Rule Breaker Portfolio Selling Strategy

The managers of the Rule Breaker portfolio held a conversation recently to discuss the sell strategy for the portfolio. The basic premise is, "Sell when you've found a better place for your money," whether that is a new stock or an index fund. Overvaluation -- by traditional metrics -- is not a reason for us to sell.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By The Breaker Team
December 22, 2000

Brian Lund: We're talking today about when to sell. We've got a whole strategy about how to find Rule Breakers. Once we've bought a Rule Breaker, what do we say about when to sell it?

David Gardner: I think we have a fine strategy about when to sell. Whether we have used it effectively is another matter, but the thinking behind it remains sound. There are some differences between The Motley Fool sell strategy and the Rule Breaker sell strategy. Let's talk about The Motley Fool sell strategy first.

We say, "Write down the reasons you bought a stock in the first place." That's right: Take a sheet of paper, or open up a word-processing document, and write down your thinking succinctly. You now have a wonderful guide -- your own original thinking -- for following the investment. If at some point the story changes (for better or worse), you can reevaluate. Each of us should have something like this "living document" to follow our stocks. If the company no longer fulfills your vision for the investment and you just don't believe it'll beat the market in the future, it's time to sell. Then you put the money in another investment that you believe will outperform the previous one, which might be a new stock or one already in your portfolio.

Brian: Or an index fund.

David: In some cases. Of course, you might do things in reverse order. In other words, you might find a new promising investment opportunity that you want in your portfolio, but you don't have any cash. What do you do? Look at your holdings and ask yourself, "Which of my companies has the least promise over the next 3-5 years?" That's the one you sell, since presumably you are convinced that your new prospect will outperform it. Good investing fulfills one of our company's core values: a relentless search for better solutions.

The Rule Breaker sell strategy is distinct from The Motley Fool sell strategy (which, by the way, factors in tax implications). We keep a very close eye on our companies to make sure that they haven't Tweened or jumped the shark, which in some cases might be the same moment. If we see those events happening, we carefully reevaluate our holding.

Paul Commins: I want to jump in and reinforce something that David just said. I think it's important that people not rush into buying Rule Breakers under any circumstances. It's important to emphasize that you don't have to have another Breaker in mind before selling a currently held Breaker. As Brian says, an index fund can be the investment that you believe will outperform the one you're selling.

David: Yes. Now, I'd also like to say that I believe very much in this idealized sell strategy. I will certainly be constructively critical, however, and say that we have not always used it effectively ourselves. Jeff Fischer, one of the busiest guys at our company, and I have managed this portfolio at various times. I will often travel for most of a month, and not check my stocks every 15 minutes. I'm comfortable enough with my investments that I don't have to.

At the same time, though, Jeff and I haven't always had the time to do the necessary work, like writing sell reports or doing research necessary to whittle down a list of possible buys to a single one. We manage our portfolio just as anyone does, under real-world time and attention constraints. As a result, even though we have a platonic ideal of a sell strategy, we don't always carry it out effectively down here on Earth.

Brian: That's always the case, of course. Any strategy -- buy or sell -- exists in an ideal form, not in reality. We do our best to implement our buy and sell strategies, but we will never do it perfectly.

David: Well, part of the reason we brought you and Paul aboard is to be more responsive. That does not mean we trade more, but it does mean we have the resources and bandwidth to put more attention on selling earlier on, one hopes, than ATC Communications at $3 and change, or whatever it was...

Brian: Should any consideration be given to valuation when selling? Some folks might say that it's time to sell a stock like Amazon.com (Nasdaq: AMZN) after a big run like the one we saw in 1999.

Paul: If we require 10x/5y potential for a stock and we believe that this potential has been eroded, then I would argue that selling might be appropriate. I see this, however, as more of a highly optimistic evaluation of business potential than as any kind of "fair" measurement of current market value versus "intrinsic" value (although, of course, there is an element of value in the idea).

David: We're certainly always conscious of our companies' market caps. We always consider where it could end up. But, if you're asking whether we sell something because its P/E went above 60, the answer is firmly no.

Brian: Naturally, that's the case. After all, we're buying companies that traditional metrics rate as overvalued. We would never have bought them if traditional overvaluation were a factor. We have sold portions of America Online (NYSE: AOL) and Amazon in the past, to put some money into new possibilities and to lessen their overall percentage in the portfolio. The latter is a matter of portfolio management -- another reason to consider selling.

Paul: It's probably good to mention explicitly, given the current market climate, that we don't factor macroeconomic trends into our selling strategy. For the most part, we spend our limited time following companies, not the stock market.

Back to companies, can you guys imagine a situation where we'd say, "This has been a great Breaker and will probably evolve into a long-term, profitable company, but it's probably topped out as far as future market- beating price appreciation is concerned," in other words, it may survive, but it won't be a Rule Maker?

David: Paul, yes, I can see that, certainly. We will hold our stocks toward their becoming Rule Makers, if in fact we foresee that possibility or likelihood. In other cases, we will sell the stock during or after its Breakerhood.

