When to Sell a Good Stock

To avoid several common investing mistakes, the savvy value investor uses a strong buy and hold strategy. Your portfolio won't suffer from the churn of day trades, you'll minimize transaction fees, and you won't pay as much of your profits in taxes as you would otherwise.

You'll eventually run into a conundrum—a point of disagreement between the investing strategies of Benjamin Graham and Warren Buffett. As you know, a profit is only a profit on paper until you realize it. A good stock may pay dividends every year, but you're unlikely to earn as much in dividends than if you found a tenbagger.

The main influencers of the value investing school of thought have all answered the question of when to sell differently. While their answers all start out by asking you about your own goals—what's your time horizon to invest, what's your tolerance for risk, how much work have you put in identifying other opportunities—they fall into two main categories, based on your fundamental conception of value.

Do you see value investing as:

• A way to exploit inefficiencies in the market?
• A way to buy great companies at good discounts?

Your answer may overlap. That's fine. In practice, your decisions will be informed by these two poles.

Sell When The Prices Reaches the Intrinsic Value

Benjamin Graham's strategy was to exploit inefficiencies in the market. His argument suggested that, in the long run, the stock price of a good company will reflect its intrinsic value. If a stock is underpriced relative to that value, and if you have a respectable margin of safety, sell when the stock's price reaches the business's intrinsic value.

The advantages are clear: it's a consistent rule, easy to understand, and it gives you a countercyclical view of stock performance. Buy low, sell high.

The disadvantages are also clear. If the company's earnings are mediocre, you'll get mediocre results. Selling at the intrinsic value doesn't necessarily account for the long term health of the underlying business. The business has to have sufficiently predictable earnings for you to make discounted cash flow projections, but predictable earnings don't make a company spectacular. This strategy also forces you to take a long view. The company could meander through undervalued prices for several years before you can realize the fair price you calculated. (Yet that's true of all stocks.)

For the best results with the Graham approach, you must dig into the quality of the company. How good is it? How consistent is it? Does its business model hold up throughout the business cycle? You'll have more difficulty finding a bargain stock on the S&P 500 than a small-cap, but bigger businesses tend to have more stable business models and management. The risk profile changes with the size and age of the company.

One other criterion applies: if you follow this model, you'll be in and out of the market more frequently than with a strict buy and hold approach. If you're the type of investor who has a dozen good opportunities identified at any time, this liquidity of your profile can be attractive! Otherwise, you might spend a lot of time with a strong cash position waiting for your next undervalued stock to appear. Neither approach is intrinsically better than the other, but one might match your tactics more closely.

Hold a Great Company Forever

Warren Buffett modified Graham's strategy to be a little pickier. He retained Graham's approach of using intrinsic value and discounted earnings calculations to decide a fair price to pay for a stock, but he went a step further. Buffett calculates the amount of money a business can produce every year to determine a projected rate of return. By retaining the stock and not selling it, he has a rule of thumb estimate about the real rate of return of the value of his investment.

This may seem like a big modification of Graham's approach, but at its core it's the same thing. If every investment had the same rate of return, everyone would buy the most boring, most stable thing possible (US Treasury bonds) and avoid anything with any amount of risk. Because that's not possible, everyone has to find a balance between expected return and risk of losing everything.

Buffett's technique looks for discounted stocks, not primarily to take advantage of their pricing inefficiencies to buy low and sell high, but to increase his overall rate of return over time. At the most basic example, a stock that costs $100 per share and pays $1 in dividends per year has a lower return than a stock that costs $10 per share and pays $1 in dividends every year. (The calculation isn't solely about dividend yield, but assume neither stock's price moves and it's still a very basic example.)

If you pay a fair price for a great business, why sell it? If it's giving you good annual returns, hold it! Reportedly, Buffett looks for a 15% annual return after taxes and inflation. That's aggressive—he can achieve that by negotiating favorable terms because he's Warren Buffett—but it can be done. In the simple example, what if he could use the Berkshire Hathaway leverage to buy those $10 shares at $9 instead? (Short answer: he's used his leverage to get a 10% improvement in his annual return.)

If anything, this approach relies even more on the quality of its businesses than the Graham technique does. It's not enough to find an undervalued company which will eventually meet its price goal. You need a Coca-Cola or Exxon which invests in its business every year to return more and more money to its stockholders. These businesses might be less frequently undervalued, but there are plenty of great businesses a lot smaller than those in the Dow 30.

Hold Until a Better Opportunity Arises

In practice, few investors have the mechanical reliability to follow a strict Graham approach, and few investors have the leverage to squeeze out the last advantages of the Buffett approach.

A hybrid approach looks for great opportunities but invests in good ones as they come up. Buy the best stocks you can at the moment, but be willing to sell them when amazing possibilities occur. To take advantage of this, keep doing your research. It doesn't take much; continue running your intrinsic value analysis as things change. Bias your selections to solid companies you wouldn't mind holding forever, but weigh future opportunities against your current holdings.

This approach has more churn than the Buffett model. You'll pay more commissions and need to manage your taxes more than if you bought and held forever. Yet you're also not buying and selling every week or month or even every year. On the other hand, you can calculate the point at which it's worth trading for a better position in a better company.

Furthermore, it can be worth keeping at least some money, perhaps quarterly dividends, in a highly liquid investment so that you can take advantage of fresh opportunities. In the case of a so-called market correction (when stocks go on sale), you may have an opportunity to exit one position in favor of something better elsewhere.

When to Sell a Stock

Obviously these strategies apply only when you have the luxury of investing patiently. Sometimes you have no choice, but ideally you have your personal finances in order such that your investments can wait out the daily fluctuations of the market and let compound growth take over.

If you can find a great stock at a good price and buy and hold it forever, fantastic! Otherwise, don't let inaction keep you from missing out on good returns. There are fewer tax and fee complications with the index fund investing strategy, and you don't have to balance your portfolio or investigate individual stocks. On the other hand, you can pursue a better return than the annual 8% of the S&P 500 index over time. Buffett's 15% is possible, with time, effort, and research.

Investing in stocks is complicated enough without trying to find a single mechanical strategy which fits every situation perfectly. If you control your own investments, the decision when to buy and sell is yours and yours alone. Learning how other successful investors have approached the subject will give you information; it's up to you to put it into practice with your own portfolio.

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