Monthly Archives: August 2009

When Should You Sell?

If someone were to ask me, “what is the most challenging task for an investor to do well,” I would suggest “selling” as the answer. For someone like me who spends the majority of his investment energy in measuring value (as opposed to predicting outcomes), identifying attractive stocks and buying them is an exercise in my comfort zone. I think I understand well the principles of valuation and have enough experience to be confident that when I buy a stock, it probably will make me some money (this, in my opinion, is why value investing is so attractive to me – I generally buy stocks that are kind of “beat up” for some reason or other and usually have limited downside).

So, having bought a stock I consider undervalued, I wait, watch and wonder how high it’s going to go (while constantly monitoring all the important details, of course). Most of the time, I have some idea about the true or “intrinsic” value of a stock, but sometimes I simply feel that the upside could be “very large.” It’s in these cases where the real challenge of selling rears its ugly head.

Early in my career, I worked with some very smart, seasoned equity analysts at Brown, Brothers, Harriman & Co. Bob Dunlop was my first mentor, and he showed me how the value investing principles I had learned in business school could be applied to the real world. We uncovered a small company called Newell & Co. This firm made paint brushes, drapery hardware, bathroom scales and a bunch of other stuff that would basically bore you to death. But the company had a plan – it would acquire small companies that made similar products which were sold into the same retail outlets it sold into and eventually would grow much bigger. The company had a reasonably good track record of doing this to that point, but the company was still very small.

The valuation of the stock was very cheap, and it had totally escaped the attention of Wall Street analysts. We pitched the idea to the head of research and while he did not totally reject the idea, he said that the company would not pay for us to fly down and see the company. Eventually we were able to meet with the Newell’s president in our office and we were very impressed with the story. Shortly thereafter we initiated coverage on the stock with a “buy” rating. I don’t recall what our initial price target on the shares was, but a quick look at the long-term chart of NWL will show that the stock price increased 10-fold in the decade following our report. By the late 1990s, the stock reached the $60 level, a 30-fold increase from when we first discovered it.

So where do you think “taking profits” in Newell would have been a good idea? Up 40%? Up 100%? Up 200%? Granted, not every stock will show the kind of appreciation of a Newell (but this is one reason I really like the mid-cap area – this is where the Newells of the world usually reside), but the fact that some Newells may still be out there should give investors some reason not to pull the “sell” trigger too early. Within the universe of stocks I am closely following right now, I must admit there are none where I expect a 10-fold increase. Yet, there are some I think could more than double from here and there a few more where the upside could be “very large.” I would not want to take profits too early and miss all that sweet potential upside.

John Neff, the famous value investor who ran the Vanguard Windsor fund for over 30 years, had an interesting approach to selling stocks which is somewhat similar to mine. He always tried to sell a stock before it reached its full potential. His idea was that he could always use the proceeds from that sale to buy other undervalued stocks. Regarding his selling discipline he said, “Successful stocks don’t tell you when to sell. When you feel like bragging, it’s probably time to sell.” That’s probably the best advice anyone could ever give about when best to sell a stock.

Sell All Stocks!

That is what some smart money managers do when they go on vacation. They sell the entire portfolio and let it sit in cash for the 2 weeks they are away. No chance of an unexpectedly bad earnings report tanking a stock. No reason to check into the office. No likelihood that any client will call looking for an update on the portfolio. In other words, a real vacation – totally removed from the daily grind and volatility of the markets. Upon their return, these portfolio managers would review the stocks they had held and would buy back only the ones they really liked. This annual purge would help them from becoming too emotionally attached to any one stock and would reset the cost basis for each stock in the portfolio. Sometimes our cost basis on a stock can cloud our judgment and prevent us from being as objective as we would like to be.

Although I’ve never done this over the course of my career, I did just take a vacation, and I really enjoyed not actively looking at the market for 8 trading days (I did take a peek a couple times). Our active itinerary (four days in Yellowstone National Park, two days visiting family in Billings, Montana and two on a real cattle ranch near La Barge, Wyoming) may not be typical, but was nonetheless relaxing and fun for my family. Upon my return I was able to review all the stocks in my active universe of coverage and, lo and behold, I still liked all of them. I tweaked a few price targets due to higher expected EPS estimates (it turns out that the forecasts companies made earlier in the year amid the worst fears about the economy were too conservative!), but all in all, the list of stock I like remains solid and attractive.

