When Is A Good Time To Sell?
A few years ago, I flew north to meet with a group of venture capitalists in Seattle and found myself in a conference room on the 34th floor of a building overlooking the waterfront and The Seattle Great Wheel. As venture capitalists, this group had decades of experience as private company investors but the conversation soon turned to public market investing. I still recollect one of them saying that he found it very difficult to figure out when to sell a publicly traded company and others in the group agreed. It was not that the person making this remark or others in the group did not know how to value companies. One of them was on the board of directors of one of the largest companies in the world and the venture capitalist making this remark had gone to Harvard Business School. The decision of when to sell an investment is a complex decision that goes beyond determining the intrinsic worth of a company.
I had heard the exact same thing from public market investors and especially value investors who were no strangers to using models to come up with a range of potential valuations for a company. The reason I say a range of potential valuations is because it is often hard to come up with a precise number when valuing a company. The future can unfold in myriad ways that sometimes escapes the imagination of spreadsheet warriors or investors using discounted cash flow (DCF) models.
A decision to invest involves coming up with answers to multiple questions including but not limited to,
- How much of my capital am I going to commit to this particular investment?
- Am I going to buy a full position with a single trade or do I plan to scale into it over a period of time?
- Which instrument do I use (stocks, preferred stocks, bonds, ETFs, options, etc.) to get exposure to this investment idea or theme?
- What is my holding period likely to be? Will I hold this position for a few months or a few years?
- What are the tax implications of this investment?
- Do I need to consider macroeconomic factors when investing in this position?
- Are there any industry dynamics I should be aware of before I invest? Is the industry a cyclical one where valuations look cheapest at its cyclical peak?
- If I am going to invest in a specific company, how is the company positioned in its industry as it relates to competition, moat, margins, product pipeline, etc.?
- Does the company have a seasoned management team that is skilled at capital allocation?
- Last but not least, what is the intrinsic value of the company and is this a good price to buy this company?
Investing is both an art and a skill. You have to fathom an unknowable future based on the current situation and past experiences. What makes public market investing even more difficult is that a lot of short-term movements are driven by investor psychology and not on account of the intrinsic value of the company. The competing emotions of fear and greed pull prices well below or above where they should ideally trade. When reading the book Hedgehogging by the hedge fund manager Barton Biggs more than a decade ago during a trip to Eugene, Oregon, I was struck by his observation that nearly two-thirds of all short-term movements in price were driven by investor psychology. While this seems obvious to many market participants, the extent to which emotions drive prices still came as a surprise to me. This is what lead Benjamin Graham, the father of value investing, to remark,
In the short run the stock market acts like a “voting machine” (reflecting all kinds of irrational attitudes and expectations), while functioning in the long run more like a “weighing machine” (reflecting a firm’s true value).
While these were not Benjamin Graham’s exact words, they come from a 1973 profile of Warren Buffett in a Lincoln, Nebraska newspaper that elaborates on the shorter version “The stock market is a voting machine rather than a weighing machine” that can be found in Benjamin Graham’s 1934 tome Security Analysis.
This emotional reaction to prices by market participants is one of several reasons that determining the right time to sell an investment is so difficult. Another is the need to figure out what you would do with the money generated from the sale. Unless you were selling to meet an upcoming expense, the sale decision now requires more decisions. Should you keep the proceeds of the investment in cash or reinvest it in another position? If it is the former, how long do you leave it in cash? If the latter, you now have to figure which new investment to plough the proceeds into. You also have to think of the tax implications of the sale if the position was sold outside a tax deferred account like a retirement account.
Real estate investors benefit from not just the tax advantaged nature of their investment or the inherent leverage, they also benefit from holding on to the asset for several years or even several decades. A 3% annual increase in the value of the real estate may not seem much but on a levered basis, it could translate into a 15% to 30% annual gain. The fact that real estate is not as liquid as stocks or bonds is a blessing in disguise.
When it comes to public market investing, is there a framework that could help investors determine when to sell a position? One method advocated by Vitaliy Katsenelson in his book Active Value Investing: Making Money In Range-Bound Markets is to determine the intrinsic value of a company and then when the position trades above that valuation, you sell the position and get into another investment that trades below its intrinsic value. While this is easy to conceptualize and Vitaliy backs up his framework with a lot of data, it supposes that the investor can accurately determine the intrinsic value of both the investment being sold and the new one being purchased. It also relies on the fact that the market may not be efficient in pricing these investments and a value oriented investor can outperform the market by taking advantage of these price dislocations.
