The Art of Stock Selling

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"25 Stocks to Own for the Next Decade"

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I see promotions like these all of the time. I read them on Web sites and in mail that I get at home and work. Even my spam e-mail entices me with the promise of instant wealth gained through the stock market. As the editor of a newsletter devoted to value-based, buy-and-hold stock investing, headlines like these irritate me to no end. In addition to being annoying, these overblown enticements share at least one more thing: a focus on buying stocks.

The investment world tends to be much more focused on buying rather than selling stocks. Obviously, knowing which stocks to buy is important. However, I think that knowing when to sell a stock is one of the biggest challenges we face as investors. It's human nature to want to sell our big winners in order to lock in gains and avoid seeing our paper profits evaporate. Often times, though, winning stocks keep running well after we sell them. On the other side, most investors hold losers well after they should in order to avoid taking a definite loss and admitting to a bad investment decision. At Morningstar StockInvestor, we have some guidelines for selling stocks that we stick to in order to minimize the impact of human nature on our sell decisions. If you stick to the four guidelines below, your investing results should improve.

It's a good idea to sell a stock when one of the following occurs:

The Stock Reaches the Sell Target
Sometimes the market overreacts to short-term events, giving you the opportunity to pick up wonderful businesses at great prices. At one time or another, almost every great company has been vastly underpriced by the market. By the same token, almost every great company has also been overpriced by the market, selling far above its fair value. This happens when investors, for whatever reason, become too optimistic about a company’s prospects. When you're lucky enough to have that happen to one of the stocks in your portfolio, you should consider taking some money off the table by reducing your position in that stock.

Deteriorating Fundamentals
As soon as you notice that the fundamentals of a company are beginning to deteriorate, you may want to consider getting out of the stock. A good place to look for deteriorating fundamentals is the balance sheet. Things to look for include rising debt levels, rising inventory levels, and accounts receivable that are rising faster than revenues. These are three common warning signs that a company’s efficiency is deteriorating. Here are some other warning signs that the fundamentals of a company are deteriorating:

• Shrinking return on equity
• Declining profit margins
• Market share losses
• Unwise acquisitions
• Unexpected management shakeups

Buying Was a Mistake
No matter how much work you put into researching stocks, you're bound to make mistakes. Even great investors make them. After you purchase a stock, sometimes you come across something you missed before. Examples of this would be shady accounting practices, seedy related-party transactions or evidence that the company’s once-wide economic moat is shrinking. If you find these or other red flags after buying a stock, you should strongly consider selling it, even if it means taking a loss. Better to cut your losses, take the tax write-off, and look for a better place to invest the money than stick with a stock that's bound to be a loser.

Trading Up or Rebalancing
During a bull market, investors often get used to ignoring financial fundamentals because virtually all stocks are going up. As John F. Kennedy said, a rising tide lifts all boats. It’s usually not until we get into a recession that investors wake up to the fact that some boats are better able to withstand stormy weather than others. Companies with wide economic moats can withstand almost any downturn, but those without them suffer greatly when times get tough. That’s why you should always be on the lookout for high-quality stocks to replace lower-quality ones in your portfolio.

You might also want to think about taking some money off the table if a stock has risen so much that it now accounts for an outsized portion of your portfolio. If a stock that used to make up 10% of your portfolio has doubled in price while the rest of your stocks have stayed flat, that stock will now make up 18% of your portfolio. That’s probably too much dependence on just one stock, so in this situation you should consider selling some shares to rebalance your portfolio.

At Morningstar StockInvestor we think that buying great companies well below their intrinsic value, focusing on 15-20 of our best ideas, and minimizing turnover are the keys to long-term investment success. Minimizing turnover, however, is not an end, but a means to achieving great results. Sometimes it's appropriate to sell a stock. We've used the guidelines above to decide when a stock needs to go, and it has served us well over the years. Hopefully, these guidelines will be beneficial to you as well.