<THE RULE MAKER PORTFOLIO>
When to Sell? --
Part 1 of 2
ALEXANDRIA, VA (August 18, 1999) -- Today's report along with its continuation tomorrow will soon be included as a "Selling Step" in our steps to Rule Maker investing, which are linked on the right side of this page.
"If the job has been correctly done when a common stock is purchased, the time to sell it is -- almost never." --Philip Fisher (Common Stocks, Uncommon Profits)This single sentence pretty much sums up our thoughts on selling. Our method of investing is focused on buying stock in the companies that will be making rules and racking up returns for decades to come. But (you knew a "but" was coming, didn't you?), we have a little confession to make -- despite our best intentions, we're not perfect. Although we diligently research each stock that is added to this portfolio, we're bound to make at least an occasional mistake. And when we do, we will probably decide to sell the offending stock that we mistook for a Rule Maker.
Deciding when to sell a holding is one of the most difficult aspects of investing. A selling philosophy can be summed up as simply as: "Sell when you find a better place for your money." That pretty much covers it, but we want to explain our thinking in a bit more depth. The list of reasons we offer below (and tomorrow) is far from comprehensive, as we chose to focus on what we believe to be the most important issues.
In this step, we're going to explore five valid reasons for selling, broken down between two categories: company fundamentals and portfolio management. Tonight, we'll explore three reasons to sell based on a company's fundamentals. Tomorrow, we'll finish up with two additional reasons to sell based on portfolio management, plus a few closing thoughts on a great way to avoid selling altogether -- charitable donations.
Before jumping into the first three valid reasons for selling, let's briefly touch on one reason that you'll notice is conspicuously missing from our list -- valuation. We don't really worry all that much about whether a stock is overpriced. In the case of the crï¿½me de la crï¿½me that qualify as Rule Makers, valuation is not a good reason to sell. If you're not convinced, you might want to go back and review the QuaVa Step, which expounds upon our belief that business quality is fully 100 times more important than valuation. Because of their high and sustainable profitability, Rule Makers typically have -- and indeed deserve -- a premium valuation.
With that disclaimer out of the way, let's jump into this nasty topic of selling.
Reasons to Sell based on Company Fundamentals
The Rule Maker Portfolio's intention is to hold stocks for at least 10 years. We agree with Warren Buffett that the ideal holding period is forever. Nevertheless, we consider the following three conditions as sufficient, if not necessary, reasons to sell.
- Crooked management
- Deteriorating financials
- Mergers, acquisitions, and spin-offs
We will not tolerate deceit from management. Less-than-honest management can rear its ugly head in many forms, including a criminal history, bad accounting, and hype-and-bail executives.
Centennial Technologies (OTC: CENLD) demonstrates the danger of a key executive with a spotty legal history. In 1996, the company was a real high flyer. Then, it came to light that the head of the company had committed several illegal acts, which caused the company's actual results to be much worse than had been reported. The end result was that the company's stock price fell through the floor and the stock was delisted from the Nasdaq. This example may be a bit extreme considering that Centennial was never a Rule Maker. Even so, this story teaches a good lesson because, interestingly enough, this problem could have been foreseen. The CEO had a history of legal troubles that came to light before anyone learned of the real problems at Centennial. By booting this stock upon learning of the CEO's history, shareholders could have avoided some major losses.
Bad accounting is another telltale sign of crooked management. Here's where we get to pick on a company like Oxford Health Plans (Nasdaq: OXHP). On October 27, 1997, Oxford first announced its difficulties and accounting irregularities. That day, I posted on the Rule Maker Strategy message board that I felt this was a stock that should be sold because the company's management had been misrepresenting their performance. Further, it sounded to me as if they had no real idea at all about the performance of their business. The events in subsequent weeks most definitely led me to lose trust in the company's management. For over a year, Oxford had been saying that everything was okay -- even as other HMO businesses were announcing restructuring plans. Not Oxford. Oxford continued to paint its picture with broad, bright strokes. Then, ka-blammo!
