At The Motley Fool, we generally encourage investors to hold on to companies they believe in for as long as they can. But there are exceptions to every rule, and sometimes holding on to a declining company won't do your portfolio any favors.
In this episode of Industry Focus: Tech, Dylan Lewis and David Kretzmann explain four situations in which long-term investors would want to consider liquidating a stock and buying into greener pastures. Also, they discuss when it's better to err on the side of holding an underperformer, rather than selling a potential knockout.
A full transcript follows the video.
This podcast was recorded on Aug. 26, 2016.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Aug. 26, and we're talking tech and when to sell a stock. I'm your host, Dylan Lewis, and I'm joined in the studio by Motley Fool premium analyst, David Kretzmann. David, how's it going?
David Kretzmann: It's Friday, it's going well.
Lewis: It's a pretty darn good Friday here at Fool HQ. We've got the company outing to the Nats game later tonight. Austin Morgan, our man behind the glass, is wearing his Anthony Rendon jersey, a name I learned how to pronounce just minutes ago. I even asked to clarify because I wasn't 100% sure. So, we have that going on, which I think a lot of Fools are going to go out to, which is great. And then, of course, it's the last Friday of the month here at HQ, so we have pizza day.
Kretzmann: Best day of the month.
Lewis: For pizza day, we get pizza from pretty much every local vendor in the Alexandria area.
Kretzmann: It's an impressive showing of pizza.
Lewis: You are an Old Town resident, right?
Kretzmann: I am.
Lewis: Do you have a personal preference? What do you go for on pizza day?
Kretzmann: I actually have celiac disease, so I have to eat gluten-free. So I automatically try to snag whatever of the Domino's gluten-free pizza is left. So I have to leave more to the rest of you to enjoy those offerings.
Lewis: That explains why we order Domino's. For the longest time, I was like, "There are all these really great pizza places, why are we ordering Papa John's and Domino's?"
Kretzmann: That's part of the reason, I think. I'm grateful.
Lewis: It makes sense to me now. So, once we wrap up the podcast, we'll go downstairs to the Foolitorium, get some pizza. You can get your Domino's. I will get my Bugsy's, which I am partial to. Love the deep dish. But before we do that, we're going to talk about when to sell a stock.
Kretzmann: It's a tough discussion, but I'm glad we're having it.
Lewis: Just a note before we start the show and really get into it -- there are a ton of different personal finance-related reasons for selling a stock. Tax loss harvesting, portfolio allocation, all that kind of stuff. We're not really going to get into that here on today's show because we don't want to do anything that would seem like blanket advice for something that's nuanced. Also, this is not a show about timing the market with selling shares. We don't do that, because we can't do that. The Fool doesn't believe in timing the market. It's not part of our ethos. Everything that we're going to discuss on today's show is when it might make sense to sell shares based on things that impact the company itself, or how you feel about that company.
Kretzmann: Yeah. To preface it all, I think each investor should be biased against selling. I think the longer we can hold our stocks, in general, everything else being equal, the better our results will be over the long term as investors. I would rather hold a losing stock too long than sell a winning stock too early, that's one way to think about it. But there are cases where, for whatever reason, if you're wanting to sell a stock, if you're considering selling a stock, there are some reasons that we'll look at that we can go into.
Lewis: Reason No. 1: The thesis is no longer intact. I have an example from my own portfolio. It isn't a time that I sold, but it's a time that maybe I would have considered selling, had circumstances been a little different. I realize that is not the same thing, but I think it's an interesting way to illustrate this.
People that listen to the show might know that I'm a bit of a TASER [International] (NASDAQ:AAXN) bull. I like the company quite a bit. I've talked about them plenty of times on the show in the past. My thesis with them has always been their core weapons segment is nice, but for me, the big growth opportunity is with their Axon body camera line, the Evidence.com cloud storage business. And that's proven out so far. Over the last two quarters, the Axon revenue has been higher than their weapons revenue, and the bookings for the segment has grown over triple digits year over year. So it's looking good.
During some of that same period, the company has sold off dramatically after reporting weak guidance. Some of that was due to a worse margin look, because of some of the changing product mix there. Some of it was due to some higher SG&A -- selling, general, and administrative costs -- which might have eaten into earnings a little bit. But the indicators for that Axon segment were strong. They'd beaten what they'd forecast for bookings, they've been continuing to add major contracts. Things were looking good there.
