I got a question from a self-described “loyal reader” of Capital & Crisis. I began to answer it, and my response turned into a mini-treatise on the art of selling stocks. Here is the question:
“Chris: I see a remarkable contradiction in your latest issue of Capital & Crisis. At the outset, you extol the virtues of [the successful investor Thomas] Phelps, who was an advocate of buy right and hold long, with the rest of your strategies, which seem based on sell half, take profits, and let the rest run. As you publish the bookkeeping on how long you have to stay in on an initial investment, undisturbed, to make a big profit at a given rate of return, why not make an equal effort to bookkeep what happens to your initial investment and final returns when you take half out every time it doubles? Let’s see what it makes you or costs you to do it that way. It seems to me that the take-profits approach is an admission of a lack of confidence in self or the company, but somehow feels like falling down stairs every time you almost reach the top.”
Let me start by saying that selling is the hardest thing to do well as an investor. I don’t think anyone does it well consistently, and that includes the whole slew of investing greats – past and present – that I’ve studied. Everyone has sold something only to see it rise higher. And everyone has held onto something only to give back lots of apparent gains.
Second, remember that Phelps didn’t say hold onto stocks blindly. He wrote: “My advice to buy right and hold on is intended to counter unproductive activity, not to recommend putting them away and forgetting them.”
Now let’s talk about taking partial profits. At Capital & Crisis, I don’t automatically advise selling half when a stock doubles. I’m against mechanical rules of all kinds. I use our judgment. When a stock is fully valued or close to it, I tend to let it go – or at least a part of it. That’s often the case after a quick double or so. If it is still undervalued, I tend to keep it.
Canadian Natural Resources (NYSE:CNQ), for example, has doubled twice for my subscribers over the time I suggested buying it. But I have never suggested taking any money off the table. This is simply because CNQ has tremendous assets in the ground, and I don’t think the stock has ever fully reflected that value. Another example: Ensco doubled, but I did not suggest selling half. Instead, I suggested closing out the entire position for a 132% gain after it made a big acquisition I didn’t like.
Sometimes, selling half is costly, as you say. Selling half on GTLS looks like a bad idea now – I suggested selling half the position for a 112% gain, and the remaining half is up 203%! Other times, selling half looks smart.
I suggested selling half of Northwest Pipe, booking a 120% gain. Eventually, as circumstances changed, I recommended selling the rest of the position. But by that time, the stock had fallen to a much lower price. Even so, both sells looked pretty decent in hindsight, as the stock remains below the lowest level at which I recommended selling, and overall, that investment booked a healthy gain of 65%.
Other great investors follow similar approaches. The late Peter Cundill, for example, was a great investor who was a fan of taking half of a position off the table after it doubled. The book to read is There’s Always Something to Do: The Peter Cundill Investment Approach by Christopher Risso-Gill. In the book, there is the story about how Cundill bought Tiffany & Co. for $11 and sold it when it hit his valuation estimate ($19 per share) a year later. The problem was that six months later, it got a bid for $50. As Risso-Gill writes:
“This outcome prompted considerable discussion among the Cundill Value Fund board members over the question of how to deal with the problem of when to sell. Peter himself could come up with no absolutely satisfactory proposal or formula. In the end, the solution turned out to be something of a compromise:
The fund would automatically sell half of any given position when it had doubled, in effect thereby writing down the cost of the remainder to zero, with the fund manager then left with full discretion as to when to sell the balance.”
Cundill later expressed it this way, “When a stock doubles, sell half – then what you have is a free position. Then it becomes more of an art form. When you sell depends on individual circumstances.” I think this is a reasonable approach and seems to navigate that treacherous corridor between fear and greed, between risk and reward. I don’t think such decisions should be automatic, but you should think about selling when valuations are full.
A good case study of failing to sell part or all of a fully valued stock is in the latest quarterly letter of the Third Avenue Real Estate Fund (TAREF), managed by Michael Winer and Jason Wolf.