Another thing to watch for as a warning sign of bad accounting is if you learn that the company's accountants are resigning because of some type of disagreement with management. This could occur during the course of a company's annual audit if, for example, a disagreement between the company's management and its CPAs develops over how a specific item should be treated for accounting purposes.
Finally, there is the case of hype-and-bail executives who sell their stock ahead of horrible news -- yet while leading up to that news, they paint a rosy picture for investors. K-Tel International's (Nasdaq: KTEL) management pulled off just this sort of scheme. In the spring of 1998, the company announced intentions to sell greatest-hits albums and videos over the Internet. Instantly, K-Tel shares boomed on the news and ran from $3 to $40 in a matter of weeks. While the stock was at its highs, company insiders flipped out 2.4 million shares -- over 30% of the entire company -- at prices of $30 to $35 per share.
These are just a handful of the deceptive practices that might prompt us to sell a company. Crooked management is incompatible with long-term company ownership.
Even industry-leading Rule Makers are subject to the constant threat of declining product/service demand and encroaching competition. We live in a competitive world where one company's competitive advantage is another company's object of envy. Take Gap Inc. (NYSE: GPS), for instance. Every other casual clothing retailer sees The Gap's stunning success in marketing basic clothing items like khakis and blue jeans, while avoiding trendy fashion fads. If one of these competitors were to in every way successfully emulate Gap's strategy, but at a lower price point, Gap's business would likely suffer shrinking profit margins.
Whether the threat is external competition or internal stagnation, we rely upon the financial statements to show any signs of business weakness. Thus, we endorse checking up on the performance of Rule Makers on at least an annual basis, and a quarterly basis is even better. This means that once a quarter (in conjunction with either the earnings press release or the release of the 10-Q), you should take the company through the basic Rule Maker Criteria. It is necessary to look at the company's financials in light of the competitive environment and business landscape as a whole. For example, if sales growth is anemic, ask yourself whether it is due to exogenous worldwide economic events or a competitor's better products. If gross and net margins are on the decline, determine whether the cause is a lower-margin product mix or pricing pressure from a competitor.
Also, if the company originally fell short of any of the minimum Rule Maker standards, then you should make sure that it is improving its performance in these areas. If it still hasn't exceeded the minimum thresholds, you should make sure that you still believe its performance in these areas can be rationalized. Ask yourself if your original perceptions of the company, its performance, and its future prospects are on course.
Now, just because a company fails to pass one or even a few of the Rule Maker criteria doesn't necessarily mean the company should be booted. Our criteria are only guidelines, not hard and fast rules. Like many a sports team, even the best companies have an occasional "rebuilding year." One good example is Intel (Nasdaq: INTC) in 1998. For a time, sales growth slowed and margins declined, but all the while, the company's 80% market share was intact. If a company falls short of some of our standards, we must understand the reasons why. Then, we must determine whether it's bearable or not.
As you can see, there's no simple formula for determining whether or not to sell. Only a sober assessment of the company's position relative to its competitors and the economy as a whole will lead to a correct conclusion. If the conclusion of your analysis is that a company's business has fallen and can't get up, then it's time to move on. This sort of collapse will usually be pretty well represented on the balance sheet. Because we focus so intently on that financial statement, we expect to be able to get out of a permanent dog before its howls grow maddeningly loud.
This isn't to say that we'll sell any of our stocks that fall more than 40% in value. Again, one of the greatest investments of the 20th century, Coca-Cola (NYSE: KO), fell 67% in value in the 1970s. If we believe in the business, we'll hold through that sort of free-falling. But if, qualitatively, we think the business model is dead meat and, quantitatively, that death shows up on the balance sheet, we'll look to sell.
When a Rule Maker is involved in a major merger or acquisition, it's necessary to reevaluate the combined company. If the new entity doesn't offer the same package of qualitative and quantitative Rule Making attributes, a sell may be in order. The same goes if you own stock in a company that decides to spin-off one or more of its business units. When AT&T (NYSE: T) spun off Lucent (NYSE: LU) and NCR (NYSE: NCR) in 1996, you might have decided to keep Lucent and sell NCR just like they did in the Rule Breaker Portfolio.
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