POST OF THE DAY
Foolish Collective
When to Sell a Stock

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By emiller8988
August 24, 2004

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Some good soul on another board was asking the forever-asked question... when do you sell a stock? I decided to write down an answer because, as always, I need to remind myself of my principles. Further, I saw this article on MSN about how "buy and hold" investing is the infantile pabulum spooned to us poor unsuspecting investors. The times are just too tough to consider buy and hold investing.

Most fortunes have been made by owning equity in a business that greatly increased in value over time, NOT by buying and selling. I am proud to say I've made a nice life for myself and family through saving and investing. The greatest investments I've made, the most profitable ones, have been those stocks I've held for many years where they just grew and grew. The great trades I've made (thankfully, there have been a few) pale in profitability to a few equities I've just bought and forgot about. Further, most of my "great trades" have been offset by equally bad ones... and when I was making the trades, I had no idea of which was which. The greatest regrets I have are all related to selling... when I just should have held.

The first grand rule of the individual investor should be to eliminate the sell decision by striving to choose investment in wonderful businesses at great valuations that will be able to grow and grow earnings for many, many years. My grandfather went bankrupt in the 29-30 crash by investing just like many did in internet craze...wild speculations and the like. He then re-grouped and developed a strict buying discipline and accumulated a very nice retirement by buying stocks. As near as I've been able to tell...from 1935 until his death, he never sold a single stock. Back then the commissions on purchase and sale were onerous for a small investor. He spent $1000 per year buying stocks, and made one single purchase in the fall of each year. It was all he could do, the most money he every made in a month's time was $400. Can you imagine the amount of research he did... he loved buying stocks and he pursued his single yearly purchase like he was hunting unicorns. He died in 1964... I still own a small portion of one of his purchases that came down through my father's estate to my sister and I. Because of his careful purchases, his only child (my father) and his grandchildren received a nice inheritance. Think about it... he held equity through the belly of the Great Depression, WW2, the Atomic bomb, Korea, the worst of the cold war, and the beginning of Vietnam... and he came through it smelling like a rose and looking like a genius without ever having sold a single stock! But... if you believe Mr. Fleckenstein, now the times are too hard for a buy and hold plan.

"Investigate before your divest" - John Bogle

First and foremost before selling you must think and act as if you were the owner of the business. Remember... think as if the business you are thinking of selling were a corner dry cleaning store... and you own it and it is your business.

If you feel you should think about selling.... you should sell a stock when its price reaches your estimate of intrinsic value, or sooner if you have a MUCH better investment to replace the investment that you have decided to sell. In considering the possible sale of a stock, you should calculate the effect of capital gains taxes that would be paid if the stock were sold, and consider the net valuation that would be received for the stock after the payment of capital gains taxes. This net-of-tax valuation for the stock that you are thinking of selling is compared to the valuation of the prospective new investment that may replace it.

The following example shows how to analyze a possible sale of a stock that is already owned....
Say you're looking at two equities.... both with 10% growth rates.
The stock you bought at $5 has a PE of 20 and sells for $100/share.
The stock you're looking at has a PE of 15 and sells for $75/share.

When you sell your stock, you get your $5 back plus $95 of capital gain. Take out 27% federal and state capital gains tax (25.65)
Equals realized gains, net of taxes 69.35
Net of tax proceeds if the stock were sold 69.35 + 5.00 cost $74.35
Gain required to get back to having $100 per share working for the investor $100.00 - $74.35 = $25.65 35%

Even though Stock B is cheaper than Stock A, with a price-to-earnings ratio, 15x, that is 25% less than the price-to-earnings ratio of Stock A, 20x, it is not at all obvious that selling Stock A to buy Stock B is a good decision when the tax effect is considered: A sale of Stock A would produce net-after-tax proceeds equal to 14.9x Stock A's earnings, which is about the same as Stock B's valuation, 15x earnings. In addition, you, the investor in Stock A would give up the use of $25.65 per share of tax money that is invested on your behalf.

Here is the choice:
A. You can continue to hold Stock A at 20x earnings, whose earnings are growing at 10% per year, and you only have to invest $74.35 of your own money. In addition, you get a "free" non-interest bearing loan of $25.65 per share that you never have to repay. That $25.65 loan is completely forgiven upon your death, and, in effect, converts into $25.65 per share of extra money that your estate will receive. Or,

B. You can buy Stock B. To buy Stock B, you have to sell Stock A for $100, and then pay $25.65 in taxes, leaving you with $74.35 to invest in Stock B. To get back to the previous amount of wealth that was working for you before, $100, your investment in Stock B has to increase from $74.35 to $100, an increase of 35%. If this were to happen immediately, the price-to-earnings ratio of Stock B would have risen from 15x to 20x. And if you sold Stock B at $100, there would be another tax to pay, $6.93 (assuming LT cap gains), so you would have $93.07 net of taxes ($100 - $75.35 = $25.65 gain x 27% tax = $6.93; $100 - $6.93 = $93.07). If another stock, Stock C, was priced at 8x earnings, and your best guess about its future earnings growth rate was 15%, then a switch from Stock A to Stock C would be more compelling.

In considering the sale of a stock, which is, of course, an interest in a business, we should try to think the way an owner of a company would think when considering a sale of the entire company: What are the future prospects of the business? Would it be better to hold onto the company, given its future prospects, or sell it today at the current valuation? If it appears that the future value of the company is likely to increase at a high rate, a business owner would probably choose to forgo a sale to an acquirer, and hold onto the company. In effect, an owner who made this choice not to sell would have decided that the "intrinsic value" of the company, as determined by the company's acquisition value, was not high enough in relation to the future potential, and value, of the business.

In many instances, the decision to sell becomes a very easy one: There is a cash offer for all of the company's shares, and you have no choice but to sell. It is also usually a fairly easy decision to sell a company with average to below average future earnings growth prospects at an appraisal of intrinsic value that has been based on valuations of similar businesses in recent acquisitions. If a company similar to the one you own is acquired for a price significantly under the present price of your equity... maybe you should consider selling. If your equity goes up and up and is selling at valuations that start to distort reality... of course consider selling. BUT... If it looks like you have a winning business at a reasonable valuation, your inclination should be to act like an owner and stick with it. Last... if the equity in your great business goes down and down and starts selling at very low valuations... for heaven's sake, don't panic. BUY MORE

That's what Mr. Buffett would do.

Clear as mud, right?

e

PS: Thanks to Tweedy Browne for much of the advice that comes from papers and PDF's filed on their web site.


Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.