The Secret to Better Returns: A Guide to Selling Stocks Strategically
When to Hold 'Em and When to Fold 'Em
Dear Investor,
I rarely sell. I try to hold stocks for as long as possible to enjoy the magic of compounding. I pick most of my stocks based on the durability and moat of their business model.
The ideal investment is one that you can hold on to forever. Just grows your money for you as long as you own it. I wrote about a good rule of thumb for finding such timeless stocks:
However, rules have exceptions and you should know when to break them.
First, I will introduce you to what I call the conventional rules of selling, and afterward, I will show you the simple rule that I follow which makes all the other rules obsolete.
What Are the Common Reasons to Sell a Stock?
Let’s start with the most obvious one: Deteriorating Fundamentals.
This point often gets misunderstood. Missed analyst expectations are often not because of deteriorating fundamentals. Even the best companies suffer occasional headwinds and can have a bad quarter. All companies change over time. Sometimes for the better, sometimes for the worst, and more often for the worst.
Deteriorating fundamentals occur for example when the customers are not using the product/service anymore and switch to a competitor, or when the financials turn negative due to mismanagement (huge debt/lower margins/negative FCF, etc.). This is usually a slow process that gives you enough time to exit a stock.
Changes in laws can also be a reason to sell a stock. I remember one particular German stock (Bet-at-home) that I had to sell when in 2017 European countries started to ban online gambling platforms.
Although I like business models that take a cut from transactions and act as the middleman, it was the right decision to sell because regulations and laws can be the ultimate business destructor:
Selling fine businesses on scary news is usually a bad decision, you need to evaluate when the news is just temporary or permanent.
“If the company you own is no longer the same company you invested in, it might be time to sell your stock.”
The next reason to sell that you hear all too often is: The stock reached its intrinsic value.
I don’t agree with this.
First, valuation is a range, not an exact number, and second, the reinvestment rate of the company’s money matters more than the valuation over the long term. Valuation helps a lot to not overpay for a stock because your risk of losing money increases the higher the price you pay.
I use valuation when buying a stock (as an additional edge when comparing against stocks from my watchlist), but not so much when selling. Why? As long as a company is able to increase shareholder value, this will lead to a higher share price over the long run. Charlie Munger explains this well:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, and you hold it for that 40 years, you’re not going to make much more than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns an 18% return on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.”
Selling because of value realization only works if you specialize in special situations (mergers, acquisitions, bankruptcy, shareholder activism, etc.), it makes little sense if you’re a long-term investor as long as the company is compounding its capital.
What’s the Most Overlooked Reason for Selling Stocks?
Now we’re getting to the interesting part. I’m an advocate of simplicity. There’s no reason to “optimize” everything when a few key factors are the ones that move the needle. So, what’s the simplest rule that makes the rest obsolete?
Comparing against alternatives.
Most of us have a finite amount of money to invest, therefore we need to evaluate new stocks against stocks that we already own. And the new stock should always be better in terms of possible total return than what we want to sell. If it has a similar potential a replacement makes little sense because then we just waste our time on the research.
It needs to be better.
To give you an example: Let’s assume you are an income investor and focus on dividend growth potential. You can easily use the Chowder Rule as guidance to optimize your team. For new readers, here’s the previous article:
You found a stock that has a low payout ratio and a Chowder Number above 15. You compare against your weakest team member that maybe has a Chowder Number of 3 and a payout ratio above 60%. It’s obvious that you sell your least convincing position to replace it with a better stock.
The same principle works with other valuation factors as long as the core rule applies: Comparing the new option against the rest.
Sometimes this can be a better stock. Sometimes it’s smarter to hold cash in your savings account and collect interest until you find a better opportunity that you compare against holding cash.
Until the next issue. 👋
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Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.