Selling Stocks: The Challenge of Reason
Features, by Mark Robertson, Managing Partner March 29th, 2005
Take a deep breath. It's not un-American to sell a stock.
First, Relax!
Take a deep breath. It’s not un-American to sell a stock. In an informal survey of investment clubs taken by Better Investing a few years ago, we discovered that many clubs have a portfolio turnover rate of low single digits. In fact many of the responding clubs reported zero turnover. Is every purchase decision that we make a GREAT decision? Do conditions ever change (read deteriorate) at the companies we own? Do you believe that “Stock prices fluctuate?” In other words, do you believe that buying opportunities present themselves as stock prices plunge and we discover undervalued situations? If this is true, then what about selling opportunities? Has anybody ever called you “stubborn?” (grin)
How much do we compromise long-term performance by being stubborn and refusing to improve our portfolios when it’s time to do so?
A few years ago, in one of my investment clubs, we were blessed with the purchase of QUALCOMM (QCOM) at split-adjusted cost basis of $2.04. A mere 4-5 years later, QCOM had rocketed to $100 as 1999 drew to a close. The motion to sell it was greeted with, “But what about the capital gains?” Another club member suggested that if it went down, and we sold it, we’d have fewer taxes to worry about? Besides, we could then replace it with some other stock from the industry group that would probably have gone down also?
You know the rest of the story. Our capital gains challenge “went away.” We did sell a few shares at $70 or $80, but the tax tail had wagged our decision dog once again. Don’t let taxes interfere with doing the right thing when it comes to portfolio design and decision-making.
Reasons to Sell
This discussion will explore the challenges of making selling decisions. Ellis Traub, in one of his presentations, makes the point that it’s not really a question of WHEN to sell. It’s more a question of WHY. I agree. The selling challenge should be approached with the same unemotional attitude that we use when performing our stock selection analysis. In an article published in the September 2004 issue of Better Investing, “Selling Stocks: The Challenge of Reason,” I shared three simple reasons for making sell decisions with our portfolios.
The word “portfolio” is CRUCIAL because the decision should ALWAYS be portfolio-centered. The three reasons are:
- Because you need the money.
- Because your company is weakening and fundamentals are deteriorating.
- Because you can make the portfolio BETTER.
Show Me the Money!
The first reason is personal. The circumstances of life dictate a need for money from time to time. The need can range from emergencies like replacing a furnace or vehicle to rewarding ourselves with a relaxing cruise to Alaska. Others may include a lump sum charitable contribution or funding a college experience. We all experience these situations.
In our family, we keep a fairly small amount of money in a money market account. The rest of our funds are invested, and generally nearly 100% invested in stocks. I’ll admit that it took a while to convince my spouse that it was a simple matter to sell a stock in the portfolio and nearly instantaneously write a money market check to make the funds available.
She asked, “Well… which stocks are candidates for sale at any time?” My answer: “They all are.” When one of these situations presents itself, we take a deep breath and update all of our stock studies for the family portfolio. In order to generate the funds, we’ll sell the stock with the lowest expected returns and keep selling until we have the necessary funds. Hopefully, we’ll never sell all the stocks before we have the money we need. Gulp.
To illustrate this, Figure #1 provides a dashboard view of a typical portfolio. The dashboard provides a summary of how much each position is worth, the expected return (PAR) from a current stock study, and quality rating (on a 0-to-100 scale, >65=Excellent, 55-65=Good, 45-55=Fair, <35=Weakest). Other important characteristics include: sales growth forecast, projected average P/E ratio, financial strength and EPS predictability according to Value Line. Take a look. If you needed $2000, which stock would you sell first?
What if you needed $4000?
