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When Should the Intelligent Investor Sell A Value Stock? (Part 2)

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When Should the Intelligent Investor Sell a Value Stock? (Part 2)  by Evan Bleker, Net Net Hunter

One of the most asked questions is when an investor should sell a value stock. Traditionally, value investors have focused on how to select promising investment candidates without paying too much attention to the question of selling.

In the first part of this series on selling value stocks, I talked about the positive reasons the intelligent investor may have to sell. Unfortunately, things don’t always work out as we expected them to and eventually we’re forced to acknowledge that an investment has gone sour. Sometimes things haven’t gone sour but just haven’t worked out like we thought they would. This can put the intelligent investor in a difficult spot.

Luckily, all the intelligent investor has to do to work out a proper sell strategy is to sit down and think about it for a while. The way I see it, there are a few key events that should spell out very clearly when value investors should cash out of their value stocks.

Sell After Erosion

Sometimes you’ll find a great value stock, have a lot of conviction about it, and then after a while watch the gap between price and value close. Unfortunately, the gap closes in the wrong direction — the intrinsic value of your firm has shrunk to match the firm’s selling price rather than the market price of the firm rising to match the firm’s value.

Maybe the net net stock was losing its NCAV little by little while the price failed to advance. Maybe the firm has lost a major customer, devastating the firm’s income stream. Maybe the company decided to issue a large number of new shares or options, burning current investors in the process. Value erosion happens to the best of us and the only thing the intelligent investor can do at this point is sell the problem holding.

 Sell Your Net Net Stocks When the Earth Shifts

Similarly, sometimes something happens that makes you reassess your original judgement of the firm’s risk-reward ratio. Something has either caused you to call your assessment of the firm’s value into question or the risk that you’re assuming when making the investment. Perhaps your standard for value — the comparative value of other firms in the industry, interest rates on corporate bonds, etc — have shifted which tips the balance unfavourably. At other times the growth you expected is just not going to materialize. Perhaps the company admits to accounting fraud and it’s entire balance sheet has to be revised. All of these events can reduce the expected return and the attractiveness of the risk-return ratio.

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On the risk side of the equation, maybe management lets investors know that it’s currently holding a lot of questionable mortgage instruments. Instead of owning the sleepy little community bank you thought you owned you now own a ticking financial time-bomb. Maybe sales shift so that, rather than the same 30% seen in the previous quarter, 70% of your housing contractor’s sales are now coming from one customer. Both of these substantially increase the risk of your holdings and the intelligent investor may be wise to cash out.

It’s Time to Say Goodbye

Sometimes things don’t look too bad but the stock price hasn’t budged. Your stock is still well below fair value and you just can’t understand why.

It may be true that eventually price and value converge — but sometimes waiting for that convergence can be devastating. That’s a fact that Sears Holdings will help me remember for many years.

Sears Holding (NYSE:SHLD) was a darling stock in the early 2000s. Led by legendary hedge fund manager Edward Lampert, the company had increased in market price by over 500% in just a handful of years. Speculation was rampant about how Lampert would unlock the firm’s hidden assets and detailed reports were made on the value of the company’s real estate. I bought in and waited, watching the share price climb marginally, fall, recover, fall, and then recover again. Years passed without the stock rising to reflect the firm’s fair value. Rather than the obvious value bet I thought it was, no further value was unlocked and the stock acted as a large anchor in my portfolio. Never again.

Graham once wrote that the intelligent investor should  be patient when it came to realizing returns but also cap the amount of time he was willing to wait at 2 or 3 years. Obviously it depends on the investment, but these types of judgements should be made before a value investor invests in a stock. Unless there is a serious change for the better, net net stock investors — and any other classic Graham investor for that matter — should sell his value stocks after a pre-prescribed length of time passes, no matter what’s happened to the stock.

Stock Swapping

To end this on a more positive note, sometimes an investor will recognize a good opportunity in the market and decide that it would make a better investment than one of his current holdings. In this case, it might make sense to sell.

I say might for a reason. It’s true that there’s always something that is a bit better than out current holdings. The question really becomes how much better that other investment opportunity has to be to justify selling one of your current holdings in favour of this new opportunity.

One of the problems with stock swapping comes down to human errors. Value investors seek a large margin of safety in part to protect their assets from the inevitable errors that are made when assessing a stock’s investment merits. Likewise, the difference in the quality of the two companies, the risk-return assessment, or the price-value spread should be large enough to justify swapping. A 5 or 10% difference might not be large enough. Similarly, there are costs associated with buying and selling securities. Things like broker commissions, exchange fees, and possible price movements must be taken into account because one or more of these could nix any advantage a value investor might derive from selling one stock to buy another.

If the difference in price is large — a stock selling for 40% of NCAV versus 50% for example — then it makes sense to swap stocks. At 50% of NCAV the stock has to double to become fairly valued while a stock selling at 40%of NCAV has to increase by 150%. That’s a huge difference. Likewise, if two stocks are both priced at 50% of NCAV, for example, but one stock has a 60% debt-to-equity ratio while the other firm is free of debt than it makes sense to sell the debt-laden company for the debt free firm.

Can You Sell When You Have To?

When it comes down to it, it’s pretty simple to know when to sell a stock. I think the tough part is — especially in the case of selling due to negative events — to be honest with yourself, or fend off your own psychology, so that you can take the necessary steps to improve your portfolio. Part of this requires developing a stronger emotional intelligence and leaving your ego at the door.

Before you can sell, though, you have to be able to buy. You can solve this problem by signing up for full Net Net Hunter membership. Not only do we have over 450 net net stocks to look at but we also dig through the listings to identify the best investment candidates. The money you could make off of even just one international net net stock would be enough to pay for full membership access for years.

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