If you’ve followed the lesson on unrealized and realized gains properly, you’ll have understood that selling is what determines your profit or loss. With this in mind, when should you sell? Most investors get the selling aspect of their investment all wrong and end up selling right when they should be buying.
The question of selling can quickly become a complicated one if you take your life events into account. This chapter aims to simplify the question for you, and by the end of it, you’ll have a good idea of how you need to approach this question.
Reasons to Sell
Broadly speaking, there are just three reasons for which you should be selling your stocks:
- Investment reasons no longer exist
- Compromised management
- Better opportunities
Investment Reasons no Longer Exist
You’ve invested in a stock for a particular reason. Let’s say you liked its prospects given the upcoming 5G revolution and think that the company is well placed to take advantage of this. You also notice that the stock is selling at a relatively cheap price, given these prospects and buy in wholeheartedly .
Fast forward eight years and you find that the 5G space has become quite crowded and your company hasn’t quite kept up with competition as well as you’d hoped. Its products still have some demand, but there are clearly other ones out there that clients prefer with increasing frequency. In short, the reasons that you based your investment on are no longer valid. Such situations indicate that it’s best for you to exit your investment and sell it.
Often, you might find that the core business is no longer relevant. For example, Blockbuster was a great company for many years and was well ahead of the curve when it came to in-home DVD rentals. However, they didn’t adapt to the streaming revolution. In fact, Blockbuster turned down the chance to buy Netflix on 3 separate occasions.
As a result, they went bankrupt. You didn’t have to wait until bankruptcy to figure out that the company had issues. The warning signs were there early on in terms of decreasing earnings as well as increased expenses. Blockbuster was a behemoth that simply couldn’t turn around in time.
Borders is another example of this. The firm was extremely slow to react to the threat that Amazon posed. While its main competitor, Barnes & Noble, struggles on thanks to its brand name and a good location strategy, Borders instead shrunk the floor space it dedicated to books. It began incorporating all kinds of products that had nothing to do with books instead and focused on opening smaller outlets.
Perhaps the worst decision of all was to completely eliminate all seating areas that book lovers prefer within book stores. The company reasoned that this would force patrons to buy more stuff. Instead, patrons simply went to Barnes & Noble instead. All in all, the chances of a bookstore surviving while moving away from books is a bit unrealistic. This alone would have sent alarm bells ringing in the mind of any intelligent investor.
Lastly, we have the most famous case of failure to adapt: Kodak. The company famously doubled down on film roll and neglected the realm of digital cameras. As a result, it’s nowhere to be found these days.
At the turn of the millennium, there was one company that dominated the markets to such an extent that these days, it’s unthinkable to imagine.
Think of the sort of headlines Amazon, Apple and Google generate, and you’ll have an idea of what Enron was like. This company was based out of Houston and was an energy trading firm.
Its business area was sufficiently complex enough for outsiders to worship management as being brilliant, and the firm ticked all the boxes with regard to political connections to be intimidating to competitors. For example, George W. Bush and Dick Cheney were close to the company’s chairman Kenneth Lay and the chief financial officer Jeff Skilling.
Given all of this, it came as a huge shock that Enron was bankrupt, and even worse, it had been bankrupt for quite a few years running and had been cooking its books in complicity with its auditing firm, Arthur Andersen (now Accenture). The only reason Lay isn’t vilified more than he is for his role in the scandal is because of the supervillain like actions that Jeff Skilling carried out.
An example of this was when Skilling dumped all of his stock prior to an earnings release while still exhorting employees to buy more stock in the company. Skilling even went so far as to abuse an analyst who dared question the financial condition of Enron’s books during an earnings call.
Dishonest management will always reveal themselves without prompting. Lay and Skilling’s behavior was notorious well before the scandal, and Enron’s culture was toxic at all times. However, people ignored this since the company made ungodly sums of money.
Another example of this was the former Wall Street giant Lehman Brothers. This was another case where an earnings call with analysts revealed deep flaws in the company’s books. In this instance, the CFO of Lehman, Erin Callan was questioned by the hedge fund manager David Einhorn. In Callan’s defense, she wasn’t committing fraud. Lehman was just too incompetent to figure out the true nature of the assets they were carrying.
The firm went bust during the credit crisis, and Einhorn was one of the first people to warn of the dangers that banks were running, even if he didn’t have a movie made around him. The case of Radioshack’s CEO falsifying his academic credentials also comes to mind.
Small lies eventually lead to bigger lies. If you begin to spot inconsistencies in the way management communicates its shortcomings or if it begins to treat everyone else like a bunch of dunces, most likely it is the management that is incompetent. You’re best served by getting out quickly.
Stocks don’t always go up. At some point, they will consolidate, and their prices will remain at a certain level for years. This is not a bad thing by itself. If you do happen to find a better company to invest in and if you’ve earned at least a 50% gain on your investment, then feel free to sell your holdings and move your money to the new venture. Remember that you will need to pay capital gains taxes when you do sell stocks at a profit. Treat the entire sale as if you’re selling a house and buying a new one. Carry out the level of preparation that such a transaction demands.
Alternatively, if you made a poor investment decision in the past (we all do), it’s ok to take a loss. Remember to analyze why the stock’s price is lower than when you bought. If you don’t believe anything about the core business has changed, then keep holding. However, if your initial research was off the mark, or the underlying sector economics no longer make sense, then you are free to sell. It’s important to analyze your losses and understand why you were wrong in the first place. This will help you make better decisions going forward. Remember you can write off capital losses come tax season.
Putting It All Together
As we come to the end of this guide, you now have a significant opportunity on your hands. While the financial media want you to believe that stock investing is a tough art to master, the best way to get ahead is to use the simple and easy to understand principles you’ve learned in this guide. This is because the simpler your principles are, the less likely you are to overcomplicate things.
Remember to keep the investment principles we spoke about earlier in your mind at all times. These alone will ensure an intelligent investment and will significantly reduce your chances of losing money. Here they are again, briefly:
The Warren Buffett test – Buy great business at fair prices. See if you can describe the business to a 10-year-old.
Understand the true business – How well do you know what drives the profits of the business?
Founder syndrome – How honest and reliable is management? Is there a succession plan in place, or does it all depend on the founder?
Intangible assets – Does the company have any brand loyalty? Does it have intellectual property like patents or trademarks? Things which don’t show up on a balance sheet.
Management quality – How well does management align the business with the economics of the industry? How well do they reinvest capital?
Sales and marketing – How dedicated is the company to sales and marketing? What is the quality of their teams? How are their key metrics looking year-to-year?
Long term focus – Is management focused on short term metrics, or does it invest resources for the long run?
Moat – A moat is a phenomenon that gives a company an unfair advantage in its field. It could be brand loyalty, a superior supply chain, sheer size, etc.
Can it weather a storm? – How well will the business perform under a stress test?
Ask yourself all of these questions prior to investing in a company. As you can see, they require a high degree of honesty from yourself. It also requires you to stay away from fad and currently popular industries if your sole reason for investment is their popularity. Instead, evaluate the company’s fundamental business and management.
Above all else, remember that a share is a slice of the business. You aren’t someone only in it for the short run. You’re an owner of the company. So, behave like one!
Read Books to Learn The Right Investment Mindset
A large part of successful investing is about Mindset. So I read many mindset books.
Recently, I read Rich Dad Poor Dad and found it quite interesting.
Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy.
The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.
He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).
It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).
Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.