A reader emailed me last week and said that he likes reading about my investment process, but mentioned that I haven’t discussed a selling strategy. Like most value investors, I spend the majority of my time reading and searching for new investment ideas. My turnover is low, and I like to think of my portfolio of companies working for me while I spend my time reading, learning and looking for new ideas. However, positions do turn over and selling is obviously a part of the business, so I thought it would be a good idea to write some quick thoughts on when to sell stocks.
To understand my selling strategy, it’s a good idea to review my thoughts on investment concepts and strategy. You can also read a summary of my investment philosophy. Basically, I’m a value investor who views stocks as real businesses that produce real cash flow from real assets. I don’t think of stocks as pieces of paper to be traded back and forth. I don’t try to time the overall market. I don’t use technical analysis, and I don’t worry about macroeconomics or government policy. I’ve tried these things in the past, and for me, I’ve found it much easier to be simple… I try to buy cheap stocks, preferably ones with higher quality. I buy a basket of them, and let compounding work its magic.
A couple of my favorite things to look for in determining quality is growth of book value over time (this tells me the company might have some sort of competitive advantage) and free cash flow yield (free cash flow divided by price-I like stock with 10% FCF yield). I also like companies that are buying back their shares, making my shares more valuable (high free cash flow often leads to share buybacks).
So it’s a simple process:
- Look for cheap stocks relative to assets or earnings
- Identify the best companies within that group of cheap stocks
- Buy a basket of them, diversifying adequately but not excessively
I very much follow the same principles that Ben Graham discussed in this piece (not the exact strategy, but the same principles).
That’s How We Buy, but When Should We Sell?
Basically, I only have three main reasons to sell a stock:
- The stock was bought at a discount and has risen to my estimated fair value.
- There is a change in my analysis of the business that leads me to believe the stock no longer offers the same value. (This often is due to an error in my analysis, and occasionally could be due to a deterioration-beyond what I expected-of the business itself.)
- There are better opportunities than what I have in my portfolio. (This only occurs if I’m fully invested, and I try to minimize using this reason. I only replace a current position with a new stock if I have extremely high conviction that the new stock represents much better value.)
The first category is the most frequent reason I use to sell. I divide my focus (Enterprising) strategy into two categories: Quantitatively Undervalued Stocks and Compounders. Usually, the biggest opportunities for large returns are in the first category. Sometimes these categories get blurred together as each individual investment is different, but my I try to categorize my stocks into one of the above categories, because that helps me determine when to sell.
Since most of my investments are in undervalued stocks, most of my selling occurs when the stock reaches fair value. In his “Simplest Way to Select Bargain Stocks”, (see link above), Ben Graham talks about selling a stock when it reaches a 50% gain, or after it’s been in the portfolio for 2 years. This is not a bad idea to consider, but it’s more systematic than I’d prefer. I like to evaluate each position in the portfolio, and each stock is different. My holding time might be months, or it might be years. I’m very patient with stocks that continue to hold the same characteristics as they did when I bought them. As Graham says, eventually the market will price stocks at their fair value. It’s a weighing machine in the long run.
So that is a general overview of some thoughts on selling. These reasons of course apply to my strategy, and each investor has their own reasons for selling. One investment strategy that I’m not currently using but actively researching and learning more about is special situation investing (essentially value investing with some sort of corporate catalyst like a merger, tender, liquidation, spinoff, etc…). This type of strategy would use a different selling tactic. Over the next few years, I will continue studying this aspect of investing and will likely employ it at some point.
But for now, I stick to the simplicity of buying cheap stocks (with the occasional compounder) and selling them as they reach fair value. Like Graham, I focus on hitting “base hits”. Focus on the process, use simple methods and simple logic, and continue to learn and improve. I’ll discuss these ideas much more, along with my overall investment philosophy.