While this may have been true in the days of old, in this new data driven age where information is readily available and algorithmic funds account for a large portion of the trading volume on the stock exchanges, these kinds of mispricings will be few and far in-between.
Another approach that some traders and investors take is to decide to sell at certain pre-determined levels. For example, taking a profit if the position goes up X% above their purchase price or sell if it goes Y% below their purchase price. The logic of selling quickly and taking a small loss is actually a good idea. It translates into admitting that the market was right, you were wrong and it is time to move on.
However, if the market is volatile, then you could inadvertently end up exiting positions that you should have held on to. In my personal investing, I found that I am often early and it was not uncommon for some of my positions to initially decline 20% to 30% before heading back up and generating large gains. A good example of this is the San Francisco based messaging software company Twilio that I purchased for a little over $26 in mid-2017 and watched it decline by almost 20% a few months later. With a founder at the helm of the company, a unique product and a very high revenue growth rate, I decided to stick with the company despite the decline. Nearly three years later, the stock is now over $100 despite the recent COVID-19 related market decline.
If I have done enough work to understand the investment I am making, it might give me enough confidence to hold it through temporary gyrations that drag it lower. However, if new information becomes available to indicate that the original investment thesis is no longer true or if the position consistently heads in the opposite direction of the market for an extended period of time, it makes sense to sell and take a small loss. Letting a small loss become a large loss because you discount new information that does not conform to your original bias is a very expensive mistake.
We discussed selling a position if it declines and starts showing a loss. How about the other side? What about a position that has gone up substantially? A rule of thumb could be something like: if the position doubles or triples, sell half the position and keep the rest. But like many rules of thumb, this a very simplistic solution, especially when it comes to investing. How long does one hold on to the rest of the position? Was the large increase in price justified or is the investment just getting started on a long ascending slope because you have a founder like Jeff Bezos at the helm?
Let me illustrate the fallacy of this kind of rule of thumb from an experience in my early years of investing. It was after the dot com bubble had burst in 2000 and the ensuing deep bear market saw stocks like Amazon trade below $10 and Apple below $2 (on a split adjusted basis). There was another company I liked back then and whose product I used a lot at that time. That company was Priceline.com, which traded with the stock symbol PCLN. After several acquisitions, the company is now called Booking Holdings with the new stock symbol BKNG. I picked up some shares of Priceline.com for $1.50 ($9 on a split adjusted basis taking into account the 1 for 6 reverse split in June 2003).
A few months after I purchased the position, the stock doubled. Despite being a new investor, I had the fortitude (or dumb luck) to hold on to the stock and then it went up another 100%. The position I purchased for $1.50 was now $4.50 in the span of a few short months. As a student of value investing, this did not make sense to me. How can a company that was valued at a certain price now be worth three times as much just a few months later? I decided to take the profit and sold the position for a 200% gain. Beyond errors of omission (Google, Chipotle, Costco, etc.) this was one of my most expensive mistakes. The stock went on a multi-year run and was trading at over $2,000 by early 2020. On a split adjusted basis, it went up more than 22,000% from my purchase price. Yes, 22,000%. I double checked my calculations and verified that the stock did not split again.
The huge gains in investing come from finding unique companies and sticking with them for the long run unless something significant changes such as the departure of an excellent CEO or a new competitive threat emerges (Blackberry’s death at the hands of the iPhone). This is why the storied investor Peter Lynch looked for ten baggers (companies that went up ten fold or 1,000%) and lead Fidelity’s Magellan fund to average annual gains of over 29% from 1977 to 1990. His “buy what you know” strategy is outlined in great detail in his book One Up On Wall Street.
In conclusion, I would say do most of your work on the buy side and don’t stress the selling part of the equation much unless you need the money for an expense or find that the market is extremely stretched and valuations are at obscene levels. Remember that markets like to climb a wall of worry and that momentum is a powerful force. Things that appear expensive will become even more expensive and will eventually reach nose-bleed levels.
I will leave you with the words of the great speculator Jesse Livermore, as detailed in the excellent book Reminiscences of a Stock Operator,
“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.”