If the results had been flipped, and they'd offered great guidance but the Axon segment -- which was my thesis going in -- had not been performing well, and they'd been missing the mark on their forecasts, and they hadn't been able to lock up some of these really important contracts, that's a circumstance where I'd consider selling the stock, because it's counter to what I'm expecting and what I'm looking for. Granted, sometimes you're right for the wrong reason. But I think that's an example of, you expect a certain thing, and you're buying into a certain story, and if it doesn't play out, and that's a hypothetical there, as a way to illustrate that.
Kretzmann: Yeah, I think that's a great example. It's something that Peter Lynch, a great investor who we talk about a lot at The Motley Fool, something he references as a yellow flag, or potentially a red flag, is if a company de-worsifies. This happens a lot with acquisitions. Let's go far out here with an example. If you have Coca-Cola go out and say, "To spur growth, we're going to buy a timber company."
Lewis: A little head-scratcher there.
Kretzmann: Right, something like that. Especially if a company is relying on acquisitions to make growth, if they start venturing outside of their core competency, where they have a competitive advantage, or where they have knowledge with that industry or segment, that's a yellow flag that the company is stretching to find growth.
Lewis: And that's getting outside of why you're investing in that company.
Kretzmann: Exactly. You're not investing in Coca-Cola to get exposure to the lumber markets. That's obviously an extreme example, but it's something to watch for, especially with an acquisitive company.
Another example here that I'll quickly go into is RetailMeNot (NASDAQ:SALE). This was a digital coupons provider. It's still around. Going back to 2012, 2013, this was a company that growing annual sales well above 40% per year. It was growing very quickly, it was a growth story. Then, in 2014, Google changed its search algorithm, organic traffic to RetailMeNot's platform plunged because they relied on organic traffic through someone searching for a coupon on Google and getting redirected to RetailMeNot. That's how they got the bulk of their traffic. Suddenly this went from a growth story to a turnaround story, because the company's desktop traffic plunged, it was actually dropping, and that's where the bulk of their ad revenue was coming from, from their desktop business. Their mobile business was still growing, but it was such a marginal portion of the business that it couldn't make up for the losses that they were seeing in that desktop segment.
Lewis: So, you're seeing the profile of that business totally change.
Kretzmann: Exactly. You're going from a business that was growing sales 25% to 40%, or even more, each quarter, to a company that's all of the sudden seeing declining sales, a turnaround story, saying, "Can they bootstrap and make that mobile segment a more prominent part of the business to make up for those losses?" That's a much different story than when you first bought into a growth company.
Lewis: And it can be kind of tough to accept that as someone that may have bought in early. But at a certain point, you're better off realizing that and deciding to do something else with that money.
Kretzmann: Yeah. At that point, you have to reevaluate the thesis, because obviously, your original thesis isn't intact, if you thought the growth would continue. You basically just have to reevaluate the thesis and say, "Going from today onward, do I think this is going to be a winning investment? Do I think it's going to beat the market? Does it have above-average chances to beat the market?" In those cases, you basically just have to start at square one and make a new thesis. And if you don't really believe in that thesis, it might be a good time to sell the stock.
Lewis: And reevaluating the business really is the first step in deciding to sell. You can drop those in a little bit synonymously for this discussion. Selling is the final act of getting out of the position, but the considerations there are very similar.
No. 2: Core business issues. This kind of ties into RetailMeNot a little bit. The idea of a company with deteriorating financials, maybe the management team changes, something like that -- do you have an example for that?
Kretzmann: Yeah. An example that I'll bring from our Rule Breakers service, is actually one of the first companies that was recommended in the service, that's Blue Nile (NASDAQ:NILE). For those who aren't familiar, this is a company that basically sells online jewelry, rings, engagement rings, stuff like that, online. It was an early e-commerce player. The company was founded in 1999. Going back to 2004, when it was first recommended in Rule Breakers, this was a company with a profit margin of about 6%, sales were growing at about 30% or higher. So this was a growth story. Looking out over the next decade, when we ended up finally selling this stock in the service earlier this year, sales growth was all of the sudden flat, the company wasn't gaining any market share, just kind of growing at the industry average, profitability had dropped over the same time period.
Basically, here, you're looking at a few different factors. You can look at sales growth, profitability, so, some of the financials. You can look at market share or competitive position. In this case, their early thesis with Blue Nile was that, as an online provider of engagement rings, they can sell cheaper prices, they can be a more convenient solution. And theoretically, they should be able to gain market share. But that wasn't really playing out, especially over that period of a decade.
