is overbought? You don't care about the VIX, or trend lines, or the 200-day moving average?" No, I don't. I don't use them because I have never seen any concrete evidence that any McClellan Oscillator or such has given anyone, ever, a better long-term advantage than good old-fashioned knowledge.

The Fool on the Hill archives contain one of the best descriptions of investment knowledge that I have ever read, written by Randy Befumo in 1997. It is titled "When NOT to Invest" and remains a must-read for people looking to make their fortune in the stock market.

Let's take a look at each of these portfolio management sell signals, and I'll try to use a real-world example to show how strange the logic is when applied to other situations.

By the way, I will repeat something I said in Wednesday's column. A quality of life issue is ALWAYS a valid "sell" signal. If you've invested all your life and have saved up and want to take some off the table, then go for it. If you can't sleep at night because of nerves, or you don't want so much of your net worth tied up in a single company, these are valid reasons to sell. They are even rational reasons to sell. But they are also external to the fundamentals of a company and should be recognized as such. Your state of mind has nothing to do with the performance of a company or its share price. There is a big difference between rational decisions and fundamental ones.

Reason 1: Don't let your portfolio become overweighted in one or two companies

This can also manifest itself as a "diversification" argument. This may be the worst rationale I know of for selling all or part of a winner, but it is also something that is almost gospel in the brokerage and financial management industry. Why? The thought that a company can make up 30%, 40%, or 50% of one's portfolio is simple to look at as an undue risk. But let's look at a real-world application.

My colleague, David Braden, started this year (conveniently enough), with 10 stock holdings worth exactly $1000 apiece. One of those holdings is Qualcomm (Nasdaq: QCOM), one of the true star performers of this year, the remainder of David's holdings (again, conveniently enough) have exactly matched the performance of the S&P.

By the way, I absolutely hate David for this, because last spring I spent a great deal of time evaluating telecommunications technologies for a purchase I intended to make. I really liked the CDMA technology that Qualcomm owned, but I didn't feel that I had a good understanding of the overall marketability of it, so I went with something I did understand: Iridium. Stupid, stupid, stupid.

So David's portfolio breaks down like this: As of today, he has $9000 in holdings that have gained 10.85%, for $9976. He also has Qualcomm, which began the year at $25 (yielding him 40 shares, split-adjusted). Each share is currently worth $292, a gain of 1168% on the year. His Qualcomm holdings are now worth $11,680, or 55% of his total portfolio. David's winner has run away from the rest of his holdings. David's broker is telling him to sell some of his Qualcomm. But why? Is the business case for Qualcomm worse than it was when David first did his comprehensive analysis? No. In fact, David is more sure than ever what a dominant technology CDMA will be. In other words, on the face of the company's performance, there is no reason for David to sell it. Conversely, there is still every reason in the world for me to still buy it, even though it mocks me so.

Reason 2: Sell when a company becomes "overpriced"

The simplest reply to this is "overpriced compared to what?" Stocks are still valued upon their potential future earnings. If a company's future earning potential, based upon your research, seems secure, then the concept of overpriced becomes unsupportable. People have been calling Microsoft overpriced for years, but its growth potential and net revenues in hindsight have supported its valuation.

Calling something "overpriced" means that you are claiming to know something that is unknowable. We think we know about a company's future prospects, but we should make our decisions based upon these rationales, and these alone. After all, any good stock with exceptional growth potential deserves to be priced higher than other, similar companies with lesser prospects.

Again, let's look at Qualcomm. If, last January, it was, by any estimation, 25% overpriced compared to other similar companies, will that 25% matter two years from now when the company's revenues have increased 10-fold? Probably not.

Reason 3: Sell in advance of a potential market downturn

Of the reasons to sell a company, this might be the worst, but it is also the one we hear trumpeted the hardest on CNBC. It comes in several forms, including the cycling of monies from one form of investment to another, as well as the "market sentiment" that proves that things are moving lower (or higher).

More times than not, these market experts turn out, even over the short term, to be wrong. How many times have you watched the market indices turn on a dime in the midst of a trading day, with no underlying rationale for the shift. It happens, really, on about a weekly basis. Think about it. We have seen some significant gains this week in the stock market, but just three weeks ago you'd think that investors had just seen their collective dogs being kicked. What changed? How would one have been able to predict? Why was it that a prognosticator from iTulip.com knew "with certainty" that October 19, 1999 was the date of the next big crash?

The answer to each of these questions is somewhere. We just don't know where. In the meantime, the market has shifted back into high gear, with such stodgy slow movers as Berkshire Hathaway (NYSE: BRK.A) moving up more than 15% in the process. Anyone who sold out in advance of the coming bear, for this and countless other periods of time, missed the boat on a significant move in share prices, but up, not down.

Let's go back to Qualcomm. Let's say my friend David sold it two weeks ago, concerned that he was witnessing the beginning of a big drop in share prices. Well, first of all, he sold at $230, meaning that he got to pay capital gains on his shares, a gain of $8200. But also, he missed out on a move of some 30% as Qualcomm proceeded to move through the roof. And for what? An external signal that he could not predict accurately and misjudged entirely.

Reason 4: Sell after the stock has had a huge run-up

This argument is the same as saying that a company that has had a strong run has likely used up most of its potential. This is market-timing at its worst. The thought process is that the company has run up and so perhaps it would be better to go and find something that has not gone up yet.

I'll use a simple, real-world analogy. Joe Single Dude has been on the dating scene for a little while. He's been taking one particular woman out for a few weeks, and he even thinks that he might really like her. They've had a great time, they have a bunch in common, and well, things have progressed nicely.

What is the sane thing to do here? Well, according to the analogy, it's time to go date someone else, someone like Scary Mary, who he took out one time but didn't really have anything in common with. But in actuality, most people, most of the time, are not going to act that way in a real-life scenario. Why do it in investing? Why cut your best prospects off at the knees in order to go search for something else? Is it rational to sell off a great company with outstanding prospects (the only kind of company a Fool should invest in) to hope for the big move from another company? Doesn't make much sense.

No, it is best to worry about your individual companies, and their prospects. Any other factor is -- if past performance is any indicator of the future -- external, unpredictable, and dangerous to the returns of the Foolish investor.

Keep on Foolin'.