| Reasons for Selling Sample Portfolio | % of Assets | Quality | PAR | Sales Growth | Yield | P/E | Finl Str | EPS Pred | ||
|---|---|---|---|---|---|---|---|---|---|---|
| Stryker | SYK | 13.1% | Medical Supplies | 70.9 | 13.5% | 11.6% | 0.2% | 28.0 | 80% | 100 |
| Sysco Corp | SYY | 10.8% | Food Wholesalers | 79.3 | 13.5% | 9.4% | 1.7% | 22.0 | 100% | 100 |
| Yahoo! | YHOO | 8.7% | Internet | 53.7 | 2.3% | 17.2% | 0.0% | 35.0 | 50% | 40 |
| Linear Technology | LLTC | 9.9% | Semiconductor | 77.1 | 24.5% | 22.2% | 0.1% | 30.0 | 80% | 60 |
| Synovous Financial | SNV | 8.5% | Bank | 73.9 | 14.8% | 7.6% | 2.9% | 20.0 | 70% | 100 |
| Apple Computer | AAPL | 7.3% | Computer/Peripherals | 52.3 | 0.3% | 20.6% | 0.0% | 22.0 | 80% | 15 |
| Motorola | MOT | 7.2% | Semiconductor | 28.6 | 16.7% | 7.9% | 1.0% | 26.0 | 50% | 20 |
| CVS Corp | CVS | 5.0% | Pharmacy Services | 73.2 | 17.5% | 14.8% | 0.6% | 22.5 | 9% | 80 |
| Coca-Cola | KO | 4.5% | Beverage (Soft Drinks) | 79.4 | 9.2% | 4.7% | 2.3% | 22.0 | 100% | 85 |
| Rite Aid | RAD | 3.8% | Pharmacy Services | 12.4 | 10.6% | 3.8% | 0.0% | 14.0 | 0% | 15 |
| Urban Outfitters | URBN | 4.5% | Retail (Special Lines) | 79.2 | 4.5% | 18.9% | 0.0% | 18.0 | 70% | 55 |
| Dell Inc | DELL | 4.2% | Computer/Peripherals | 63.5 | 12.2% | 10.4% | 0.0% | 30.0 | 100% | 75 |
| St. Jude Medical | STJ | 4.3% | Medical Supplies | 69.2 | 3.2% | 11.9% | 0.0% | 25.0 | 70% | 95 |
| Guidant | GDT | 3.8% | Medical Supplies | 68.7 | 3.3% | 10.6% | 0.7% | 19.0 | 80% | 80 |
| Circuit City | CC | 2.3% | Retail (Special Lines) | 23.0 | -0.3% | 4.5% | 0.5% | 15.0 | 30% | 30 |
| Cash-on-Hand | 2.1% | 2.4% | 2.4% | |||||||
| 100.0% | 63.7 | 11.1% | 12.6% | 0.9% | 24.6 | 74% | 67.7 | |||
| Figure #1. Sample Portfolio. This is one way of taking a fairly comprehensive look at a portfolio including holdings, quality, projected annual return, sales growth forecast, current yield, average projected P/E and other key fundamentals. | ||||||||||
If it were my situation, I’d first sell Circuit City and write us a $2000 check from the money market. This also eliminates a relatively small position. The Circuit City holding was not going to significantly affect the overall performance of this portfolio no matter how much the price advanced. If more funds were necessary, I’d probably sell the Apple Computer position. (No angry letters, please.) This is an unemotional decision that probably reflects the price advance for Apple that has occurred with the Ipod frenzy. Besides, the portfolio has more than one computer company and this town isn’t big enough for more than one.
What would you do? There is no single correct answer. We could (and should) use this need for cash to work on the portfolio quality and expected returns, too.
The important thing is to remain unemotional and immune to that Cupid-like feeling of attachment to our long-term holdings. It’s NOT un-American to sell a stock when you need the money.
When the Wheels Come Off
The first reason to sell is personal and driven by the challenges or needs of our personal situations.
The second reason is “somebody else’s fault.” It’s not even necessarily something that’s the fault of our management team. I’m sure the last buggy whip manufacturer standing had a pretty good product when they shut off the lights for the last time. Sometimes it simply IS the fault of our management team and we need to hire a new one. With common stocks, this is easier than it is when it’s personal and we’re directly involved. If our management team is failing to recognize opportunities and profitably capture them in order to build shareholder value, it’s probably time to locate that SELL button on your brokerage transaction screen and press it.
Phil Keating tells a story of two lists that he keeps in his pockets. The first list of companies are leadership companies that he owns because of an outstanding management track record. The title at the top of the list is: “Companies to Sell if the Corporate Jet Goes Down.”
The second list is a set of promising companies that never seem to quite seize the opportunities. They might be on the verge of being a good, maybe even great, company but never seem to effectively operate their business to grow and sustain profitability. But… after careful review, he knows that in the right hands… The title at the top of this list is (you guessed it): “Companies to BUY if the Corporate Jet Goes Down.”
It’s a morbid way to make a point and I apologize, a little. It underscores the reality that our management team has but one mission for the companies that we own. The mission is to grow profitably at a rate better than their competitors. We expect them to manage their capital resources effectively and to have financial strength. We expect that they will manage operating costs and exploit markets with a degree of consistency and predictability.
When they don’t, when the wheels start to vibrate, it’s time to head for the hills, hopefully before the wreck starts.
What are declining fundamentals?
It’s not an easy question. To me, it’s when the sales growth and profitability expectations begin to decline. This is particularly true when the decline is significant compared to any company’s peer group. In other words, if the profit margins are eroding (declining) while everybody else is advancing, something is clearly wrong.
If you use the NAIC stock selection tools, monitor the PTP trend using the PERT-A graph. Declines here should be taken very seriously as red flags. You need to do some comparisons to see the trend is company-specific or whether it’s pervasive throughout the industry. If you can attribute the challenges to a recession and you like what you’re hearing from management, you can take down the red flag.