Then, another thing you can look at is capital allocation. How is management allocating the cash that the company is generating? In the case of Blue Nile, the company was still producing some cash flow. Over the past five years or so, that amount started to dwindle, and the cash that they were generating, they were buying back the stock, buying back shares. And that turned out to be a really terrible investment, because the shares have dramatically underperformed. They're down about 8% over the past five years. So that's a lousy capital allocation decision on the part of management.
And then, the co-founder and CEO, Mark Vadon, he left in 2013. So all of the sudden, you have a business with deteriorating financials, a weak competitive position, or, certainly they're not in a position where they're gaining market share, and then you have the co-founder and CEO leaving and going to another company, Zulily, in 2013. A combination of all those factors shows a deteriorating business.
Lewis: That is, in a lot of ways, the perfect example. Pretty much touched on every different element of the deteriorating business that we mentioned there.
No. 3: You believe the company has gone beyond a reasonable valuation. I think this is probably one of the toughest ones to nail down, particularly because, as Fools, a lot of the companies we like are growth-oriented, and they have these very gaudy valuations.
Kretzmann: Exactly. I think something you have to keep in mind here is, if you like everything about a business except the valuation, you probably don't want that to be the only reason you sell, because valuation is such a tough thing to pin down. Let's say you really love a business and you want to sell because of the valuation. That kind of implies that, at some point, you'd be interested in buying back shares. If you love the company and let's say the stock got hit in half, you'd probably want to buy shares. The problem with that is that you'd have to be right not just once but twice. You have to be right first when you sell the shares, and you have to be right when you buy the shares.
Lewis: And we talked about how difficult timing that is.
Kretzmann: Yeah. So, all of the sudden, you're not just timing one thing. When you buy or sell, you are timing both. And that just raises the probability that you're going to make a bad decision as an investor. I'll preface this section by saying, you probably don't want valuation to be the only reason you sell a stock. But maybe you sell your position in stages, maybe you just sell half of it, something like that.
Lewis: Yeah, I think the way to think about this, and it is, like you said, very difficult, is, if there's a massive disconnect between what the business is being valued at and the value and growth that you're able to recognize, then you might have a case for selling shares. And maybe if you're looking for indicators there, are you agreeing with the total addressable market that's being assigned to this business or service or segment or product or whatever? Or is it just unfathomable to you? And if the company has growth plans, whether they would be physical locations, entries to foreign markets, do you believe they'll be successful there? If not, if it's no to either of those, then maybe you have a case for selling.
Kretzmann: Yeah. I think it's important to look at, what does valuation mean? And really, what the valuation means for long-term investors is, it gives you an idea of what the company needs to do to become a good long-term investment for you. Let's look at a recent tech company IPO, Twilio (NYSE:TWLO). This is a company that makes communication software for apps that companies like Airbnb, Uber, integrate into their apps. All sorts of communication stuff.
Lewis: This is a company that's going to be a topic of a tech show down the road.
Kretzmann: So this is a preview of Twilio from a valuation perspective. Right now, Twilio's not generating net income or cash flow. So one of the valuation metrics you can look at is sales. [Price-to-sales] ratio is 21 for the company, and that's a lofty number. To give some context, Facebook trades at a P/S ratio of 16, Twitter at about 5, and LinkedIn -- being bought out by Microsoft (NASDAQ: MSFT), which we'll talk about in a bit -- at about a little over 7. So Twilio is clearly trading at a premium compared to some of these other tech companies.
To justify the valuation today -- let's say you want to invest in Twilio because you think over the next five years, this is a company that can grow and be a market-beating investment from today. Just some back-of-the-envelope math here: If Twilio grows sales at 35% annually each year for the next five years, and trades at a P/S ratio of 8, in five years, the stock would less than double from today.
Lewis: And those are impressive growth rates.
Kretzmann: I would say, from what I understand of the company, I think that's a pretty optimistic scenario. But perhaps they can grow sales at 50%, maybe they'll trade at a higher valuation. It's tough to pin down. But back-of-the-envelope math like that gives you an idea of what the company needs to do to justify the stock today. In the case of Twilio, that seems like you're taking on a lot of risk for not-so-great of a reward. That basically means the company has to pump out lights-out growth quarter after quarter, year after year, and still trade at a premium valuation in five years to less than double from today. I think, in the case of Twilio, I would look to other areas. If I owned this stock, I certainly wouldn't be looking to add at these levels.
