Stocks will be recommended for sale on a regular basis in the newsletter. Here is an overview of some of the basic reasons why we make those calls, and some of the circumstances for which long-term oriented investors might consider selling stocks from their portfolios.
Academic research confirms that individual investors are notoriously bad at knowing when to sell. Often, investors sell too soon or too often, generating higher-taxed short-term capital gains and greater commissions, all the while removing the best performing companies from their portfolios—along with the all of the future gains those companies will generate.
Other times, investors sell too late, hanging on to stocks even in the face of their abysmal fundamental performance, driven by an emotional attachment to those companies that can’t be shaken by logic or reason.
It can be useful to keep in mind a few helpful guidelines for knowing when to sell a stock from your portfolio.
As long-term investors, we select stocks based on their potential over the coming five years. Our practice is to review results each quarter, and in cases where a company stumbles with lackluster sales, earnings, or margin growth, we tend to management the benefit of the doubt for one to three quarters, giving executives the opportunity to get the business back on track.
In these cases, there is little urgency for current shareholders to sell their shares quickly. When it first becomes obvious that a company is facing troubles, its stock price takes a dive, and the price remains depressed until conditions change. The damage has been done, and the share price isn’t likely to rebound in the near term.
Investors in these stocks should pay particular attention to the underlying fundamental performance of the companies over the next three to five quarters. If the company doesn’t show signs of significant recovery, then selling may be the best course.
Avoid falling into the trap of holding out indefinite hope for an underperforming company quarter after quarter after quarter. After four or five successive quarters of poor performance, the rest of the market may file the stock in a folder marked “Do Not Buy.” Once so classified, even if the company’s circumstances turn around, the market may be reluctant to acknowledge the progress with a higher price until the improved condition is “confirmed”—for perhaps even as long as a year or two.
Holding on to “dead money” when it could be working better for your portfolio will considerably reduce your returns, so selling is often a wise choice.
Remember: if you are uncertain about a company’s future potential, there will always be companies that you can find that will offer more compelling growth opportunities. Replacing an ambiguous situation with one in which you are more confident is usually a smart move.
In other cases, a stock may show diminished potential for future returns, either because it has performed well in the past and seen its price grow, or because conditions have changed and future earnings and sales growth is less likely to appreciate at a level high enough to sustain the price growth demanded from an equity portfolio.
If a stock’s future potential total return is so low that it comes close to the return that you could achieve from a relatively risk-free investment, such as from holding long-term U.S. government bonds. In the present low interest-rate environment with the 20-year bond yielding around 3.4%, it’s unlikely that the projected total return of the types of growth companies that we favor will often be below that rate. Still, a stock with a projected total return in the mid-single digits might reasonably be considered a sell candidate.
Another measure that may suggest an overvalued situation include if relative value is greater than 150%. This indicates that the company’s current P/E ratio is 150% of its average P/E ratio and at the extreme high end of its valuation range. The P/E ratio will likely only decline from this level, amplifying any price declines that may come.
On the Stock Selection Guide, if the Upside/Downside Ratio is less than 1-to-1, this indicates that the potential reward is roughly equal to the potential risk at the current price. Since we like to stack the odds in our favor, if the upside is limited when compared to the downside, it might be the right time to sell.
It’s important to note that selling is a highly-individualized process. The specific tax circumstances of your holdings, such as whether or not they are held in a taxable or non-taxable account, or whether gains would be taxed at short-term or long-term rates, may impact your decision to sell.
Other considerations that can affect portfolio sells (and purchases) include making adjustments to help the diversification and weighting of the portfolio, or to harvest capital gains and losses at tax time. Often, though, these decisions will be aided by the evaluation of the fundamentals and valuation metrics.