As a value investor, my mentality is to only invest in a company if I can see myself holding onto its shares for the next few decades. In other words, selling my stocks isn’t an option. However, I could’ve made an error during my analysis, which lead me to invest in that company to begin with. I believe that it is important for everyone buying stocks to know when to sell them. After doing countless hours of research to figure out when Warren Buffett (billionaire investor) sells his stocks, I came across the “Warren Buffett Accounting Book” written by Stig Brodersen and Preston Pysh. When I read this book, I got a lot of my questions about Buffett’s investing strategies answered. In this blog post, I will go over 5 fundamental questions that can help you decide if it’s time to sell a stock or not. These are also 5 of the big overarching questions that help Buffett decide if it is time to pursue other investments.
- Is the company still managed by vigilant leaders? Here is what bad leadership looks like: the management is taking on more and more debt, to the point where you think the debt obligations would prevent the company to be agile during downturns in the market; the return on equity (i.e. calculated by dividing net income by shareholder’s equity) is not strong and consistent; management’s incentive plans focus on stock price advancements, rather than long term growth of the company; current ratio (i.e. calculated by dividing current assets by current liabilities) stays below 1.0. All of this is a recipe for disaster in the future. If you notice that the captain of your ship is taking your ship towards a disastrous storm, it would be foolish to not ditch that ship when the weather is nice and there are other ships with better captains nearby.
- Does the company still have products and services that have long term prospects? As Warren Buffett says: “Will the internet change the way we use the product?” If your answer to Buffett’s question is YES, then you might want to start looking for other investment options. If your product/service is losing its competitive advantage (i.e moat), then that’s a wake up call.
- Are the company’s earnings still stable and predictable? It is important that the company demonstrates a consistent earning capability, book value growth, and a stable return on equity over the years. A company should always aim to increase the wealth of its shareholders, which means that the company’s assets must increase and/or the company’s liabilities must decrease. These changes must come from its earnings, and not borrowed money (debt). So, if you notice that the company’s earnings are dwindling and the company is not addressing that issue, then you should start looking around for other attractive investment opportunities.
- Based on the projected cash flow, what kind of return do you expect at the current trading price? After performing a Discounted Cash Flow (DCF) analysis on your investment, if you notice that a 1.5% discount rate gets you to the current trading price, and a 10 year US federal note (zero risk investment) yields you a return of about 2.6% annually, then you might consider investing in the safer option with higher return. You want to make sure that as the trading price increasing, the cash flow is growing accordingly. If the price increase is unjustified and your margin of safety is not adequate, you should consider decreasing your holding.
(Note: I would recommend this free calculator. Although it doesn’t take into account the free cash flow, it does take into account the growth of book value (i.e net worth of the business) and dividends paid. I like this free calculator much more than the calculators that just take into account the revenue (i.e. income) of the business.)
- What will the tax implications be? For an investor, tax is the biggest expense. The idea is to let your investment grow and compound for long period of time, and prevent government from taking its cut. This way you will be rewarded by higher relative returns and lower tax rates. So, before deciding to sell your existing investment, you need to know what kind of taxes you will be paying and if it is worth going after that “other” investment. Let me illustrate. If your current investment is giving you a 4% return, do you think it is beneficial to get out of that investment and pursue another company which provides a 5% return? Yes, it is a higher return. However, always take into account the taxes you would have to pay. In other words, pursuing that 5% return might be a bad decision at the end of the day.
Hope you learned a little and found this blog post helpful. We talked about the 5 questions that could help you decide if it is time to get out of an investment or not. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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