When do we sell a stock? – A Business & Buffett’s Perspective

Recently, I again asked the question of when should Value Investors sell a stock.

Based on my research, i found out that the reason why Value Investors sell their stock is very closely tied into the reason of why they buy the stock in the first place.

The key reasons why a Value Investor would buy a stock is because of the combination of these 2 reasons:

1) The business is a good, profitable business.

2) The business is selling at a reasonable or cheap price.

So, coming back to when do we sell a business after we buy it? The guideline is to look back at why you buy it in the first place and ask if the 2 reasons are still valid.

In other words, Value Investors sells businesses when either one of the reason for buying is no longer valid. i.e.

1) The business is no longer good and profitable.

2) The business is no longer selling at a reasonable price (i.e., it is over priced).

Let me add one more possible reason to sell,

3) When there is better opportunity.

Here is an extract of an article on Selling Lessons from Buffett

Selling Lessons from the Sage of Omaha

In “An Owner’s Manual,” distributed to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholders in 1996, Buffett wrote:

Do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. … Instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.

“Indefinitely” is a long time. Although Buffett was talking about his own company, Berkshire Hathaway, his advice applies to any well-run company. With regard to Berkshire‘s portfolio of companies, he noted in his 1996 letter to shareholders that:

We continue to make more money when snoring than when active. … [Y]ou simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.

The last sentence gives us the first clue about when to sell: if the company no longer provides “excellent economics” or is no longer run by “able, honest management.” Thus, if your original investment thesis is no longer valid, consider getting out regardless of the stock price.

When Businesses are no longer “good”

In the same 1996 letter, Buffett offers up General Motors, IBM, and Sears as companies that seemed invincible, but then suffered competitive attacks from upstarts, causing their stocks to plunge. These three companies were what he calls “impostors” rather than “inevitables” — truly great companies with insurmountable competitive advantages.

To Rebalance or Not to Rebalance

Buffett’s belief in inevitables means he also eschews rebalancing a portfolio when its winning stocks grow to be a large part of your portfolio. Finding inevitables is so rare and so rewarding that it would be crazy to sell them:

To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

Stop Losses???

As a corollary, you shouldn’t sell a solid business just because its stock has declined. Reputable publications such as Investors Business Daily recommend setting a stop-loss at 8% below your purchase price. Buffett disagrees in his 1987 letter to shareholders:

After buying a farm, would a rational owner … start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have brought on the previous day?

The correct answer is no to both of Buffett’s questions. If a company is fundamentally sound, the price decline would make the stock more of a buy than a sell.

At the very least one should reexamine one’s evaluation of a company’s fundamentals when its stock suffers an unusual price decline.

Cigar Butts

Interestingly, in his 1989 letter to shareholders, Buffett does advocate selling early when you’ve bought a “cigar butt” — a mediocre company with one puff of pleasure left before it sinks permanently into oblivion. Such companies are out of favor for good reason and sell at very low prices. They may have one last gasp of success causing the stock to go up temporarily, and when that bounce happens, Buffett says you need to sell immediately:

“Time is the friend of the wonderful business, the enemy of the mediocre.”

Short Term Trading?

One last issue to consider is taxes because the only return that matters is your after-tax return. Buffett hates paying taxes and thus wrote in his 1988 letter to shareholders that he would prefer to hold on to his investments forever:

When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.  We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.

Although he qualifies his buy-and-hold philosophy as applying only to those companies with “outstanding businesses and managements,” he is loathe to sell even mediocre businesses. Principle 11 of the 1996 Owners Manual states:

You should be fully aware of one attitude Charlie and I share that hurts our financial performance: We are very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. Gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.

Extracted from http://www.investingdaily.com/14729/warren-buffett-on-when-to-sell-a-stock

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Mind Kinesis Research Team

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