A closer look, quarter-by-quarter at projected returns and quality for Rite Aid.
My preference is to monitor the quality rating, a 0-to-100 scale based on relative growth, relative profitability, financial strength and EPS predictability. We’ll use Rite Aid, to illustrate. Figure #2 provides a historical look at quality and expected returns for Rite Aid. This chart is my version of portfolio analysis and you can think of each point on the x-axis as the results of a quarterly stock study. The green bars are split-adjusted stock prices. The red line is the projected annual return (PAR) and the blue line is the quality trend. Remember, >65 is an excellent company, ranking among the top 20 of all rated companies. In this case note that Rite Aid was a good, even excellent, company well into 1998. The stock price peaked during late 1998. A slight “down draft” in the quality rating actually begins in early 1998 and at some point, mid-year, Rite Aid shuffled into a “Good” quality rating with a rating between 55-65. The decline continues and accelerates during 1999 before falling off the quality cliff in October 1999.
At what point does a quality down draft get my attention? A yellow flag goes up after the third consecutive quarter of declining quality and I’ll explore a little more closely. I heed the words of Brad Perry. Continuously ask: “Does the company lack the strengths and favorable long-term prospects I saw when I bought the stock?” But it pays to be patient, hence the nine month period. “Investors should not rush to judgment when a hitherto strong company hits an air pocket.”
After solid results in the early 1990s, subsequent years became a different story.
For Rite Aid, this wasn’t an air pocket, at least one of the engines fell off the “plane.” See the Figure #3. Profit margins were hammered for a number of years, finally showing a glimpse of return to profitability in 2004. The visual analysis says it all. The point is that by monitoring the quality, it’s not likely that the stock would have been sold at $50, but there’s a pretty good chance that — following this philosophy — it may have been sold between $15 and $30.
Do you have any companies you think are examples of quality in decline? The turnaround trap is a terrible temptation for investors. I’ve been there and done that. We’re naturally optimistic or we wouldn’t be here in the first place. When faced with deteriorating fundamentals, it’s really, really tempting to listen to management’s fearless forecast of a return to growth and profitability. It’s important to remain unemotional. Facts and results matter more than hopeful prognostications. What do the trends tell you?
Be willing to push that SELL button. Your portfolio will probably be better, in the long run, for your courage.
Weeding, Feeding and Pruning
This discussion has visited three reasons to sell a stock. To recap, (1) You need the money. Update your stock studies and it will usually make the most sense to sell the stock with the lowest expected return. Repeat the process until you have the proceeds you need to fund your life circumstance. (2) Sell if a stock has declining fundamentals. We looked at how this might be measured with a trend that looked for instances of deteriorating quality ratings. (3) Sell to make the portfolio BETTER.
Figure #1 provided a BEFORE portfolio. Figures 4-5 display a log of transactions made and the condition of the portfolio after each individual decision, and an AFTER portfolio which displays the portfolio characteristics after we’ve done some weeding, feeding and some pruning.
Take a look. We weeded Circuit City, Rite Aid and Motorola. We fed CVS and accumulated more shares and then proceeded to invest in a group of higher quality companies with higher expected returns. Note the effect on the total portfolio quality, expected returns and projected sales growth between the “BEFORE” and “AFTER” conditions.
| Reasons for Selling Sample Portfolio | %Cash | Industry | Quality | PAR | Sales Growth | Yield | P/E | Finl Str | EPS Pred | |
|---|---|---|---|---|---|---|---|---|---|---|
| BEFORE | 2.1% | 63.7 | 11.1% | 12.6% | 9.0% | 24.6 | 74% | 67.7 | ||
| AFTER Selling Circuit City | CC | 4.3% | Retail (Special Lines) | 64.7 | 11.1% | 12.8% | 9.0% | 24.9 | 75% | 68.5 |
| AFTER Selling Rite Aid | RAD | 8.1% | Pharmacy Services | 66.8 | 10.8% | 13.2% | 1.0% | 25.3 | 78% | 70.8 |
| AFTER Selling Guidant | GDT | 11.9% | Medical Supplies | 66.8 | 10.8% | 13.2% | 1.1% | 25.3 | 78% | 70.8 |
| AFTER Accumulating CVS | CVS | 9.4% | Pharmacy Services | 66.9 | 11.2% | 13.3% | 1.0% | 25.5 | 78% | 70.6 |
| AFTER Selling Yahoo | YHOO | 18.1% | Internet | 68.3 | 11.2% | 12.9% | 1.2% | 24.5 | 81% | 73.9 |
| AFTER Selling Motorola | MOT | 25.4% | Semiconductor | 72.2 | 10.1% | 13.4% | 1.3% | 24.3 | 84% | 79.1 |
| AFTER Buying Fifth Third | FITB | 18.2% | Bank (Midwest) | 72.9 | 11.3% | 13.3% | 1.4% | 24.0 | 84% | 80.9 |
| AFTER Buying Lowe’s | LOW | 6.1% | Retail Building Supplies | 73.8 | 13.5% | 13.6% | 1.1% | 24.1 | 85% | 83.4 |
| AFTER Buying Gentex | GNTX | 0.8% | Auto Parts | 74.8 | 14.3% | 13.8% | 1.1% | 24.0 | 85% | 83.5 |
| Figure #4. Decision Log. Starting with the “before” portfolio, this series of transactions displays the effect of each decision on the portfolio fundamentals and return expectations. | ||||||||||
The Stryker and CVS Corp positions are a little hefty and we need more information before doing any pruning. How much money flows into the portfolio monthly? Will these oversized positions take care of themselves (become suitably smaller as a % of total assets) simply with the new cash infusions?