It was a good letter, and I respect the managers for admitting and discussing their error. TAREF owned a big position in Forest City Enterprises. It was a terrific investment for the fund. Over the 10 years ending Sept. 30, 2008, Forest City delivered a return of 16.7% annualized.
However, for the three years ending Sept. 30, 2011, the stock generated an annualized loss of 29.4%! Messrs. Winer and Wolf write: “After 10 years of providing shareholders with stellar returns, most of those returns have been given back… So what happened?”
Lots of things changed with the company over that span, as you might imagine, and they discuss them. But Winer and Wolf conclude that they made a mistake not trimming the position in 2006 and 2007. “The stock traded at all-time highs, and it became more difficult to justify the stock price without stretching our valuation estimates.”
Because of this experience, they have adopted a revised approach. This includes being “more proactive in reducing and/or eliminating holdings based on price appreciation or to reallocate into securities with more-attractive valuations.”
Winer and Wolf sum up:
“These proactive portfolio adjustments do not represent a change in fund management’s fundamental approach to analyzing businesses and the prices of their securities, nor does it mean that we are now engaged in ‘market timing.’ We time our entry and exit from securities positions based upon fundamental valuations, not on expectations of price movements in the market.”
I think that is well said. And it’s essentially how I think about the problem.
In the end, what you want to do is go in as a buy-and-hold investor. You want the effects of compounding to work for you, as well as the favourable tax treatment that goes along with buy-and-hold.
So I think it is important to enter every new investment with a buy-and-hold mentality. Even modest rates of return pile up to extraordinary heights over time. But you also want to be alert to when your thesis is no longer true.
Back in May 2005, I visited Ralph Wanger in Chicago. Wanger, if you don’t know, was another great investor. He led the Acorn Fund to market-beating returns over a 26-year stretch.
He spent two hours with me, just talking about his philosophy of investing. I loved it and included my summary of the interview in my first book, Invest Like a Dealmaker. Wanger’s sell discipline was pretty simple: Sell when your reason for owning the stock is no longer true.
This is probably my favourite reason to sell. When the main thesis for owning the stock vanishes, it’s often a good time to go. If a great balance sheet is one of the reasons you own something, for example, and it does a deal that makes the balance sheet weak, then it’s time to go. Or if you bought a stock because of a big gap between the stock price and NAV and that gap closes, then it’s time to at least think about selling.
There are also portfolio considerations to think about. If I need to sell something cheap to buy something cheaper, then I will. Some regular trimming is good, I find, to stay invested in the best and most-convincing ideas. This makes evaluating selling hard, too, because maybe what I sold continued to do well, but maybe what I bought did a lot better.
So this is a long answer. But believe me; I’ve given the art of selling a lot of thought. I track every sell I’ve ever recommended to my subscribers, with the idea of trying to learn something from it.
The bottom line: There is no magic way to sell to ensure maximum gains every time out. I think anytime you sell, you could cost yourself money if that stock turns out to be a big winner. I understand that risk.
On the other hand, as Third Avenue shows, there are also risks in getting too complacent about a holding. When the market gives you a great price to sell, you should be willing to at least think about reducing your position. As long as valuations remain reasonable, though, you may hold a stock indefinitely as the stock and the value of the business grow together over time.
Also, we don’t have to be perfect in holding onto everything we buy in aiming for Phelps’ 100-to-1 returns. The main idea is to know how those big returns happened and what investors had to do to get them.
Phelps summed it up best. “Just as a slight change in a golfer’s grip and stance may improve his game, so a little more emphasis on buying for keeps, a little more determination not to be tempted to sell… may fatten your portfolio. In Alice in Wonderland, one had to run fast in order to stand still. In the stock market, the evidence suggests, one who buys right must stand still in order to run fast.”
for Markets and Money
This article originally appeared in Markets and Money USA.
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