"Never lose money" may be Warren Buffett's rule No. 1. He says the next one on the list is "See Rule No. 1." But if you look at the turnover in Berkshire Hathaway, you'd guess that "Don't sell a winner" is his real rule No. 2.
If there's one thing that stings more than taking a bath on the next big bust, it's selling out of a big winner only partway up the mountain and leaving 50%, 100%, 200%, or more on the table.
It's a pain I know personally. As a value type, I make most of my buys on the low side and look to get out when the market brings the price back to what I consider fair. That might work well with a mature behemoth like Nokia (NYSE:NOK), but it can give you cramps when you're talking about other kinds of companies. Ask some of my colleagues how smart they feel about selling their Abercrombie & Fitch (NYSE:ANF) shares about 1,000% ago.
But at least I know I'm in good company. Fool co-founder Tom Gardner learned this lesson the hard way when he sold Whole Foods (NASDAQ:WFMI) -- already a 70% gainer -- from his Motley Fool Stock Advisor picks in early 2003. Since then, it's more than doubled.
Even the legends get this wrong. Peter Lynch speaks eloquently about screwups like this in One Up on Wall Street, where he laments selling what would eventually become Time Warner (NYSE:TWX) back in the 1970s, after it ran from $26 to $38. What's so bad about a 46% gain? Well, Lynch watched Time Warner climb to $180 a share, and he noted that even after it crumbled following the infamous Atari debacle, it was still at $60. He made similar screwups with Toys "R" Us, and he's got eye-popping charts that show stories such as SmithKline -- now part of GlaxoSmithKline (NYSE:GSK) -- running from $6 to $60 over a period of 14 years. Even after the blockbuster Tagamet was priced in, investors could have had a triple in eight years.
Unfortunately, figuring out when to sell may be the last lesson the market teaches us, but it's one that's vitally important to our long-term success as investors. In my never-ending quest to become a better investor, I've been examining my sell-side mistakes to see what the stocks have in common -- besides profits and cash flow, which is something I will take for granted here.
In general, I find that sales I've come to regret have always come from stocks that share the following attributes.
1. They are the premium brand in their field. Coffee? You want Starbucks (NASDAQ:SBUX). Flash memory? SanDisk (NASDAQ:SNDK) is the number one game in town. Upscale, healthy groceries? That's Whole Foods. The biggest name in teens-through-20s clothing? It's Abercrombie.
2. They are the No. 1 because they have a superior approach to the business. This is vitally important, and it can manifest itself in many ways. But you can almost always find the evidence of the superior business in the margins. In the case of a SanDisk, its mixed-source approach for raw flash memory gives it pricing power its competitors lack. Abercrombie's customer-pleasing designs and engaging store formats enable it to make full-price sales, which gives it some of the best margins in the biz. Whole Foods may look like just another (very expensive) grocery store, but its proactive efforts to reward employees makes it much more than a run-of-the-mill, union-hobbled supermarket.
3. They have continued, often underestimated, mass-market growth potential. Most of the best long-term winners in my memory sell products that end up directly in consumers' hot little hands. Let's go to Starbucks again. Look expensive? Would a few thousand more stores in China change your mind? How about two or three outlets in every wing of every airport in the U.S.? In the world? SanDisk's No. 1 market for new memory chips is in new cell phones, and when's the last time you saw a phone that was getting dumber, or needing less memory? Whole Foods? Well, let's just say that I live near one, and that parking lot is a mess of success.
4. They look expensive. Yup, superior businesses often sell for high prices, but that doesn't mean much, because price is just a snapshot, and real value will be measured by what the business does down the road.
The bottom line is this. Price alone is a very bad reason to sell. Yes, stocks can get expensive, but when they're attached to superior companies with a track record of outperforming expectations, you should sit on your hands and let your winners run. Don't be surprised by companies that always surprise. Unless the business story changes, selling, even for a profit, might be the worst mistake you can make.
Will David, who made Whole Foods a new Stock Advisor pick in the fall of 2005, do better than Tom? A free 30-day trial will let you find out. You'll also have full privileges to the entire catalog of past picks and back issues, with no obligation to subscribe.
Time Warner is also a Stock Advisor pick, while GlaxoSmithKline is a Motley Fool Income Investor pick.
Seth Jayson is always looking for another winner, but until he finds one, he's content not to screw up his current crop of outperformers. At the time of publication, he had shares of SanDisk, but no positions in any other company mentioned here. View his stock holdings and Fool profile here. Fool rules are here.
