The 3 Good Reasons to Sell a Stock, No. 3: The Gray Areas

In this episode of Motley Fool Answers, hosts Robert Brokamp and Alison Southwick want to focus on one question -- but it's a big one, especially for long-term investors: When should you sell a stock? To provide the answer, they've tapped Motley Fool Chief Investment Officer Andy Cross and Ron Gross, the advisor for Motley Fool Total Income.

In this segment, they talk about the third category of acceptable reasons to unload -- but actually, these are rationales they view as "debatable." From "busted investment thesis" to overvaluation, from asset allocation to C-suite shifts, the Fools consider the iffy cases.

A full transcript follows the video.

This video was recorded on Aug. 14, 2018.

Ron Gross: Let's talk about some fun ones where they're kind of a gray area and they're debatable, and I like this first one, because you'll often see in Foolish literature this is one of the first ones. It says, "We sell when our original thesis is busted." I actually don't buy that, because if a thesis has changed, all that means is that now it's a new investment. It's a different investment. It has to be reanalyzed in that vein. It shouldn't be an automatic reason to sell a stock.

Here's a quick example. Let's say you bought a company because you thought they were going to grow organically [meaning by itself] 5-10% over the next 10 years. Then suddenly the company announces it's going to go into acquisition mode and spend a decent amount of money to try to grow revenue 10-20% a year. Now your original thesis is busted. The company is now spending much more money than you thought. They're going to be making acquisitions, which is always dicey, but they're going to be growing much faster theoretically.

Do you sell automatically, or do you reevaluate and decide if that's a company you want to own? I would prefer to reevaluate and see if that was a company that I wanted to own going forward, based on the new information. The old thesis, again, is in the past. The new thesis is about the future.

Andy Cross: The valuation is high. Upside is limited. Again, getting back to valuation. Very nuanced, here. We love to, as much as we can, let our winners run and as investors who tend to invest in exciting technology and consumer-friendly stocks, those tend to trade at higher multiples of earnings, cash flows, and revenues.

I talked about Okta today. From a traditional valuation metric perspective, it's what she values. And some people might not even buy that or some who owned it [especially because it's done so well], might want to sell that for a variety of reasons. I would not. I still think the long-term prospects for that business are pretty remarkable.

However, if it is to a point where a valuation comes into question, that is a debatable one [and] you might think about selling. And how you go about thinking whether a stock is richly valued or not is nuanced, as we all know, when it comes to valuation.

Gross: Theoretically, you wouldn't want to own a stock in your portfolio that you think would not be a market beater, because you could replace that stock with the S&P 500. Then the question is how you tell. That's where it gets dicey and it gets debatable because there's so many ways to theoretically tell if a stock is a market beater going forward.

But it involves so many assumptions that you're almost, invariably, going to be wrong. Value guys try to get in the ballpark and try to get it more right then we get it wrong, but it's not an easy thing to do.

Cross: And by the way, Ron and I actually do talk about this a fair bit. If a company looks fairly valued based on whatever metrics you are using, it doesn't mean that stock's not going to actually grow or that company's not going to grow. A lot of times in theory it will grow at its return on capital. So, it doesn't just mean that a stock is fully valued. Now I'm going to sell and get it out. Even if you are thinking from a valuation perspective, it doesn't mean stocks that look fully valued won't actually perform and grow. They still might.

Gross: That's really important and I want to reiterate something about that. When we put a sell recommendation on a stock, we're not saying that that stock is going to go down in the future. We're saying that stock is not going to generate future returns that are appropriate to whatever strategy we're pursuing, whether it's trying to beat the S&P 500 or another benchmark. Often, we'll put up a sell and someone will come up to me and say, "That stock is up 4% since you said to sell it." And I'll say, "Yes, but the market is up 10%. It wasn't a market beater." That's a key distinction. A sell doesn't mean we're saying a stock is going to go down.

Allocation is too high. We've discussed this a couple of different times. Again, it's debatable. I gave my number -- 7% gets me a little nervous. Some folks use 15-20% and they're fine. It's individual and it's really based on your own personal risk tolerance.

Cross: A key executive leaves. Succession planning. There are some who wouldn't want to own Berkshire Hathaway because the succession planning is not exactly clear. We don't know what's going to happen after Warren leaves. Some may sell on that.

Elon Musk -- we may not know what he has in store. Succession planning is the consideration we put on leadership at the organization. If you don't feel like they've been able to support the organization or can support the organization if an executive, founder, or CEO leaves, that could be a reason that you may want to sell.

There are times when the leader or a founder may be just so ingrained in the organization [like Tesla, perhaps], where that organization might go through some tough periods if that person was to leave. For The Partnership Portfolio, we can talk more about this later today during our main stage breakout. We did think a lot about founder-led organizations, obviously, but also what's behind them. Do they have the kind of support from the corporation to be able to sustain it if, for some reason, a founder or key executive leaves?

There's always talk about Sheryl Sandberg leaving Facebook to go run whatever company you want to name [Disney always comes to mind when Robert Iger leaves]. If she left, would that be a reason to sell the stock? We don't think it's a reason straightaway; however, it is something that you may want to pay attention to if it happens.

Gross: And be wary of grandchildren. Sons and daughters taking over for a father or mother sometimes can work out. Grandkids almost always screw it up. They've been rich for so long it just doesn't work.

Cross: There's a study out there that says that third or fourth-generation owners of public organizations as they get passed on don't actually underperform the market. Don't quote me on that, but I'm pretty sure it's out there someplace.

As for what to sell, this again gets more nuanced and more particular to each individual, but our advice with a lot of Tom's thinking is to start with companies that you've lost interest in. Like I said, I sold Express Scripts because it was a small part of my portfolio. I didn't feel like owning it anymore. It didn't have my interest. It's a great place to go.

Look more at the bottom than the top. Again, start with your smaller positions. The ones that are less meaningful to your portfolio is a good start rather than starting with your largest portfolios which hopefully are the companies that you have the most confidence in. For me [right now] it's Home Depot and Berkshire Hathaway.

Gross: As we said earlier, it's harsh, but the market really doesn't care what you paid for a stock. The future is the only thing that matters and not the past, so understand that. I wouldn't even look whether you have a gain or a loss on a stock when deciding whether to sell it or not. It truly is irrelevant to the investment decision.

Cross: Remember core principles to your investing approach. How you think about investing. This is your portfolio or the portfolio for your family. How you think about your principles to investing is really important.

I have strayed over the years. Different approaches that I just didn't feel comfortable with and owned stocks that didn't really match the way that I thought about investing for whatever reasons when I got into the stock. I wanted to part ways.

And again, you want to make your portfolio yours. David mentioned that earlier. As best as you can, you want your portfolio to try to represent your belief in the world, or at least start to get there and that approach, because then you're going to be much more comfortable following those stocks. I had Philip Morris for many years, and after I got married, it didn't quite meet the criteria of my family anymore [mostly my wife]. We ended up selling the stock. The same with ExxonMobil.