The decision to buy stock in a company is fairly straightforward. Is it a great business? Is it trading at a significant margin of safety (MOS)? Am I confident in my valuation and assessment? Answer “yes” to those questions and you’re on your way to business ownership.
But when do you sell?
I’ve had, in some fashion, the following question e-mailed to me a number of times:
When would you exit? Maybe when the stock trades close to current intrinsic value, but isn’t it supposed to go up 15% per annum from there since I’m using the 15% discount?
There is only one reason to ever sell your stock-when you find better value elsewhere. Allow me to explain:
Better Value: What’s That?
Put your money where you’ll get the best value-be it in a business, bonds, cash, real estate, or anything. Value is a combination of potential growth and capital preservation. As Buffett says,
The first rule is not to lose. The second rule is not to forget the first rule.
Rule #1: Never lose money. Rule #2: Never forget rule No.1.
Two rules: 1. Preserve the principal. 2. When in doubt see Rule #1.
It all adds up to one thing: Half of investing is growth; half is not losing money in the process. When investing in businesses, your company should be offering enough growth and enough safety that you don’t have to feel stressed or concerned. In fact, you should feel absolute confidence and comfort.
When Price Meets Value
When buying businesses at a discount, you are predicting the future. If you are right-or somewhat right-the price should eventually get close to, or exceed, the business’ intrinsic value. But, you have to be right.
Deciding whether or not to sell when the price meets the value is more a question of the quality of the business vs. the desire to take profits. If you own a truly wonderful, nearly invincible business, you’ll likely want to hold onto it because you can reasonably expect the company to continue to grow-steadily and consistently.
If you don’t own one of the greatest businesses in the world, you may find more value in selling and finding another business. Yes-the 15% discount rate should give you a price that would allow you to earn 15% for the long term. Still, your business would have to perform exactly as (or better than) you projected.
Enter The Margin Of Safety
The MOS does two things: It enhances your returns and it helps shield you from losses. When a great business is priced around its value, it is because the value is based on certain expectations which may or may not be realized.
Consider the following: You expect your business to grow at 14%, but it actually grows at 10%. When you buy this business at a 50% MOS, you will likely profit (though not as much as expected) and be able to sell when you realize that growth has slowed and you overpaid.
But, if you buy (or own) that business at a fair price based on an expected 14% growth rate, but the actual value is less because of slowed growth, the price will likely follow the value-down.
Case In Point: Adobe Systems
When discussing the crash of the early 2000s, most people assume that irrational exuberance and accounting scandals meant that there was no way to avoid losses or profit through it all. But what really happened in the early 2000s? Price followed value.
Adobe Systems: Wonderful business, rapid grower, industry leader, cash generator. Here’s a PDF (29kb) (consequently, an Adobe PDF) of Adobe Systems from 1993 to 2007. As a stock trader and shareholder, you would have been shocked, disgusted, and perhaps burned by Adobe’s 70%+ drop from late 2000 to late 2002.
As a business owner buying with a large MOS, you would have bought Adobe in late 1998-when the market was valuing the then $6 billion business for $2.5 billion. Had you sold in 1999 when the price met the company’s value, you would have had about a 100% annual return.
If you held the business because it was wonderful, you would have known it was grossly overpriced and that it would likely have dropped, but you would still have had:
- a 19% average annual return after it tanked to its 2002 lows;
- a 41% average annual return after price met value again in 2003;
- a 26% average annual return by mid-2007.
So, Should I Sell?
How confident are you in your companies? If your data and reasoning tells you that you have predicted, with a degree of certainty, the future of your business and you think that it is offering you the best value-hang in there. If not, sell and go find better value elsewhere.
Just remember: Your return is directly tied to your prediction of the value of your company. If your company is fairly priced, it had better be wonderful or you’re taking big risks. That’s no fun, is it?