That said, I am still hearing commentary here and there about the market being “overbought” or that a correction is inevitable. In most cases, this commentary comes from people who wanted investors to sell stocks and raise cash in March. As long as $5 trillion of investable funds are sitting on the sidelines and a large portion of the commentary is negative, I find it hard to believe that a major correction is likely to happen. It could, of course, and I never make predictions, but I feel very comfortable owning stocks right now.

So, returning the title of this note – “Sell All Stocks?” Now? Get serious. No way.

Where’s the Good News?

It’s hard to be a stock market bear these days. With the S&P 500 up over 45% since its March lows, I suspect that anyone who has been telling you to sell stocks and hold cash (or gold) is feeling a bit sheepish right now. And yet, many of them are still out there pounding away on the Big Bear Story – the economy has massive structural imbalances, U.S. consumers still have heavy debt loads, the housing market is on life support, toxic assets still abound on bank balance sheets, massive commercial real estate write-offs are coming, people are still losing their jobs, etc. And if that isn’t enough to scare you into selling stocks (or not buying them again), they can dust off the nasty, old hyper-inflation specter (absent seen since the 1970s) and try to convince you that if the recession doesn’t get you, then the massive inflation coming down the road will.

The casual observer may wonder why the stock market has appreciated when all around us we only see bad (at least at face value) news. Take the latest employment report for example. At face value, the report shows that 247,000 people lost their jobs in July. How in the world could that be good news for the stock market? Well, you see, the stock market always cares about data (government releases, corporate earnings, etc.) relative to expectations. The market had been expecting a July job loss of 275,000; by the perverse calculus of the equity market, the July employment report was deemed “good” news.

This idea of the market responding to numbers versus expectations is a key factor as to why the market is up so much since March. At some point earlier this year, the numbers ceased to worsen at an accelerating rate. The numbers (economic data, earnings, etc.) were still bad, but were not getting much worse. Later, the “badness” of the numbers started to improve. About now, the numbers are getting “less bad” at an accelerating pace. For all the talk of the need for structural change in the U.S. economy, the pattern of how the stock market interprets and responds to new information is classically typical. In other words, the stock market since March has responded in an absolutely normal and rational fashion to the new data it has been shown.

Alas, dissecting the past is always easier than predicting the future. I never make predictions (“official” ones anyway), but I do watch those who get paid to do it for a living. Last week the percentage of equity strategists who are bearish declined to be roughly equal in number to those who are bullish. For months, bearish strategists vastly outnumbered the brave, but clearly contrarian, bullish ones by a large margin. To me, this strategist parity suggests that the market can continue to rise. As things continue to get “less bad” and when we eventually begin seeing legitimate “good” news (like the third quarter U.S. GDP figure, which is likely to be positive, from what credible economists are saying), I suspect more of the bearish strategists will change their minds.

This week Abby Joseph Cohen, Goldman Sachs’ equity market strategist, stated that she believes a new bull market has begun and that the S&P 500 could close the year somewhere in the 1,050 to 1,100 range. The first rule of being a Wall Street equity market strategist (I used to be one) is to never make a prediction which features both an exact time and market level. This is why you hear things like, “I think the market will eventually reach the 1,200 level” or “I think the market can be higher by year end,” but rarely, “I think the market will reach 1,200 by year end.” Abby Joseph Cohen, being the seasoned strategist she is, finesses this by providing a range for her year-end forecast. Anyway, I think her comments are significant because I think this is the first time a high-profile strategist has come out and said that the bear market is over.

I tend to agree with her, and given the large amount of skepticism out there, the huge mountain of cash still on the sidelines and the massive amount of pain investors experienced during the bear market (hence their reluctance to jump right back in), I can see the market continuing to climb this wall of worry.