| Reasons for Selling Sample Portfolio | % of Assets | Quality | PAR | Sales Growth | Yield | P/E | Finl Str | EPS Pred | ||
|---|---|---|---|---|---|---|---|---|---|---|
| Stryker | SYK | 13.1% | Medical Supplies | 70.9 | 13.5% | 11.9% | 0.2% | 28.0 | 80% | 100 |
| Lowe’s | LOW | 12.2% | Retail Building Supplies | 79.8 | 20.7% | 15.4% | 0.3% | 25.0 | 90% | 100 |
| Sysco Corp | SYY | 10.8% | Food Wholesalers | 79.3 | 13.5% | 9.4% | 1.7% | 22.0 | 100% | 100 |
| Linear Technology | LLTC | 9.9% | Semiconductor | 77.1 | 24.5% | 22.2% | 0.1% | 30.0 | 80% | 60 |
| Synovus Financial | SNV | 8.5% | Bank | 73.9 | 14.8% | 7.6% | 2.9% | 20.0 | 70% | 100 |
| CVS Corp | CVS | 7.6% | Pharmacy Services | 73.2 | 17.5% | 14.8% | 0.6% | 22.5 | 90% | 80 |
| Apple Computer | AAPL | 7.3% | Computers/Peripheral | 52.3 | 0.3% | 20.6% | 0.0% | 22.0 | 80% | 15 |
| Fifth Third Bank | FITB | 7.1% | Bank (Midwest) | 80.7 | 18.4% | 12.2% | 3.0% | 20.0 | 90% | 100 |
| Gentex | GNTX | 5.3% | Auto Parts | 91.3 | 17.4% | 17.1% | 2.0% | 22.0 | 80% | 85 |
| Coca-Cola | KO | 4.5% | Beverage (Soft Drink) | 79.4 | 9.2% | 4.7% | 2.3% | 22.0 | 100% | 85 |
| Urban Outfitters | URBN | 4.5% | Retail (Special Lines) | 79.2 | 4.5% | 18.9% | 0.0% | 18.0 | 70% | 55 |
| St. Jude Medical | STJ | 4.3% | Medical Supplies | 69.2 | 3.2% | 11.9% | 0.0% | 25.0 | 70% | 95 |
| Dell Inc | DELL | 4.2% | Computers/Peripheral | 63.5 | 12.2% | 10.4% | 0.0% | 30.0 | 100% | 75 |
| Cash-on-Hand | 0.8% | 2.4% | 2.4% | |||||||
| 100.0% | 74.8 | 14.3% | 13.8% | 1.1% | 24.0 | 85% | 84 | |||
| Figure #5. “AFTER” Portfolio. The portfolio is BETTER because of the changes made. Quality, expected returns and the average sales growth forecast are higher. | ||||||||||
Any time a stock is sold, there are tax implications. Although we shouldn’t allow the “tax tail” to wag our decision dog, the impact of taxes must be factored in to the decision process. Stocks can also be sold to generate realized losses to offset capital gains, and this can be worth reviewing.
Many investment clubs that I have visited (or been part of) seem to have a hard time evaluating a sell decision without a matching reinvestment decision. I’m not sure how this massive guilt trip has been placed on so many people, but it’s an epidemic. My opinion is that one decision at a time is hard enough. As displayed in the transaction log, take them one at a time. Evaluate each motion on its own merits. There are always opportunities to buy leadership companies at sufficient expected returns, and I think it makes sense to take our time when shopping and seeking the best opportunities.
I’ll close with a word about PATIENCE. As Brad Perry points out, a turnover ratio of 10-20% is “enough” to manage a portfolio well. In other words, a stock portfolio of 12-20 stocks would see 1-4 sell decisions per year. My point is, this sample portfolio needed a lot of work. Even when a portfolio needs a whole bunch of tender loving care, it doesn’t have to happen in one, two or even three meetings. It should be a patient and very continuous process. Make the best decisions that you can muster at any point in time — and keep doing it for however long it takes.
And that’s part of the beauty and fun, because it never stops.
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.