How to know when to sell a stock

In the last post, we examined the conditions under which we want to buy a stock. We develop our Star List of ultra-high quality companies, and then we buy those that have the best combination of value along with quality at each point. But how can we know when to sell? As we have examined, low turnover is better for portfolio returns for several reasons. So, the ideal amount of selling would be zero. But can this be possible?

When I build my Star List of companies, I only select companies that I think can maintain durable and sustainable high returns on capital for many decades or longer. I want companies that will survive the test of time. These companies are exceedingly rare, so out of a universe of 30,000+ stocks in the world, I have identified maybe around 100 that make the grade. In limiting my search for stocks to this set of the highest quality companies, I am essentially eliminating one big problem from my strategy – the need to make frequent decisions about when to sell. As Warren Buffett has said, “our favorite holding period is forever.” By pre-selecting high quality companies for my shopping list of stocks, I can maintain extremely low turnover which has been shown to be advantageous for returns in investing.

That being said, there will very occasionally be times when selling will be necessary. These few situations are:

• When a company’s situation has fundamentally changed for the worse on a permanent basis. This would be something that will permanently impair its return on capital going forward. A new or better technology supplanting the company’s product, or permanently changed consumer tastes are examples of this. A government regulating the industry, lawsuits with potential judgments that are large enough to threaten the existence of a company, or threat of insolvency due to debt burden and poor management are other examples. Temporary bad news does not qualify here. For example, it is doubtful that a few of E. coli cases at McDonalds’s, as discussed in the news lately, will be anything more than a temporary blip in McDonald’s future prospects. It might seem bad for a short time as the stock dips, but 20 years from now, no one will be thinking about that as they head to McDonald’s for a quick meal. So, the stock will do just fine over time.
• When a company becomes so greatly overvalued that other opportunities are more attractive and the overvaluation is excessive enough to compensate for the capital gains taxes incurred. Mild overvaluation is usually not enough because the capital gains taxes you incur will impair the growth of your portfolio in the future, since you can no longer use those funds to compound in your portfolio. Therefore, you must be more than compensated for the trouble of incurring that tax and for taking any selling action in your portfolio. You need to be able to say “this is definitely way overvalued,” and not just “I think it might be overvalued.”
• When there is a once in a decade or lifetime situation that becomes available and you do not have any other funds to take advantage of it. In that case, you might sell the least attractive set of investments in your portfolio, such as the investments that are the most overvalued or the lowest quality companies. Again, this has to more than compensate you for the taxes and turnover you incur. This is not for just any opportunity that comes along. You have to be able to say something like “this is the most amazing opportunity I have seen” and not “I think this might be an opportunity.” An example would be a great company like Coke trading at a price to free cash flow of six when it normaly goes for many multiples of that.
• When you will need the money within the next 10 years. If you have an expense coming up where you will need the money in the next 10 years and it is large enough that you cannot save it up by, for example, just setting aside a fraction of the dividends instead of reinvesting them, then these funds should not be invested in stocks. You should sell some stock and set the funds aside in a Treasury bond or similar low risk instrument with a duration comparable to or shorter than the timeframe where you will need the funds. Be sure to set aside enough for taxes also. If possible, consider forgoing the purchase until the funds have been saved up rather than sell some of your precious stock holdings. But, things sometimes happen, so if this is unavoidable, you must make the difficult choice to sell.
• When you can take advantage of a special situation. An example of this would be holding A class shares of a company in a tax advantaged account and trading them in for B class shares that normally trade at a 10% premium, but are now trading at a 10% discount. Then, when the situation reverses and the A shares are back to trading at a 10% discount, switching back to A shares. Voila, you now own 21% more shares without having done anything but arbitrage share classes. This particular situation usually only works if you do it in a tax advantaged account because of the capital gains incurred.

Remember, you become what you practice. So, if you condition yourself to sell often, you will continue to sell often. If you condition yourself to sell only rarely and with great reluctance, you will get better at buying and holding. Therefore, in the above points, consider if it is worth it for you to activate your behavior of selling as an additional factor in weighing your decision.

I think one of the strengths of the Star List method of investing, even over and above index investing, is that when practiced well, you can have extremely low turnover and a buy and hold mentality. If you practice something like “cigar butt” value investing, you will by necessity have to sell more often. With the Star list investing strategy, you should only rarely have to sell, which eliminates one difficult set of decisions from consideration. It will allow you to practice investing in a manner that enhances returns by maintaining extremely low turnover. For example, it has been shown that funds which have high turnover produce lower returns. Other studies I have read show that high turnover reduces the average investor portfolio returns by multiple percent per year on average, as well. It is critical that you cultivate a process that maintains a buy and hold attitude, and Star List investing does just that.