It might be never, but investors should focus on how share price relates to a company's intrinsic value and also consider their alternatives before making a move, says StockInvestor editor Matt Coffina.
Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. One of the biggest questions that stock investors have is when is the right time to sell? Here to shed some light on this subject is Matt Coffina. He is editor of Morningstar StockInvestor.
Matt, thanks for joining me today.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: So, what are the key things that investors should keep in mind before exiting a position? Is just a big sell-off in the stock enough to maybe raise a red flag knowing that you should get out? What are those key factors there?
Coffina: I think the key thing to keep in mind is how a stock's price compares to its intrinsic value. This is true both on the upside and the downside. Say some news comes out that a company's margins are going to be much higher than other investors previously anticipated, than you previously anticipated, and the stock runs up 20%. Is that a time to sell? Well maybe the fair value estimate on that stock is actually up 30%, in which case it could be even bigger bargain than it was before the news was released.
Similarly on the downside, it depends on why the stock went down and what the new fair value estimate is. If intrinsic value doesn't change and the stock goes down for no good reason, that might actually be a time to consider buying more rather than selling just because the stock is down.
Glaser: So what would you think about things like a stop-loss order, and say, "I am definitely going to just cut my losses after 20%," or something like that?
Coffina: I think that's not a good strategy in general. [Noted investor] Peter Lynch once said, "Show me somebody that has a stop-loss order of 10% below their purchase price, and I'll show you someone that's guaranteed to lose 10%." Stock prices move for all sorts of reasons. We have flash crashes every once in a while where the stock price is down for no reason at all. The stock price might recover within an hour. But if you had a stop-loss order sitting out there, it's quite possible that your shares will be sold at that low price, and then you won't have an opportunity to buy back.
Similarly, stocks often make their biggest moves after hours when earnings are released and other news comes out. In those circumstances, a stop-loss order won't help you at all. The stock could open up 20% down, and then a 10% stop-loss order is going to cause you to sell your shares for 20% less. But it's not really going to save you any money.
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Glaser: Warren Buffett always says that one of his rules is that he never wants to lose money. How should investors think about protecting the downside and making sure that they're not going to ride a stock all the way down?
Coffina: So, I don't think Buffett meant that you should avoid any temporary losses in stock value because that will be an impossible mandate even for the greatest investor of all time. I think what Buffett is really talking about there is a permanent erosion of intrinsic value, which is to say that you buy a stock for $100 a share and the actual fair value estimate of the intrinsic value of that company falls to say $80 a share and never recovers. That would be a permanent impairment of capital, and that's what we want to avoid.
I think the best way to avoid that is to look for companies with wide economic moats and expanding economic moats. And on the other hand [try to] avoid companies whose competitive positions are deteriorating, what we would call companies with negative moat trends, companies whose economic moats are shrinking or that are in a very weak competitive position and are likely to see a decline in intrinsic value over time. As Buffett says, time is the friend of the wonderful business and the enemy of the bad business.
Glaser: If you do decide that maybe a company story really has changed and you think the shares do look overvalued, how do you decide exactly when is the right time to pull the trigger? How should maybe alternatives, where you can put that cash, play into that decision?
Coffina: That can be one of the hardest things for investors to do, I think, is recognizing when they were wrong and when it’s time to move on. I think we need to be careful about what psychologists will call loss aversion, where investors often don't want to recognize a loss or admit that they're wrong. That could be a very damaging strategy to your wealth if you just stick with the story that's deteriorating or a company that's not quite what you thought it was just because you don't want to recognize that loss. You could end up with a much worse loss down the road.
I think the availability of alternatives is really the key variable here. Every investment decision is relative. So, when you decide to own one stock, you're also deciding not to own any number of other stocks, cash, bonds, options, or whatever it is. If we have a better opportunity, then that is the best time to sell and put that capital to work in something better. A company with a really deteriorating competitive position that could be worth less in the future than it's even trading for today, you'll be better off in cash than recognizing a loss.
The good news is that there are almost always opportunities in the market somewhere. So, if you can identify a good one even if the stock is trading perhaps slightly below fair value, if you can find another stock trading at an even deeper discount to fair value or a higher-quality business, a business that is more likely to increase in intrinsic value over time, I think it can make sense to make that trade.
Glaser: We've talked a lot about businesses where maybe the story isn't working out. But there are also some where maybe the company is still performing very well, but the stock price just has really run up and maybe the market just has unrealistic expectations where the valuation becomes very high. How do you think about those businesses, where you still think the business is great, but the valuation has gotten away from you? When is the right time to sell those?
Coffina: Those are very tough situations, as well. Warren Buffett says that his favorite holding period is forever. He would rather never sell the stocks that he owns, but there can be circumstances where even a great business improving in intrinsic quality, growing its intrinsic value, reinvesting capital at high rates of return, growing earnings, growing dividends, and so on, still gets to be overvalued just because investors get too excited about the name.
I think this is really where our Morningstar Ratings for stocks of 1 star come into play. So, if a stock is rated around 1 star, that would be a good time to consider maybe moving on to other opportunities. And again it comes down to relative valuations. So, if you have one great business trading at a 30% premium to fair value and another trading at a 10% discount to fair value, if it's of equal quality, that could be a good trade to make.
But that said, I would say investors never really need to feel obliged to sell a stock. You don't need to ever really sell to have very good returns in the market. And the reason is that fair value estimates tend to increase over time; companies do tend to grow earnings and raise their dividends and so on, which means that a very high-quality company is likely to be worth much more five and 10 years from now than it is today.
Glaser: Matt, I appreciate your thoughts today.
Coffina: Thanks for having me.
Glaser: For Morningstar, I’m Jeremy Glaser.
