Answers To The Hardest Decision – When Do I Sell A Stock? by Chuck Carnevale, F.A.S.T. Graphs
I’m going to start this article with the same opening statement that I utilized in a previous article I wrote on knowing when to sell a stock. The most common complaint that I have heard from investors over my 40+ years in the financial services industry is as follows: “Everyone wants to tell me what to buy and when, but no one ever tells me when to sell.” Consequently, it seems to me that whether you are a novice investor or a grizzled old veteran, the decision as to when to sell a stock is considered the most difficult decision investors have to make.
When to Sell a Stock – The Power and Protection of Fair Value
Personally, I believe the sell decision is difficult for most investors because of the natural emotional response that motivates them to feel they must do something, especially during turbulent times. In other words, when they are experiencing volatility within their portfolio holdings, they feel a strong desire or even a need to take action. However, more often than not, the best action for investors during volatile markets is to sit tight and do nothing. But the innate “fight or flight response” that is embedded in virtually every living thing is often impossible to resist.
However, if we check in with some of the best investment minds that ever walked the planet, we find that they have disciplined themselves to take a different approach. For example, in the 1996 Berkshire Hathaway Annual Report Warren Buffett stated: “inactivity strikes us as intelligent behavior.”
Additionally, in legendary investor Philip Fisher’s excellent book “Common Stocks and Uncommon Profits” in chapter 6 titled “When to Sell and When Not To” Philip Fisher gave us this nugget of wisdom: “If the job has been correctly done when a common stock is purchased, the time to sell it is-almost never.”
Both of these legendary investors are suggesting avoiding the temptation to do something because they believe that the best course of action is usually to sit tight. At this point, it’s important to not overlook the importance of doing the job correctly when the stock is initially purchased. This was a primary theme of my recent article titled “Get Higher Returns And More Dividend Income-In Less Time With Less Risk.”
To my way of thinking, doing the job right implies identifying a great business through research and due diligence and then exercising the discipline to only purchase it when valuation is sound, or better yet, at a bargain level. Doing this puts you in the position to be able to walk through turbulent waters with a minimum of risk to your long-term financial future.
However, in addition to doing the job right in the first place, it’s also important that investors possess a realistic understanding of how stock prices work in an auction market. In financial parlance, stock charts are often referred to as “mountain charts.” The reason is because just like a mountain, a stock price chart that is ascending upward will contain numerous peaks and valleys in between.
Consequently, I have coined a metaphor suggesting that great investors and great mountain climbers share a common understanding. Both recognize and accept the reality that in order to get to the highest peaks you must be willing to traverse the occasional valleys along the way. Therefore, in order to be a successful long-term investor, you must accept the unavoidable reality that there will be short-term periods where your performance will be negative. Even more importantly, these periods of negative performance are unpredictable.
However, there is a caveat with this allegory that relates to doing the job right in the first place part. Once you have been climbing the mountain for a while and are looking for the next higher peaks, it’s important to know that you’re on the right mountain. However, it is one thing to walk down a valley while on your way to a next higher peak, and it’s another thing altogether to walk all the way back down to the bottom because you’re on the wrong mountain.
Avoid Selling Just Because the Price Drops
Up to now, I’ve attempted to establish the principle that selling should be done very sparingly – if at all. Furthermore, implicit in determining when to sell is knowing when not to sell. Short-term market price drops are rarely a valid reason to sell a strong business.
I believe that as long as fundamentals remain strong, a drop in price is more likely to initiate a buy decision than it is a sell decision. I believe this is important, because in my anecdotal experience many investors are inclined to sell a stock if the price drops below the price they paid for it. Admittedly, averaging down doesn’t always work out as expected. However, I have seen more people take unnecessary losses by selling a perfectly good stock than I have seen people losing more from averaging down.
The following series of graphs on my personal experience with Stryker Corporation (SYK) represent a case in point. I originally purchased the company on July 28, 2008 at a price of approximately $64 per share (see the green dot on the graph). The price had recently fallen from overvaluation based on earnings growth at that time to what I considered fair valuation. However, as illustrated on the graph, the company’s stock price promptly fell to approximately $40 a share – representing close to a 38% unrealized loss.
However, in spite of the fact that we were in a recession, the company’s earnings held up quite well, but they did reduce their dividend. I made the decision to hold it, and on May 21, 2010 I had become comfortable that this strong company’s business was once again on the upswing and added more to my original position at a lower price of approximately $53 per share.
However, once again the price of Stryker promptly fell almost 20% to just over $43 per share before beginning to recover by year-end. The dividend was increased, and the company’s earnings growth returned to double-digit levels. Therefore, once again I continued to hold for the long run because I believed in the company’s fundamental health and strength.
My patience and judgment was further tested in 2011 when Stryker’s stock price swooned again to levels below both of my previous purchases. But once again, fundamentals remained strong, the dividend was increased again and I added to Stryker a third time at a price of approximately $51 per share. By now I was in the middle of my fourth year of owning the stock, and my returns up to that time based on price action were meager, to say the least.
Fortunately, it did not take long after my third purchase for Stryker’s stock price to embark on a steady and sustained advance. The good news is that my faith in Stryker has turned out to be a very profitable and rewarding investment. But importantly, it wasn’t blind