In general, a screening tool such as the Foolish 8 system deals indirectly with the question of what kind of small company stocks to buy. It's only natural that the investing process should begin with the concept of buying stocks first; after all, you need to purchase a stock in order to potentially experience all of the well-documented benefits of stock ownership versus other forms of investment.
Learning how to buy stocks is a lot like buying a ticket to get into the investing game. So, it's no wonder that the large majority of "How to Invest" publications tend to deal almost exclusively with the issues related to buying stocks rather than selling them. If there was a book entitled How to Sell Great Stocks, who in the world -- outside of a retail broker -- would want to buy it?
But as in other intellectual pursuits, it is often helpful in investing to invert questions once in a while and look at them from a 180-degree different perspective. Different perspectives may be what make markets, but they are also what make great investors. True insights come from thinking about things in different ways, in ways that are not obvious. So, in the spirit of inversion, we'll start our weekly commentaries on small company investing by addressing the question of when to sell small companies, rather than when to buy them.
Truth be told, the selling question is the harder of the two, which is why I think so little attention is paid to it. Investors have myriad rules of thumb and mental models to govern buying decisions -- focusing on stocks with low price-to-earnings ratios, identifying companies with rising margins, and looking for stocks with high relative strength readings are just a handful of the many common buying strategies. Buying disciplines will be examined in turn, but it is the selling disciplines that interest me most in small cap investing, since they are discussed so infrequently. This might be because straightforward rules of thumb are few and far between when it comes to selling.
That situation doesn't make a whole lot of sense, especially if you are taking a businesslike approach to investing. Businesses make selling decisions from time to time, such as divesting certain operations, selling stakes in joint ventures, and even selling themselves outright in buyout transactions. What selling guidelines do companies use, and how can they be incorporated into an individual investor's repertoire? Maybe reverse-engineering the problem will yield some insights. Just as medical researchers promote general health by studying those who are sick, maybe some insights into buying companies may be revealed by examining when to sell them.
In the small company world in particular, firms tend to make selling decisions under two main circumstances -- when the growth prospects or economic returns from the activity in question are no longer attractive, or when a good price is offered. As in most things related to business, there are special "code words" that go along with each of these actions to spin them in the best possible light. When conducting a sale of a slow-growing or low-returning business, companies are likely to describe the sell decision as "shedding a non-core operation" or "getting back to the basics." On the other hand, a sale motivated largely by a good offered price is sometimes termed as "recognizing the most value for shareholders." As the Mary Poppins song goes, a spoonful of sugar makes the medicine go down.
There are various other reasons to sell a business or a portion of a business, but the two themes of deteriorating business quality and receiving a good purchase price tend to show up again and again. In the next few columns, we'll examine the business rationales behind both of these selling decisions and look at some recent small company transactions as examples. With any luck, finding out why businesses are sold will shed some light on how to incorporate a proper and rational sell discipline into a sound small company investing strategy.