source : http://www.gurufocus.com/news/136542/philip-fishers-investment-series-when-to-sell-a-stock
Philip Fisher's Investment Series: When To Sell A Stock
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Jun. 15, 2011 | Filed Under: APPL, MFST, HSOA, X, BRK.A
"I made my money by selling too soon." ~ Bernard Baruch
The above quotation makes perfect sense so long as you did not sell Berkshire A-shares (BRK.A) when they reached $10,000 around 20 years ago or Apple (APPL) shares when they doubled to $20 around a decade ago. Those "pigs" certainly did not get slaughtered.
The most difficult task a value investor faces is deciding when it is time to sell a stock. In theory, the process of liquidating a position should not be any more difficult than deciding when to purchase an equity. However, in reality, most successful value investors are much better at picking entry points than exit points.
Part of the problem is psychological in nature. Relatively few value investors are discouraged if the market price of a stock drops after they purchase shares; most anticipate that will be the case. However, when they liquidate a position most investors continue to monitor the share price for a period of time after they sell and lament the fact that they have sold too early.
The subject of today's article is a discussion of the factors to consider when making an intelligent sell decision. I will borrow Philip Fisher's ideas about when to sell growth stocks and then discuss my own opinions on the best time to cash in on cyclical stocks.
Philip Fisher's Three Rules for Buy and Hold Selling
In Chapter six of "Common Stocks and Uncommon Profits," Philip Fisher discusses three general conditions which suggest that a stock should be sold; they can be summarized as the following:
1) The investor has made an error in his/her assessment of the company.
2) The company has deteriorated in some way and no longer meets Fisher's 15 points for purchasing a stock.
3) The investor finds a better company which promises higher long term results after factoring in capital gains.
For typical investors, point number one would be the most common reason for selling a stock. Most of us are not a Buffett or a Fisher — we simply do not perform the extensive diligence nor possess the intellectual faculties to completely understand the extensive long-term dynamics of a business. Numerous times I have perceived moats that do not exist or I have become overly ambitious in regard to the prospects of a turnaround in a business. Almost invariably the anticipated turnaround never takes place or the misperceived moat is exposed. When that is the case, the prudent thing to do is acknowledge one's mistake and sell the company.
Accounting embellishments or outright fraud also fall under this category. Monitoring the veracity of financial statements as an ongoing process is imperative in deciding when to hold or sell.
Take the case of Home Services of America (HSOA), a stock that Scott Black once recommended to the Barron's Roundtable in early 2007. Black clearly did not conduct sufficient diligence in researching the company. Rather, he accepted the fraudulent accounting provided by the company resulting in one of the worst Roundtable picks imaginable.
It did not take an accounting genius to surmise that investors who purchased HSOA had made a serious mistake. Cash flow from operations did not resemble accrual earnings, account receivables were mounting and a related party transaction surfaced that clearly indicated that the company was exchanging cash from one hand to the other. Investors had a period of many months to escape the stock before in was de-listed. However, many still refused to abandon the company in the face of blatant fraud.
I recall writing an article which was titled "The Jig Is up at HSOA;" it was met with vehement protests by supporters of the company who refused to acknowledge the fraud. Here is a synopsis of the HSOA's problems written in the fall of 2006:http://seekingalpha.com/article/18714-home-solutions-of-america-story-gone-from-bad-to-worse
Fisher's second point is generally a much tougher call than his first point. One has to determine whether the growth company is merely suffering from a temporary trough in revenues and profits or whether the nature of their business has changed permanently.
Very few businesses encounter regular sequential growth which perfectly matches the estimations entered on a spread sheet. In fact, one should become suspicious if a company always seems to exhibit symmetrical growth patterns, never missing a beat and always bettering analyst estimates. If the symmetrical patterns last for an extended period, it is likely that the company is managing their earnings to meet the expectations of Wall Street analysts, in an attempt to maintain a high price per share. If managers receive large bonuses as a function of operating profits or returns on equity, or stand to profit from cashing in on stock options, the financials should be scrutinized all the more.
Fisher specifically points out that if the company's growth slows to a rate similar to that of the economy, the stock should probably be sold. Peter Lynch would concur; he referred to such stocks as slow-growers and they represented his least favor type of stock.
