Tuesday, February 21, 2012

When To Get Off The Bus

Figuring Out When To Sell

Every investor must figure out what to buy, when and how much to pay. We spend a huge amount of time and effort pursuing the next investment, and Gawd only knows how many gazillions of pages have been written on how to do it. However, unless you are Warren Buffett, every purchase ultimately requires one to make a decision about when to sell this particular investment and at what price. Unfortunately, much less attention is paid to the sell decision, in part because the investment industry is primarily focused on taking in funds rather than disgorging them. Yet make no mistake: when you sell and for what price is just as important as the purchase decision. There are a few key considerations on sell strategies which vary according to the nature of the investment and the goals of the investor.

Start by asking yourself, what kind of investor am I? If you are a typical value investor, you wish to buy cheap and sell dear, necessitating periodic sales. If you are a growth investor, you seek to buy companies which have unappreciated growth opportunities, but eventually will sell when growth starts to lag. If you are an indexer adhering to an asset allocation, by the very nature of your portfolio construction you will be buying and selling as allocations drift away from targets. Finally, if you are a true long term buy and hold (LTBH) investor you truly do plan on buying shares, putting them away and never selling. Everyone but the LTBH investor should have a well thought out sell strategy, and I would argue that even the LTBH types should know when to get off each particular bus they are riding in their portfolio.

Appropriate sales strategy also varies by the type of investment. Bonds tend to be the least complicated, since at least one exit strategy is assured when you purchase a bond: maturity of the bond. In the interim period between when you buy and when a bond matures, the sale strategy depends on the type of bond. Junk bonds should be sold for two reasons: 1) the issuer’s credit profile is deteriorating and you can still get out with more than is likely to be recovered in a bankruptcy, or 2) the bond has appreciated to a price equal or in excess of the contractual call price. Investment grade bonds are typically not callable, so one would want to sell if the issuer’s credit quality declined or if the excess yield on the bonds over treasuries no longer compensates investors for the risks involved. Treasury and agency bonds should be sold when you believe that yields are likely to rise significantly or when you believe the absolute level of yields in not attractive (I struggle to understand why retail investors would buy 10 year treasuries yielding 2% or less).

Equities are significantly more challenging to sell successfully, and the likelihood of leaving money on the table is a lot higher than is the case when selling bonds. Unlike bonds, equities have no maturity date and there is far more variability in the potential value of an equity as the state of the world (and the state of the issuer) changes. Given these challenges, how should one go about selling equities? When you buy a stock, you should have a strong idea of what you think it should be worth. Sure, there are a few great businesses that probably should never be sold, but the vast majority of equities can and usually do become over-valued and a failure to sell when that is the case usually results in missing out on a big profit (since over-valued stocks frequently drop). If you have a good idea of what the stock is worth when you buy it, you should update that figure at least annually and when the stock nears this target price.

When the stock reaches your target, a reassessment is probably a good idea. Sometimes companies change enough that your target price should be revised upward. However, be careful not to let the enthusiasm that propelled the stock to your target cloud your judgment. From time to time I have fallen victim to exactly that and missed my chance to bag a large profit. If you do not trust your ability to remain objective, there are two ways to put the sale decision on “autopilot.” One method is to use good til cancelled limit orders. This is simply a standing order to your broker to sell a particular security when the price hit’s a certain level. Sir John Templeton is famous for using this method to buy cheaply; there is no reason it cannot be used to sell dear. A second way to automate the sale decision is to sell a covered call on the position when it starts to approach your target sales price. Using covered calls can also generate some incremental income as you take in call premiums. However, if you use covered calls to manage your selling, keep the call maturities within a few months. Otherwise you increase the risk that the stock spikes briefly, your call goes unexercised, and by the time the call expires the price of the stock has dropped below your sell target.

You should also get comfortable that you will occasionally make a mistake when selling. Many moons ago I bought a deep value stock when everyone hated it. For $11 a share I bought a company that was drowning in cash flow even while it was on the front page of the Wall Street Journal with a scathing article about the company’s accounting practices (which only affected non-cash items). This company was one of the most-shorted stocks on the NYSE for over a year and they were also one of the largest by market cap with no analyst coverage. After time passed, the company put its huge cash flow to work and bought back enormous quantities of its stock, which eventually provoked a nasty short squeeze. I sold into the squeeze in the mid $40s because that was what I regarded as full valuation. More fool me, as the stock eventually hit $70 in the squeeze and a couple years later was taken private at over $60. It happens, and when it happens to you just sleep well secure in the knowledge that over the long term you have adopted a selling strategy that helps you capture the gains your carefully chosen investments have generated.

As always, do your due diligence and BE CAREFUL. You can lose money on this stuff, and I am just an anonymous stranger on the internet. I could be a talking dog for all you know.

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