When to Sell a Stock (and Common Mistakes to Avoid)

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This newsletter is adapted from a previous video Drew Cohen did on When to Sell a Stock.

When investing, most people worry most about when to buy a stock.

The harder part, though, is figuring out when to sell, and that is what this Five Minute Money newsletter will cover: the only times it is actually appropriate to sell a stock.

What “Overvalued” Actually Means.

Many people assume that if a stock is overvalued, it must be sold.

That is not true.

Say a stock trades at $300 and the estimated fair value is $400.

Moving from $300 to $400 does not mean the stock should be sold, and it does not mean the stock stops returning money after that point.

Saying a stock is worth $400 means that at that price, an investor would earn a fair return, while at $300, an investor would earn an outsized, abnormally high return.

Buying something at fair value still returns something, just a fair return rather than an outsized one, and a lot of investing comes down to figuring out what that fair return should actually be.

An undervalued stock should produce a higher, outsized return going forward, while an overvalued stock should produce a lower return than what counts as fair for owning it.

None of that, on its own, is a reason to sell.

So should an investor ever sell purely on valuation?

That gets addressed later, but first, three more straightforward reasons to sell, according to Phil Fisher.

The Three Reasons to Sell.

Warren Buffett, one of the most successful investors of all time, would probably be the richest person alive today if he had never donated any of his Berkshire Hathaway stock.

His well-known mentor is Benjamin Graham, whom he started his career working for and who is the reason Buffett became known as a value investor.

But Buffett has credited another influence, someone he admired from afar, Phil Fisher, with making him a better investor.

Fisher never ran a big investment fund; his clients were private, high-net-worth individuals he quietly managed money for.

He did write a book, though, called Common Stocks and Uncommon Profits, and in it he lays out the three reasons, and only three reasons, to sell a stock, still one of the simplest and best explanations there is on the subject.

Reason #1: Fundamental Deterioration.

The first reason is fundamental deterioration: something in the business starts going wrong, and it is no longer as attractive or as strong as it once was.

Growth might start slowing, there might be a volume contraction, costs might be structurally increasing, a management team might leave and get replaced by someone no good, or some IP might expire or get overtaken by a technological advancement.

Kodak is a classic example.

For a long time, Kodak had a very attractive business: once someone bought a camera, they were stuck buying the same roll of film from Kodak over and over, letting it charge a lot for that film because of the lock-in, the same razor blade model that let Gillette charge a premium for blades once someone already owned the razor, with every blade purchase becoming recurring revenue.

In Kodak's case, the technological landscape shifted as digital cameras came about, and its film business eventually became obsolete.

An investor paying attention to developments in the camera industry could have grown concerned fairly early, even if the warning signs were not yet showing up clearly in the numbers, and because Kodak's fade from a high-quality company to near bankruptcy took many decades, there was no need to catch it instantly; taking a year to figure it out still would have meant enjoying a long stretch of high profits and high returns first.

Gillette itself, while not a standalone public company anymore, went through similar pressure once direct-to-consumer brands like Dollar Shave Club, along with e-commerce and Amazon more generally, opened up distribution channels that used to run through just a couple of options on the average supermarket shelf, bringing a lot more pricing pressure as a result.

The rule here is not to play games once this kind of deterioration shows up: do not wait around telling yourself the price might come back before selling.

Holding a business after recognizing it is deteriorating, purely because the stock price might move up, is not investing at that point, it is speculating.

Reason #2: A Mistake in the Analysis.

That could come from a variety of places: maybe a competitive advantage was not as strong as it was thought to be, maybe competitors were assumed to be many years away from a substitute product and instead rolled one out much quicker, or maybe it was a straightforward calculation error, like forgetting to back out stock-based compensation from a free cash flow figure, or not realizing how much of that free cash flow was actually interest income that would disappear once interest rates dropped.

As soon as a mistake like this is identified, and after accounting for it the business is no longer one worth owning long term, that is the moment to sell.

Continuing to hold after reaching that conclusion, purely because the stock price might still go up, is speculating again rather than investing: investing means profiting off the underlying cash flows of a business and the economic value it creates, while trading means profiting off the hope that the same piece of paper gets sold to someone else at a higher price later.

There is nothing wrong with trading as its own activity, some people do fine with it and some people lose everything, but it is a different activity from investing.

