When Should I Sell My Stock?

By Joe Ponzio on September 20, 2007  |  8 comments

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?

Also Filed Under "How to Think About Investing"

• Have You Read Buffett?
• Why Ask Me? Ask Mohnish.
• Just Because You Know The Value...
• Big Moat Business Part II