In today's world Microsoft (MFST) would probably fall into that category, although at its current price it is quite debatable whether the company should be sold, held or purchased. Such mature companies frequently turn into the dividend darlings of Wall Street, offering secure returns for conservative investors or retired investors who seek steady income. Certainly, these slow growers are excellent purchases during times of economic turmoil so long as they can be purchased at the right price and they are capable of sustaining their dividend.
Growth is not paramount to long term value in certain circumstances. Consider Berkshire-owned See's Candy. See's has exhibited very low growth for a number of years. However, they have consistently maintained their unit sales while being able to steadily raise prices. See's has become the gift that keeps on giving, sending capital back to its parent year after year which exceeds the total price which was paid for the company. In such a case, continuing to hold a low-growth entity merely for it continual flow of dividends makes considerable sense. After all, the capital can always be redeployed elsewhere.
Fisher's third point is largely irrelevant when trading in a tax-deferred account or a Roth IRA. Without having to factor in capital gains, the decision to switch out to a better value which holds more upside potential is a relatively easy decision.
Another point which has become largely moot over the years is the cost of switching stocks, specifically sales commissions. In Fisher's day it was an expensive proposition to pay round trip fees. When I first started trading, switching stocks could run into hundreds or thousands of dollars by the time the commission was paid to enter one and exit another. Today, huge lots of stock can be exchange with virtually no switching fees incurred.
Of course, capital gains still factor into decisions and state capital gains rates can make the switch an expensive proposition. In my state no distinction is made between short-term or long-term capital gains — they are taxed at a 7% rate. If we add in the top federal capital gains rate of 15% for long-term holds, one is left with a switching fee of about 22%. Many times the decision is easy if a stock runs much too high and another falls precipitously. However, if one is purchasing and holding extremely conservative large-cap stocks the decision is not nearly as easy.
Consider the example of switching Apple Computer (APPL) to Microsoft (MSFT) if one holds a large long term capital gain in Apple. Is the switching fee of 22% worth the move? That is a very difficult question that does not hold an easy answer.
Fisher would first consider the management of both companies. Certainly since Bill Gateshas retired, Microsoft has not regained the edge it once had. Although it is unclear if Gates could have performed significantly better than Steve Ballmer has in the last decade. How about the long term impact to Apple should Steve Jobs become unable to continue as its CEO? The same question is asked on regular basis in regard to Berkshire. What will happen in the long term when Buffett steps down?
I cannot answer the question about Apple and Microsoft but if I owned Berkshire, I certainly would not pay the switching fee. In fact, I will be inclined to buy Berkshire stock after Buffett steps down so long as the market overacts significantly to the announcement.
Buffett has set up Berkshire to thrive long after his retirement. At some point the huge cash flow will be returned in the form of steady dividends as the mounting capital can no longer be strategically allocated. I suspect as the years pass, at worst Berkshire will become a sort of "Widows and Orphans Fund." More likely, its "handpicked" management will continue to purchase some of the best businesses the world has to offer and steadily outperform both the general economy and the major indices.
Selling Cyclicals
You will probably never again hear me cite Jim Cramer in regard to value investing but I will acknowledge that his advice on buying and selling cyclicals makes perfect sense. Cramer advises buying cyclicals when they appear expensive and selling them when they appear cheap.
Holding cyclical stocks when they still appeared to be cheap ranks as one of my biggest investing blunders. At least I can consider myself to be in good company when it comes to making that mistake.
Readers may recall Jeffrey Gendell who managed Tontine Capital. Gendell was a theme-based value investor who made a fortune in the early and mid-2000s by loading his portfolio with cyclical companies. In 2003 and 2005 his hedge fund recorded gains in excess of 100% in each year.
However, in 2008, several of Gendell's funds were wiped out shortly after the financial crisis ensued. One of the funds was down over 90% in 2008. His funds were loaded with highly concentrated positions in steel companies, engineering firms related to the energy sector, various construction companies, and numerous small companies which were tied to the housing industry. Gendell lamented in a shareholder letter in the Fall of 2008 how he was ambushed by the financial crisis but still believed that the companies he owned were cheap on a current and forward earnings basis. http://michaelcovel.com/pdfs/tontine.pdf
Gendell bought US Steel (X) long before it turned around in the early 2000s and he made a fortune, at least temporarily. His major error was that he did not sell the company when it still appeared to be inexpensive prior to the financial crash. US Steel proved to be a metaphor for his entire cyclical-based portfolio; ascending like the beginning of a ride on roller coaster then crashing on the first big dip. The 10 year chart of X tells the story:http://moneycentral.msn.com/investor/charts/chartdl.aspx?symbol=x&&CP=0&PT=10
Certainly Gendell's losses were magnified by extraordinary circumstances, however stocking one's portfolio strictly with companies whose earnings are a direct function of worldwide demand for such things as steel, homebuilding, commodities, and other construction related areas is a risky endeavor. So is attempting to sell a cyclical precisely at its earnings peak, without regard to a "black swan" event such as the financial crisis. It has been my experience that the price per share of a cyclical stock is generally in decline well before its earnings begin to descend. US home builders were a perfect example in the mid 2000s; Gendell was invested in the home builders in addition to his other cyclical companies.