Reason #3: A Better Opportunity.

The third reason is finding a better opportunity.

Investors want to be allocated to the businesses with the highest potential return over time, so if a portfolio of stocks shows some names with clearly more potential than others, or a new business turns up that looks genuinely exciting, it makes sense to move some money toward that stronger opportunity and away from the weaker one, whether that is because the original stock's price already ran up a lot or because the business itself just is not as strong as the new one found.

That said, diversification still matters, so this is not license to go overboard concentrating a portfolio around a single new idea.

Two Reasons to Never Sell.

There are also two things, drawn from Fisher as well as from Warren Buffett and Charlie Munger, that should never be treated as a reason to sell a stock.

Reason #1: Market Volatility.

Selling a stock with the idea of buying it back cheaper is trading, not investing, and treating it as a strategy is an absolute catastrophe, because at that point the business itself is no longer what is being evaluated.

If you own the whole business, you would never act this way.

Imagine owning an entire, very profitable local restaurant making $2 million a year, and in 2007 deciding, "things are pretty good this year, I'm going to go ahead and sell it because I think there's going to be a financial crisis, and I'll buy it back next year in 2008."

People would look at you like you were crazy.

Even in the rare case where that macro call turns out right, prices do not always move in predictable ways: there are plenty of times a company is struggling and at its worst, and unexpectedly, its price goes up anyway.

Because of that, real investors do not speculate on these factors, and they do not sell out of fear over volatility.

The one exception is when something genuinely impacts the business itself, a war or something comparably disruptive, in which case selling is justified, but because of the actual impact to the business, not because the stock price moved.

Reason #2: Selling on Valuation Alone.

The second is selling purely on valuation, one of the things investors struggle with most, and there is no single absolute answer here.

What can be said is that most great investors essentially never do it, with few exceptions.

The easiest way around the question of whether to sell a stock that has gotten expensive, one where it is genuinely hard to see how the business could generate cash flows that sustain the valuation, is to look for other opportunities instead, which loops right back to Fisher's third reason.

Charlie Munger makes a similar point when he says a portfolio tends to perform best when its holdings are in real competition for capital with each other, so instead of agonizing over whether to sell a stock trading at 50x earnings, it is much easier to go look for other opportunities and, once one turns up, weigh the two directly against each other.

There is also a pattern worth being patient about: when you do find a truly great company, it tends to outperform to the upside and do things that could not have been expected, and because of that, it very often looks a little overvalued along the way.

That does not mean buying a stock in spite of it looking overvalued, but it can mean being more patient with a position already owned, since a company correctly identified as reinvesting at a very high return on invested capital, and consistently finding new opportunities, is going to be able to do things that simply cannot be perceived in advance; that is a reasonable assumption to make about a position already held, even if it should never be assumed on the way into a new one.

There is also a tax angle to that patience.

A stock that has gone up a lot and carries a large embedded gain triggers a real tax bill once it is sold, and that deferred tax amount works almost like an interest-free loan from the government, letting more capital stay invested in that position than would otherwise be there, since the government cannot call that loan until the position is actually sold.

Because that embedded gain functions like a mild form of leverage, without the more dangerous kind that can get called at the wrong time, it is reasonable to accept a somewhat lower return in exchange for holding onto it.

Summary.

Put together, these five ideas all point back to the same underlying distinction, which is that investing is a judgment about the business, while trading is a bet on the stock price.

The three real reasons to sell, fundamental deterioration, a mistake in the original analysis, and a better opportunity elsewhere, are all judgments about the business itself or about where capital is best put to work.

The two things that should never trigger a sale, market volatility and valuation on its own, are judgments about price instead, and acting on those is what quietly turns an investor into a trader.

None of this means ignoring valuation entirely; a stock that looks expensive is still worth watching closely, but the right response is to go find a better opportunity, not to sell and sit in cash waiting for a better price.

The businesses most worth being patient with are the ones already identified as genuinely great, since those are exactly the ones most likely to do something unexpected, and the tax bill triggered by selling a large embedded gain is one more reason that patience tends to pay for itself.

For More on When to Sell a Stock, check out the video below.

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Nothing in this newsletter is investment advice nor should be construed as such. Contributors to the newsletter may own securities discussed. Furthermore, accounts contributors advise on may also have positions in companies discussed. Please see our full disclaimers here.