When to sell – this is one of the most difficult questions an investment manager faces. We fear selling because of many reasons:
- We don’t want to be ‘wrong’ and look ‘stupid’
- We think that an investment only needs time to succeed
- We tend to re-affirm previously made decisions
- We don’t understand why we were wrong
- Our ego fights to protect itself
I’m offering a simple two step solution that any portfolio manager can use when determining if an asset should be sold.
- If you had never bought the security and looked at it today – how would you evaluate it? Would it be an opportunity or something you should consider passing on? If you can’t name off a few simple reasons why you think it’s a good buy or hold, it should be SOLD!
- How is the business performing. Analyze the cash flow first, the margins second, and the sales third. Turnarounds are unlikely, if the trend is down and you have no strong basis for why the business should improve then SELL.
Notice I did not mention major news, missed guidance, high valuations, or stock price performance. Selling on major news can be a terrible time to sell because bad news is rapidly baked into stock price while good news is typically slowly absorbed. Missed guidance can be a strong signal to sell but not an absolute reason to do so. High valuations can become reasonable if expectations are met. When a company has a rich valuation, understand why and see if the projected growth is reasonable. Stock price performance can cloud your judgement and cause you to think short-term versus long-term oriented. We love to be right about our decisions and see results instantly, unfortunately, successful investing requires patience.
Taking a quick peek into Sears (SHLD) I would note the following.
- Free Cash Flow was (-) starting in 2011.
- Gross margins dropped ~2% between 2011 and 2012.
- Sales decreased between 2011 and 2012.
- Return on Sales went negative in 2012.
- Revenue was on a steady decline for many years.
- Return on Invested Capital (ROIC) went from 3% in 2011 to -30% in 2012.
- The balance sheet from 2011 to 2012 took an unhealthy turn with a large uptick in liability mix.
Sears crashed from a top of $144 per share in 2007 down to $23 per share in 2008, one could have waited until the impact of the recession leveled off to see what businesses would recover and which would not. Going forward some years to 2011 and 2012 a wise investor should have noted a multitude of very clear sell signals and could have saved themselves from a significant further decline in market value as Sears traded at $70 per share in 2011 and is now at $3.36 per share in 2018. Beyond the sheer decline of market value, the other loss that investors often forget is the opportunity cost of investing that money from 2011 to 2012 into a more successful business which has grown from 2012 to 2018.
Don’t get attached to your stocks and your prior decisions. Cut your losses and shift money into businesses with strong performance.