D. R. Horton (DHI)
The following is a 10-year summary of DHI, one the largest US home builders:
Income Statement - 10-Year Summary (in Millions)
http://moneycentral.msn.com/investor/charts/chartdl.aspx?symbol=US%3aDHI&CP=0&PT=10
D.R. Horton started dropping in mid-2005 well before its earnings had peaked. If an investor had waited to sell until mid-2006, a year where they recorded their second best earnings, investors would have seen the value of their holding drop by nearly 50%. Holding the company though the financial crisis until today would have resulted in nearly a 75% drop, even considering the current recovery in the share price.
Conclusion
1) Making correct sell calls is an extremely difficult process for investors.
2) A different set of rules apply when determining whether to sell high-grade companies or lower-grade cyclical companies.
3) Philip Fisher's three conditions for selling a stock should be evaluated before selling a growth stock.
4) Cramer is right about something — specifically, cyclical stocks should be sold when they still appear to be fundamentally cheap.
5) A stock should be sold immediately if impropriety or fraud is indicated.
The above quotation makes perfect sense so long as you did not sell Berkshire A-shares (BRK.A) when they reached $10,000 around 20 years ago or Apple (APPL) shares when they doubled to $20 around a decade ago. Those "pigs" certainly did not get slaughtered.
The most difficult task a value investor faces is deciding when it is time to sell a stock. In theory, the process of liquidating a position should not be any more difficult than deciding when to purchase an equity. However, in reality, most successful value investors are much better at picking entry points than exit points.
Part of the problem is psychological in nature. Relatively few value investors are discouraged if the market price of a stock drops after they purchase shares; most anticipate that will be the case. However, when they liquidate a position most investors continue to monitor the share price for a period of time after they sell and lament the fact that they have sold too early.
The subject of today's article is a discussion of the factors to consider when making an intelligent sell decision. I will borrow Philip Fisher's ideas about when to sell growth stocks and then discuss my own opinions on the best time to cash in on cyclical stocks.
Philip Fisher's Three Rules for Buy and Hold Selling
In Chapter six of "Common Stocks and Uncommon Profits," Philip Fisher discusses three general conditions which suggest that a stock should be sold; they can be summarized as the following:
1) The investor has made an error in his/her assessment of the company.
2) The company has deteriorated in some way and no longer meets Fisher's 15 points for purchasing a stock.
3) The investor finds a better company which promises higher long term results after factoring in capital gains.
For typical investors, point number one would be the most common reason for selling a stock. Most of us are not a Buffett or a Fisher — we simply do not perform the extensive diligence nor possess the intellectual faculties to completely understand the extensive long-term dynamics of a business. Numerous times I have perceived moats that do not exist or I have become overly ambitious in regard to the prospects of a turnaround in a business. Almost invariably the anticipated turnaround never takes place or the misperceived moat is exposed. When that is the case, the prudent thing to do is acknowledge one's mistake and sell the company.
Accounting embellishments or outright fraud also fall under this category. Monitoring the veracity of financial statements as an ongoing process is imperative in deciding when to hold or sell.
Take the case of Home Services of America (HSOA), a stock that Scott Black once recommended to the Barron's Roundtable in early 2007. Black clearly did not conduct sufficient diligence in researching the company. Rather, he accepted the fraudulent accounting provided by the company resulting in one of the worst Roundtable picks imaginable.
It did not take an accounting genius to surmise that investors who purchased HSOA had made a serious mistake. Cash flow from operations did not resemble accrual earnings, account receivables were mounting and a related party transaction surfaced that clearly indicated that the company was exchanging cash from one hand to the other. Investors had a period of many months to escape the stock before in was de-listed. However, many still refused to abandon the company in the face of blatant fraud.