Filed under: How to Think About Investing
Related Stocks: ADBE
I calculated the intrinsic value for each year and then plotted it over the price. Of course, stupid me I lost (or accidently deleted) the Adobe spreadsheet. I’ll recreate it and post it to this comment later.
You should check up on the value of your companies each year. Though businesses tend to change slowly and you can’t hold your business accountable for one bad year, you do want to be able to spot problems in owner earnings before they show up as problems in revenues and net income a year or two later.
Buy-and-hold doesn’t mean buy-and-forget, it means buy-and-let-time-do-its-thing. Time will reward good businesses and penalize bad ones. You need to know if your companies ever cross that threshold.
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Hi Joe. I’m also a big fan of Warren Buffett and Benjamin Graham, they’re one of the few people who actually make sense when it comes stock valuation and investing philosophy. I just wanted to add to your post that in addition to re-valuing the business ever so often, you should also check where the price relative to the intristic value. If the stock is severely overpriced, you should sell it and buy when drops back to a reasonable price (as long as the fundamental business hasn’t changed). I believe that’s part of Buffett’s strategy as well. Thanks for the cool site and keep up the great work!
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With respect to AF’s post: I would say as part of that analysis on when to sell, you need to account for the tax ramifications of the sell date as well. If you are within one year, it may not make sense to sell even if overpriced relative to intrinsic value, but that may come down to your overall view on how the business is doing. If everything remians cool as far as you are concerned, why sell. Inside of a IRA, then go for it, in a taxable account, I think you must take the tax consequence into play. There is my 2 cents. 
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I have to agree with both of you. The only thing I would throw in is that you need to consider the quality of the company. If you own a great company that, for some freakish reason, was selling at a huge discount, you may not want to sell when it is fairly priced.
What happens if the stock price never drops to a deep discount again? What if you expect your company to continue to grow rapidly – consistently and comfortably? If, after having bought Coca-Cola in 1988, Buffett had sold in 1990 when the company’s stock reached and exceeded the business’ value, he’d never be able to buy again and he would have missed out on billions of dollars of gains and his now $250 million a year dividends.
My two cents.
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I’ve only been value investing for a month now. Unbelievably, a company I purchased shares in September is already being bought by another company! It’s for a price a little lower than what I calculated as “fair value” using DCF methods, but wow!
I have to say, I’m a little disappointed because Joe said that his experience was that it took 1-2 years for a company to become fairly priced, or something of that sort. This was too quick!
I’m not sure what to do now, I guess the details of the sale will determine whether I get cash or get shares, but I was not prepared for this so soon. I was ready to buy and hold for at least 2 years.
My only regret is that I didn’t have more cash to invest in September, and that I didn’t learn about value investing earlier. Hopefully, this is the start of a successful run in investing!
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Great work Allen. I constantly hammer the point of 1-2 years because I want everyone to realize the importance of patience. That said, the reality is that it can happen at any time – even a few days or a month after buying. Just be prepared to wait a few years for the majority of your stock prices to regress back to the norm.
I’m a bit confused – did you buy at a steep discount and now your company is being acquired for a fair price? Or, did you not wait for the discount? I guess I’m asking – are you going to pocket a handsome (huge) gain in one month?
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My analysis showed that I was buying at a steep discount (I may have been just lucky – the company only had 4-5 years of financial data). I didn’t anticipate that it would be bought out at all, I was counting on the long-term stock price to follow the “value” I had discovered.
So, I did get a huge gain in one month, but only percentage-wise, that’s why I wish I had more cash in Septemeber to buy. I also didn’t have as much confidence as I am new to value investing. But this boosts that confidence up one notch.
So, now I guess I’m going to get cash, as it looks like the company taking over is on a foreign stock exchange. The “bad” part, if you can call it that, is that I didn’t want to pay the short-term tax rate, but I don’t think I can really get around that now!
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how did you plot the intrinsic value of Adobe across the years? Did you have to calculate it each year? Could you share the Excel sheet(s) where you calculated the data. Also does that mean one needs to re-calculate the value each year for all our investments?
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