A couple of weeks ago, we looked at a happy dilemma currently facing so many Hidden Gems subscribers. These fortunate/unfortunate souls bought some of our recommendations on the cheap. But despite having held them for far less than our expected holding period of three to five years, they've found some of these stocks have already gone through the roof. With five of our recommendations having doubled in less than two years, and another two getting close, lots of Fools are asking: Is it time to sell?
Well, like I said, we addressed that question a couple of weeks ago and concluded that in the end, your decision for when to sell a winner should depend on valuation. A strong business, whose stock has performed better than expected, remains a strong business. And as Foolish investors, we're buying part ownership in small businesses -- not in four-letter ticker symbols. So we focus on the business and try, to the best of our ability, to ignore what its stock does. So long as the underlying business performs well, the company's stock price movements should not control our decision to buy or sell.
One question gives rise to another
Which raises another question: What do you do when the business itself changes or turns out to be something other than you thought it was? Those are two of the three situations that master investor Philip Fisher addressed in his classic collection of advice for the individual investor, Common Stocks and Uncommon Profits. Over his decades of investing experience, Fisher concluded that there are only three good reasons for selling a stock:
- When it becomes clear that the original rationale for purchasing was flawed.
- When a company no longer qualifies as a top performer.
- When there is a better place to put your money.
Today, I want to look at, and expand on, each of these three classic reasons for selling.
Oops, my bad
We're all human. We're all fallible. It stands to reason that, from time to time, we're going to make mistakes -- both you in your own investing choices, and, yes, we too at Hidden Gems, in some of our recommendations.
But that's not necessarily a bad thing. After all, we learn better from our mistakes than our successes. Walk across a room successfully, and you learn nothing. Stub your toe along the way, and you learn to look down right quick.
For example, those of us who invested in Lucent (NYSE:LU) in the late 1990s learned to "look down" the balance sheet for inventories and accounts receivable rising faster than sales. (I hope) it's safe to say we won't soon be fooled by channel stuffing again. Enron's fall taught us to look down even further, for evidence of off-balance-sheet entities. And investors who bought into high-flying dot-coms had a very long look down, as their stocks plunged towards bankruptcy, passing rising "New Economy" refuseniks like Berkshire Hathaway (NYSE:BRKA) on their way. Thus we were reminded that revenue growth is not a be-all and end-all -- profits matter, too, and valuation matters most of all.
The key is to learn from your mistakes, in hopes that over time you'll make fewer and fewer of them. And to learn to recognize the signs of a mistake, so as to more quickly discard a badly chosen company. Over nearly two years and 42 recommendations to date, Hidden Gems has bitten the bullet and thrown out three companies whose businesses just didn't seem to be shaping up as we'd hoped. One of the three was even beating the market by a hefty margin, but we simply lost faith in management. The other two were showing deteriorating fundamentals, convincing us that we'd backed the wrong horse(s). So out they all went. And since our sales, each of the three stocks has continued to decline in value.
The moral of the story is this: Making mistakes is inevitable. But admitting mistakes won't prevent -- and may help -- you to earn 33% gains and crush the S&P 500 by a 4-to-1 margin.
Um, this isn't what I ordered
Sometimes, you buy a company and later discover that it isn't at all what you thought it was. But this time, it wasn't your fault -- the business itself changed. In 2000, shareholders of fast-growing Internet provider AOL learned that their company planned to tie the knot with clunky old magazine hawker Time Warner (NYSE:TWX). In 2002, the opposite happened to shareholders of LendingTree.com. They learned that their fast-growing mortgage facilitator was to become a snack for perennial dot-com eater InterActiveCorp (NASDAQ:IACI). In each case, investors who bought into tiny fast growers found themselves faced with the prospect of owning much larger conglomerates -- not at all what they had bargained for.
Sometimes, the change is even more striking. A company like genomic data collector and reseller Celera Genomics (NYSE:CRA) up and decides it will enter the pharmaceuticals business. When the family dog decides it's evolving into a giraffe, that's an excellent time to examine the new animal and decide whether it's housebroken. And if not, then put that giraffe out to pasture.
Wouldn't you really rather have a Buick?
Fisher also named a third and final "acceptable" reason for selling. But this one he seemed conflicted about: selling one stock because you've found something better. A student of human nature, Fisher recognized that investors can be tempted to too quickly sell the "angel we know, for the devil we don't." To chase momentum stocks because "they're going up," and ditch our underperformers simply because the market hasn't yet caught on to the reasons we decided they were great deals in the first place.
Imagine the frustration of an investor who sold Coca-Cola (NYSE:KO) back in January at its near 15-year-low P/E, because the stock didn't seem to go anywhere -- in order to buy into the stem-cell miracle worker ViaCell (NASDAQ:VIAC). ViaCell priced its IPO at $7 on Jan. 21, then proceeded to more than double in price over a few short days. Had an investor cashed out of Coke to buy shares in ViaCell, he'd have traded away a stable return on Coke, missed a hefty dividend payment, and lost money on his new honey -- all because he thought he'd found "something better."
So there you have it, folks -- the three classic reasons for selling a stock. This Fool agrees with the first two: "sell when you've made a mistake" and "sell when your company has changed." On the third, I'm as conflicted as Fisher was -- and for the same reason. It seems to me that, if you've bought a company based on sound logic, and the story hasn't changed, you should trust your initial instincts and your original research. Don't discount those, and don't sell your judgment of yesterday short, just to chase the hot stocks of tomorrow.
We certainly won't be doing that at Hidden Gems. For our members (and if you aren't one yet, we've got a free month-long trial on offer, so sign right up!), we'll tell you right away when we think we've made a mistake. We continuously monitor our selections and we'll let you know if the story changes for the worse. And as for selling just to buy something new, never fear. To date, some of our original selections have been doing so well, business-wise, that we're much more likely to suggest you double up on what you already own.
Fool contributor Rich Smith has no position in any companies mentioned in this article. The Motley Fool's disclosure policy leaves nothing to chance.