I recall writing an article which was titled "The Jig Is up at HSOA;" it was met with vehement protests by supporters of the company who refused to acknowledge the fraud. Here is a synopsis of the HSOA's problems written in the fall of 2006:http://seekingalpha.com/article/18714-home-solutions-of-america-story-gone-from-bad-to-worse
Fisher's second point is generally a much tougher call than his first point. One has to determine whether the growth company is merely suffering from a temporary trough in revenues and profits or whether the nature of their business has changed permanently.
Very few businesses encounter regular sequential growth which perfectly matches the estimations entered on a spread sheet. In fact, one should become suspicious if a company always seems to exhibit symmetrical growth patterns, never missing a beat and always bettering analyst estimates. If the symmetrical patterns last for an extended period, it is likely that the company is managing their earnings to meet the expectations of Wall Street analysts, in an attempt to maintain a high price per share. If managers receive large bonuses as a function of operating profits or returns on equity, or stand to profit from cashing in on stock options, the financials should be scrutinized all the more.
Fisher specifically points out that if the company's growth slows to a rate similar to that of the economy, the stock should probably be sold. Peter Lynch would concur; he referred to such stocks as slow-growers and they represented his least favor type of stock.
In today's world Microsoft (MFST) would probably fall into that category, although at its current price it is quite debatable whether the company should be sold, held or purchased. Such mature companies frequently turn into the dividend darlings of Wall Street, offering secure returns for conservative investors or retired investors who seek steady income. Certainly, these slow growers are excellent purchases during times of economic turmoil so long as they can be purchased at the right price and they are capable of sustaining their dividend.
Growth is not paramount to long term value in certain circumstances. Consider Berkshire-owned See's Candy. See's has exhibited very low growth for a number of years. However, they have consistently maintained their unit sales while being able to steadily raise prices. See's has become the gift that keeps on giving, sending capital back to its parent year after year which exceeds the total price which was paid for the company. In such a case, continuing to hold a low-growth entity merely for it continual flow of dividends makes considerable sense. After all, the capital can always be redeployed elsewhere.
Fisher's third point is largely irrelevant when trading in a tax-deferred account or a Roth IRA. Without having to factor in capital gains, the decision to switch out to a better value which holds more upside potential is a relatively easy decision.
Another point which has become largely moot over the years is the cost of switching stocks, specifically sales commissions. In Fisher's day it was an expensive proposition to pay round trip fees. When I first started trading, switching stocks could run into hundreds or thousands of dollars by the time the commission was paid to enter one and exit another. Today, huge lots of stock can be exchange with virtually no switching fees incurred.
Of course, capital gains still factor into decisions and state capital gains rates can make the switch an expensive proposition. In my state no distinction is made between short-term or long-term capital gains — they are taxed at a 7% rate. If we add in the top federal capital gains rate of 15% for long-term holds, one is left with a switching fee of about 22%. Many times the decision is easy if a stock runs much too high and another falls precipitously. However, if one is purchasing and holding extremely conservative large-cap stocks the decision is not nearly as easy.
Consider the example of switching Apple Computer (APPL) to Microsoft (MSFT) if one holds a large long term capital gain in Apple. Is the switching fee of 22% worth the move? That is a very difficult question that does not hold an easy answer.
Fisher would first consider the management of both companies. Certainly since Bill Gateshas retired, Microsoft has not regained the edge it once had. Although it is unclear if Gates could have performed significantly better than Steve Ballmer has in the last decade. How about the long term impact to Apple should Steve Jobs become unable to continue as its CEO? The same question is asked on regular basis in regard to Berkshire. What will happen in the long term when Buffett steps down?
I cannot answer the question about Apple and Microsoft but if I owned Berkshire, I certainly would not pay the switching fee. In fact, I will be inclined to buy Berkshire stock after Buffett steps down so long as the market overacts significantly to the announcement.
Buffett has set up Berkshire to thrive long after his retirement. At some point the huge cash flow will be returned in the form of steady dividends as the mounting capital can no longer be strategically allocated. I suspect as the years pass, at worst Berkshire will become a sort of "Widows and Orphans Fund." More likely, its "handpicked" management will continue to purchase some of the best businesses the world has to offer and steadily outperform both the general economy and the major indices.
