Selling on Valuation

We sell when we have a better place to invest our money -- either we have a specific stock in mind, or else we believe that owning a broad market index like the S&P 500 will do better. Perhaps a great stock attracts our attention, or a business we own deteriorates or doesn't resemble anything like the one we bought. And I mean that in a bad way.

But do we ever sell for valuation reasons? Good question. We buy with a valuation criterion, the 10x/5y requirement, because we want our investment to be able to appreciate 10 times in 5 years. That's because unprofitable or newly profitable companies whose products can transform the way we live are very risky, so we want huge possible returns to compensate us for our risk.

Hmmm. How has this Port valued stocks, anyway?

The Fool Ratio
In the earlier days, the Fool Portfolio (the precursor of the Rule Breaker Portfolio) sometimes bought growth stocks because they were undervalued according to the price-to-earnings-to-growth (PEG) ratio, dubbed the Fool Ratio. Why? "In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share."

So if Gardner's Genies (Ticker: WISH) sported a price-to-earnings ratio of 10 and was slated to grow at 20%, it would have a Fool Ratio of 0.5. Stocks with Fool Ratios less than 1.0 are undervalued, exactly 1.0 fairly valued, and over 1.0, overvalued. This begs the question of who is estimating the growth rate and how reliable it is, but you get the point. The Fool Ratio was one of many tools used for buying and selling.   

But no later than 1996, David Gardner was already thinking that the Fool Ratio didn't fit certain types of companies -- especially those he would later dub Rule Breakers. For example, that year the Fool Port sold Medicis Pharmaceutical Corp. (NYSE: MRX) because the shares were fully valued according to the Fool Ratio. We wrote that it would be tougher to call the company fairly valued if it were different -- a "world beater" (Can you say "Rule Breaker"?) whose products would "massively transform the way we live." Then, it might make sense to stay invested because the future could hold far greater gains. It wasn't a world beater, and the Fool Port sold. In the rear-view mirror, that same thinking applied to our 1995 sales of Ride Snowboards and Boston Technology. They weren't going to change the world, so we weren't likely to forego future whopping returns.

"Overvalued!"
Another example of changing attitudes toward valuation came a year later in a buy, not a sale. In 1997, the Port purchased shares of Amazon (Nasdaq: AMZN), hailing Amazon's great Internet business model. As it often did with buys back then, the Port applied the Foolish 8 Small Cap strategy criteria, showing how the stock could provide a fairly quick double even though many believed it wildly overvalued.

The managers beat the drum even more, saying that they were on the trail of a company with far bigger ambitions and possibilities, a company that by the turn of the century could deliver returns far exceeding a mere 100%: "If Amazon.com can capitalize on the brand name that it is already building, build a strong repeat-purchase community, and run a profitable operation into the next century, then... well... let's save that for the next section." After which section the report asks, "You see why we think Amazon.com is going to be huge?"

These words were written in September 1997, when "into the next century" was a little over two years away. This looks a lot like "Can we obtain explosive returns in a few years?" -- the same question we ask with 10x/5y. We looked ahead, rather than back, to determine whether the company was overvalued or not.

The Community speaks
When we asked the Fool Community to look at the sell strategy for the Rule Breaker Port, most believed that the 10x/5y criterion contained its own sell rule.

Caesium advises, "With the introduction of the 10x/5y... you de facto introduced a sell strategy. If your periodic review of your holdings indicate they do not now meet that criterion then you have your sell trigger." davefeatherstone takes it one step farther: "Just sell whenever a stock is no longer a 'Rule Breaker' -- whenever the reasons for the buy are no longer valid (Celera Genomics (NYSE: CRA) is an egregious example). This sell strategy ensures that all port members are, and always will be, Rule Breakers." Ditto tecmo, saying to sell when 10x/5y is met or when no longer achievable, pointing the finger directly at AOL Time Warner (NYSE: AOL).

norationalbasis prefers a mechanical rule first: "Sell 1/2 of the holding once it doubles, and sell again on each additional double from that point." But then he agrees, "Sell the remainder when you determine that fundamentally, for whatever reason, the company no longer meets the criteria -- management (Celera Genomics), 10x5y (AOL), deteriorating fundamentals (Amazon), wake up from drunken stupor (Human Genome Sciences (Nasdaq: HGSI))." An intriguing idea. The selling of halves may happen more or less, anyway, if we sell parts of a holding that becomes disproportionately large, as AOL Time Warner has been.

The view from here
To sum up, we sell when we have a better place for our money, whether a specific stock or the average market, represented by S&P Depositary Receipts (AMEX: SPY) ("Spiders") or a similar instrument. We also sell when our reasons for buying no longer hold, such as when the business has fundamentally changed (for the worse!), as with Celera (though we may live to eat those words).

It makes great sense to follow the advice of the Foolish Community and regularly evaluate companies for their compliance with the Rule Breaker criteria, including 10x/5y potential. A stock that can't deliver possible 10x/5y returns? We oughta be looking for better places for our money.

Fool on! And enjoy updated Portfolio returns below. Nice week, nice month so far.

Want to enjoy David and Tom Gardner's further adventures in investing -- and stock ideas -- every month? You can, in The Motley Fool Stock Advisor!

Tom Jacobs (TMF Tom9) co-manages the Rule Breaker Portfolio. Well, la dee dah! At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Port Returns -- 5/20/02 Market Close:

          RB       S&P     S&P 500
         Port      500      DA*    Nasdaq
Week     5.94%**   1.61%    --     2.97%
Month    2.49%**   1.39%    --     0.79%
Year   -14.49%**  -4.90%    --   -12.76%
CAGR***
 since 
 8/4/94 24.90%    11.77%  13.71%  11.66%