Lewis: Yeah, totally makes sense. You touched on LinkedIn before. No. 4 for us is: The company has been bought out. LinkedIn is one of the companies we want to discuss here. A high-profile example of this is the Microsoft acquisition of LinkedIn. In June, Microsoft announced they were buying LinkedIn for $26.2 billion, $196 per share, in an all-cash deal. You look at LinkedIn shares now and they're trading around $192, give or take, there's a little hover there. The deal is supposed to close at the end of the year. And I think you have some investors who are like, "Okay, it's at $192 now, closing price is $196, eventually I'll get that 4% lift if I hold on." [Editor's note: It's a 2% difference.] I think there's a decent case to be made for LinkedIn shareholders that you've experienced the bump that you're going to get from the acquisition. If you have anything else you want to do with that money, it's very understandable to just sell those shares and actually have liquid assets to work with.
Kretzmann: Absolutely. I think the one reason you might want to hold shares is mainly for tax reasons. If you bought the shares in a taxable account within the year, it would make sense to hold the shares past that year mark, because then the capital gains taxes you would pay go down. Otherwise, yeah, it makes sense to sell. In the case of the Microsoft and LinkedIn acquisition, there's very little chance of a competing offer coming through or the deal falling through.
Lewis: Yeah, the boards are on board here. It seems like a pretty open-and-shut case. I don't think there's going to be any competitive regulatory issues. Is it worth holding out for that extra $4? Unless it impacts your holding period, like you talked about -- that was a great point -- probably not.
On the flip side, another one to think about, a different type of deal and a different consideration here, another deal announced in June -- Tesla (NASDAQ:TSLA) said it would be acquiring SolarCity (NASDAQ:SCTY.DL) for $2.6 billion in an equity deal. The terms here: SolarCity stockholders will receive 0.11 Tesla common shares per SolarCity share. So if you owned 10 shares of SolarCity, after the deal closes in Q4, you would now own 1.1 shares of Tesla. I think it boils down to, if you don't want to be a Tesla shareholder, you should probably sell your SolarCity shares prior to the company transferring over.
Kretzmann: Exactly. And there can be deals that are in between. It might be a cash and equity deal, or something like that. But in a situation like Tesla and SolarCity, if you're a SolarCity shareholder, you want to evaluate whether or not you want to be an owner of Tesla shares. That's really the question. If you don't want to be a Tesla shareholder, you sell. So, you evaluate the management. Do you believe in Elon Musk's vision? Do you like the financial situation of Tesla and SolarCity combined? Do you like the market prospects? All of those things would be things you want to take into account.
Lewis: Yeah. So, we realize we showed the two ends of the spectrum there in acquisitions. There are some blended deals. But I think that gives you a little bit of flavor for the different considerations. Anything else on the "when to sell" side before I let you go, David?
Kretzmann: No, I'll just give a quick example from Tom Gardner for why you should be biased toward holding a stock rather than selling. I think you should definitely think twice before selling a stock. An example that Tom Gardner gives is, going back to '95 or '96, Tom had invested in Dell, and the stock was trading at a premium valuation, it popped up about 25% within a few months. So he thought, "It's a little frothy, I'm going to sell now." So he sold the shares. He never ended up buying back the shares. Over the next decade or so, Dell went up 40 times in value.
Kretzmann: So, you think about that -- no amount of losers that you sell, no amount of stocks that you sell at a good time, is going to make up for that winner that you cut short too early. So like I said earlier, I'd much rather hold a losing stock too long than sell a winning stock too early. When I look back over the past decade of my investing so far, my biggest mistake by far has been selling Chipotle or Monster Energy too early, because you lose out on those potential gains, rather than selling a potential loser on time.
Lewis: And those are both businesses you loved, I'm guessing, but it was a matter of valuation?
Kretzmann: Right. And a tendency that people have, for whatever reason, our psychology, if we're in a position that maybe we need to raise money to buy a house or fund something in our life -- in my case, it was funding college tuition -- we'll usually tend to gravitate toward selling our winners first, and we'll keep our losers longer. I think, if anything, it should be flipped. If you're really in a position where you want to sell something, start with your losers first rather than your winners. Humans have a tendency in investing to cut the flowers and water the weeds, and that will just kill your returns over time.
Lewis: That is an excellent expression to wrap up on. Cut the flowers and water the weeds, I love it. Well, listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out and say, "Hey," you can shoot us an email at email@example.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out the Fool's family of shows at Fool.com/podcasts.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis. Thanks for listening and Fool on!