Jeff Fischer: I believe that, in between Breaker and Maker, during that sometimes long period of transition, a stock price can level for a while. We don't have enough past experience to know this for sure, but it seems somewhat logical. AOL is a good example, as perhaps is eBay (Nasdaq: EBAY), which is flat the past two years.

Paul: One thing that's absolutely crystal clear to me is that successful Breakers tend to leap upwards in sudden bursts that take them well beyond any "fair" value of the moment, and that the only people who profit from the full extent of these leaps are those who hold throughout. Selling bits of a Breaker "on doubling" or some other similar strategy will cost you big time if the Breaker pans out.

Brian: We've mentioned our 10x/5y consideration. If a company reaches 10x, is it time to consider some selling for reinvestment elsewhere?

Jeff: That depends on the situation. AOL has been up 10,000% for the Breaker Portfolio at times, which is about 10x beyond 10x. After 10x/5y occurs, it makes sense to reevaluate the holding, but not necessarily to sell.

Paul: I agree. I wouldn't sell if I thought it could become a Maker. Certainly we don't expect AOL to do 10x in the next five years, but that doesn't mean we sell.

Brian: So 10x isn't a goal, but an investment consideration at the time of purchase.

Jeff: Yes. And if that consideration comes to fruition, it's as good a time as any to consider the potential from there forward. Consider the "ceiling" on the company. How large can it possibly become?

Paul: Once a company Tweens and heads toward Maker status, should we think about "ceilings" any more?

Jeff: I think about ceilings all the time. They're the same as potential. I don't want to own a company if it has realized its full potential.

David: That's true... but I mostly agree with Paul's point. For Fools who've held AOL for 3-5 years, there would be a huge capital gains bill to pay upon sale for something that may still have 15%-20% annualized returns in it, even if not the 60% of the Rule Breaker.

Paul: Which brings up an important point: Our sell rule is context-dependent. We don't necessarily think that we or anyone else should buy AOL or Amazon now, just because we hold it. That AOL is in our portfolio doesn't mean that we still consider it a Rule Breaker and, accordingly, our rules for not selling it might be hugely different from another's rules for buying it.

David: Paul is properly pointing out the importance of context -- one of my favorite words.

Brian: Is there a reason to sell a big winner to try to get more out of another investment that has 10x/5y potential?

David: Yes, but if you have truly found a Breaker that became a Rule Maker, and you foresee market-beating returns in that company, meaning that you are riding an amazing stallion, tend to be skeptical that a given potential Breaker you might invest in could rival your Secretariat. I'm only counseling caution.

Jeff: We buy Rule Breakers. What they become is often something different. Hopefully they become Makers.

David: We'll soon introduce "checklists" for each stock, the "living document" that we have, in which we'll share our thinking for each company.

Let us know your thoughts about selling on the Rule Breaker Strategies discussion board.

Rule Breaker Portfolio


12/22/00 as of ~8:30:00 PM EST

Ticker Company Price
Change
Daily Price
% Change
Price
AMGNAMGEN INC3.064.81%66.75
AMZNAMAZON.COM0.382.47%15.56
AOLAMERICA ONLINE0.621.65%38.28
CRAAPPLERA CORP - CELERA GENOMICS3.9412.94%34.38
EBAYEBAY INC6.5623.08%35.00
HGSIHUMAN GENOME SCIENCES8.3113.16%71.50
SBUXSTARBUCKS CORP0.310.70%45.25

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(8/5/1994)
Annualized
Rule Breaker5.42%(15.12%)(7.73%)(50.35%)707.08%38.69%
S&P 5002.44%(0.47%)(0.68%)(11.11%)184.89%17.82%
S&P 500 (DA)2.32%(0.45%)(0.65%)(10.64%)199.15%18.72%
NASDAQ7.56%(5.14%)(3.11%)(38.15%)249.50%21.65%

Trade Date # Shares Ticker Cost/Share Price Total % Ret *
8/5/944020AOL0.4538.284569.89%
9/9/972640AMZN3.1815.56527.80%
12/16/981160AMGN21.4466.75211.27%
7/2/98470SBUX27.9545.2561.87%
9/22/00560HGSI80.0571.50(10.69%)
12/17/991260CRA39.7634.38(13.54%)
2/26/99600EBAY50.2635.00(30.37%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain *
8/5/944020AOL$1,816.44$153,885.60$224,661.60
9/9/972640AMZN$8,408.40$41,085.00$58,500.70
12/16/981160AMGN$24,875.50$77,430.00$52,554.50
7/2/98470SBUX$13,138.62$21,267.50$8,128.88
9/22/00560HGSI$44,830.50$40,040.00($4,790.50)
12/17/991260CRA$50,093.00$43,312.50($6,780.50)
2/26/99600EBAY$30,158.00$21,000.00($9,158.00)
 
Cash: 
Total: 
$5,375.09
$403,395.69
 

* Our long term totals include both our realized and unrealized gains. For instance, we have sold portions of AOL and Amazon in the past, and those realized gains are included in our total returns for these stocks.



Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.