When to Sell

The Small Cap team dig into the essential skill that is knowing when to sell. This is the third part of a 3-part series covering when to Buy, Hold and Sell equities. Click here to read Part One “When to Buy” and Part Two "When to Hold".

SUMMARY
When to sell a stock is a key part of any investment process. We believe there is one main reason all investors should sell a position, when the investment case is no longer working. Knowing your initial investment thesis and what constitutes a move away from this thesis are key to understanding when to sell. In this article we discuss the art of selling and a stock we sold from the Small Cap portfolio. 

Our favourite holding period is forever, or is it?

“Our favourite holding period is forever” has to be one of the most quoted of Buffet’s list of wonderfully simple yet complex quotes. Whilst we agree with his way of thinking here, in our experience investing is usually harder than just buying a stock and holding it forever.  The main reason for this is that to hold a stock forever suggests that a company’s management team/s keep delivering on shareholder expectations year in, year out, and also management generation in, management generation out. Whilst we occasionally come across a company we believe is well placed to achieve this, in reality this is extremely rare to find. 

The one key reason to always sell 

We believe there is one key reason when you should always sell a stock: when you are wrong. 

Investing is an incredibly humbling pursuit as even the best investors in the world will be wrong a lot of the time.

"In this business, if you're good, you're right six times out of ten. You're never going to be right nine times out of ten."
- Peter Lynch

A lot of investors struggle to come to terms with this investment fact of life, and many never do. However, in our experience, to accept this truth is to allow yourself to prepare for the inevitable.

"If you are truly prepared then you should be prepared to be wrong."
- Ian Cassel, Micro Cap Club

​Being prepared for being wrong allows you to take the necessary action to limit your losses when it happens, and limiting the losses from your losers is arguably a bigger driver of long term investment returns than maximizing the returns from your winners. 

The key to selling when you are wrong is to know exactly what being wrong looks like in each particular stock, and this comes down to knowing what your investment case was at the time of investment. We keep detailed notes so we can reflect backwards with clarity, and move forwards with focus and discipline. And we also take note at the time of investment of what future “deal-breakers” may look like in any given stock. If and when any of these events do unfold, we will have a significant timing advantage versus the market in understanding what it means. 

Are there any other reasons to sell apart from being wrong?

Yes, in our opinion there are 2 more reasons to consider selling:
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1. Over-valuation: As value based investors, a happier case to be selling is when a stock has risen to the point that it materially exceeds our valuation target. This may be when it is trading above its historical earnings multiple range at a level we feel we cannot be justified, or if it is trading at a significant premium to our assessment of its asset backing. 
2. Capital requirements: The only other reason we believe in selling is when you have found a better investment opportunity and need the capital in order to buy that stock. 

Once you have decided to sell, move fast

“Your first loss is your best loss” is one of those pieces of advice we are all given when we begin our investment careers but it harder to put into action than it may appear. To sell quickly requires an early understanding versus the market that your investment case has gone off track, and the ability to disconnect yourself from any emotional biases, and thus to sell without further ado. 

Hard as it is, we believe that once you know you are wrong selling quickly is generally the right strategy.

"Take your losses quickly and your profits slowly because your objective is not just to be right but to make big money when you are right."
​- Bill O'Neil

Learn your lessons and then never look back

In the cases when we have sold stocks because we were wrong, we analyse where we have gone wrong and the lessons we can learn, and then we never look back at those stocks. Once we have got it wrong once the chances are higher than normal that we will get it wrong a second time if we were to revisit those stocks (no matter how tempting it may be). We have heard those dangerous words “it’s different this time” uttered too many times in the face of contrary evidence to trust ourselves to revisit previous mistakes. It no longer matters what happens to those companies from your perspective looking forward. The best thing you can do is to focus on your present investment portfolio with a long term view to the future performance. 

Portfolio Example: Reverse Corp (ASX:REF)

We were historically shareholders in Reverse Corp (ASX:REF). Our investment case for the stock was based upon management recognising that the company’s upside potential was highest in a break-up scenario rather than in continuing to invest in their sub-scale online contact lens business. When it became clear that management were in fact committed to drawing down on their substantial cash reserves to pursue the online contact lens expansion strategy which we felt was value destructive, we immediately sold our stock. In hindsight this was the right thing to do from a performance perspective, but more importantly it also was the right thing to do to ensure our investment process has integrity. 

CONCLUSION
Whilst selling is a key part of our investment process we aim to do so only when we have made a mistake, when a stock becomes over-valued, or when we require capital for a better idea. All 3 scenarios are natural parts of the investment process. When an investment case is not working, we aim to take corrective action as soon as possible. Reverse Corp is a great example of a stock we sold quickly and for the right reasons.