Selling Cyclicals
You will probably never again hear me cite Jim Cramer in regard to value investing but I will acknowledge that his advice on buying and selling cyclicals makes perfect sense. Cramer advises buying cyclicals when they appear expensive and selling them when they appear cheap.
Holding cyclical stocks when they still appeared to be cheap ranks as one of my biggest investing blunders. At least I can consider myself to be in good company when it comes to making that mistake.
Readers may recall Jeffrey Gendell who managed Tontine Capital. Gendell was a theme-based value investor who made a fortune in the early and mid-2000s by loading his portfolio with cyclical companies. In 2003 and 2005 his hedge fund recorded gains in excess of 100% in each year.
However, in 2008, several of Gendell's funds were wiped out shortly after the financial crisis ensued. One of the funds was down over 90% in 2008. His funds were loaded with highly concentrated positions in steel companies, engineering firms related to the energy sector, various construction companies, and numerous small companies which were tied to the housing industry. Gendell lamented in a shareholder letter in the Fall of 2008 how he was ambushed by the financial crisis but still believed that the companies he owned were cheap on a current and forward earnings basis. http://michaelcovel.com/pdfs/tontine.pdf
Gendell bought US Steel (X) long before it turned around in the early 2000s and he made a fortune, at least temporarily. His major error was that he did not sell the company when it still appeared to be inexpensive prior to the financial crash. US Steel proved to be a metaphor for his entire cyclical-based portfolio; ascending like the beginning of a ride on roller coaster then crashing on the first big dip. The 10 year chart of X tells the story:http://moneycentral.msn.com/investor/charts/chartdl.aspx?symbol=x&&CP=0&PT=10
Certainly Gendell's losses were magnified by extraordinary circumstances, however stocking one's portfolio strictly with companies whose earnings are a direct function of worldwide demand for such things as steel, homebuilding, commodities, and other construction related areas is a risky endeavor. So is attempting to sell a cyclical precisely at its earnings peak, without regard to a "black swan" event such as the financial crisis. It has been my experience that the price per share of a cyclical stock is generally in decline well before its earnings begin to descend. US home builders were a perfect example in the mid 2000s; Gendell was invested in the home builders in addition to his other cyclical companies.
D. R. Horton (DHI)
The following is a 10-year summary of DHI, one the largest US home builders:
Income Statement - 10-Year Summary (in Millions)
| Sales | EBIT | Depreciation | Total Net Income | EPS | Tax Rate (%) | |
| 09/10 | 4,400.2 | 99.5 | 17.2 | 245.1 | 0.77 | -146.33 |
| 09/09 | 3,657.6 | -556.8 | 25.7 | -549.8 | -1.73 | 0.0 |
| 09/08 | 6,646.1 | -2,631.8 | 53.2 | -2,633.6 | -8.34 | 0.0 |
| 09/07 | 11,296.5 | -951.2 | 64.3 | -712.5 | -2.27 | 0.0 |
| 09/06 | 15,051.3 | 1,987.1 | 56.5 | 1,233.3 | 3.9 | 37.93 |
| 09/05 | 13,863.7 | 2,378.6 | 54.0 | 1,470.5 | 4.62 | 38.18 |
| 09/04 | 10,840.8 | 1,582.9 | 47.4 | 975.1 | 3.09 | 38.4 |
| 09/03 | 8,728.1 | 1,008.16 | 31.6 | 625.96 | 2.05 | 37.91 |
| 09/02 | 6,738.83 | 647.51 | 22.5 | 404.69 | 1.44 | 37.5 |
| 09/01 | 4,455.51 | 407.8 | 40.75 | 254.87 | 1.1 | 37.5 |
| Note the accompanying chart: |
D.R. Horton started dropping in mid-2005 well before its earnings had peaked. If an investor had waited to sell until mid-2006, a year where they recorded their second best earnings, investors would have seen the value of their holding drop by nearly 50%. Holding the company though the financial crisis until today would have resulted in nearly a 75% drop, even considering the current recovery in the share price.
Conclusion
1) Making correct sell calls is an extremely difficult process for investors.
2) A different set of rules apply when determining whether to sell high-grade companies or lower-grade cyclical companies.
3) Philip Fisher's three conditions for selling a stock should be evaluated before selling a growth stock.
4) Cramer is right about something — specifically, cyclical stocks should be sold when they still appear to be fundamentally cheap.
5) A stock should be sold immediately if impropriety or fraud is indicated.
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