With the stock market off to its best start since 1987, stocks may have gotten ahead of themselves and look primed for a correction to begin any day now. Crystal-ball gazers predicting a stock-market crash include John Hussman and Joe Granville. Consequently, perhaps we should take a look at our portfolios with the aim of raising some cash and analyze which stocks are candidates to be sold?
This begs the question of how one decides which stocks should be sold. Our Investing Daily investment experts have already provided some guidance on this question in a previous advisor roundtable. It’s a good read; I highly recommend it. But I thought it would be interesting to learn what Warren Buffett himself – arguably the greatest investor of all time – has written in the past concerning the art of selling stock. To find out, keep reading!
Selling Lessons from the Sage of
In “An Owner’s Manual,” distributed to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholders in 1996, Buffett wrote:
Do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. … Instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.
“Indefinitely” is a long time. Although Buffett was talking about his own company, Berkshire Hathaway, his advice applies to any well-run company. With regard to
We continue to make more money when snoring than when active. … [Y]ou simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.
The last sentence gives us the first clue about when to sell: if the company no longer provides “excellent economics” or is no longer run by “able, honest management.” Thus, if your original investment thesis is no longer valid, consider getting out regardless of the stock price.
Spot the Impostors
In the same 1996 letter, Buffett offers up General Motors, IBM, and Sears as companies that seemed invincible, but then suffered competitive attacks from upstarts, causing their stocks to plunge. These three companies were what he calls “impostors” rather than “inevitables” — truly great companies with insurmountable competitive advantages.
My takeaway from these examples is that while Buffett’s preferred holding period is forever, this only applies to a handful of inevitables. The rest should be sold if their competitive positions deteriorate or their stocks become significantly overvalued.
To Rebalance or Not to Rebalance
Buffett’s belief in inevitables means he also eschews rebalancing a portfolio when its winning stocks grow to be a large part of your portfolio. Finding inevitables is so rare and so rewarding that it would be crazy to sell them:
To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.
Stop Losses are a No-No
As a corollary, you shouldn’t sell a solid business just because its stock has declined. Reputable publications such as Investors Business Daily recommend setting a stop-loss at 8% below your purchase price. Buffett disagrees in his 1987 letter to shareholders:
After buying a farm, would a rational owner … start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have brought on the previous day?
The correct answer is no to both of Buffett’s questions. If a company is fundamentally sound, the price decline would make the stock more of a buy than a sell.
Let me play devil’s advocate, though, and suggest that it’s good to maintain a healthy respect for the market’s opinion of which stocks are fundamentally sound. After all, a stock could be selling off for a good reason. Just because the market is sometimes irrational does not mean that it is always so. Wouldn’t it have been nice to have gotten out of Fannie Mae or Lehman Brothers with only an 8% loss?
At the very least one should reexamine one’s evaluation of a company’s fundamentals when its stock suffers an unusual price decline.
Interestingly, in his 1989 letter to shareholders, Buffett does advocate selling early when you’ve bought a “cigar butt” — a mediocre company with one puff of pleasure left before it sinks permanently into oblivion. Such companies are out of favor for good reason and sell at very low prices. They may have one last gasp of success causing the stock to go up temporarily, and when that bounce happens, Buffett says you need to sell immediately: “Time is the friend of the wonderful business, the enemy of the mediocre.”
One last issue to consider is taxes because the only return that matters is your after-tax return. Buffett hates paying taxes and thus wrote in his 1988 letter to shareholders that he would prefer to hold on to his investments forever:
When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.
Although he qualifies his buy-and-hold philosophy as applying only to those companies with “outstanding businesses and managements,” he is loathe to sell even mediocre businesses. Principle 11 of the 1996 Owners Manual states:
You should be fully aware of one attitude Charlie and I share that hurts our financial performance: We are very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. Gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.
I’m not sure I understand why Buffett is against gin rummy behavior if it would likely improve portfolio performance, but it may be that he simply hates paying unnecessary costs of any kind. He would prefer to hold on to a minimally profitable company and hope for some improvement rather than pay taxes and the transaction costs involved in replacing it with another business that may not turn out to be any better.
Differences in Short-Term vs. Long-Term Tax Rates are Significant
When you analyze the wealth-destroying effects of taxes, Buffett’s maniacal avoidance of them makes perfect sense. For upper-bracket investors, the difference between short-term (i.e., a stock held less than 366 days) and long-term capital gains tax rates is huge: 15% versus 35%. Taxes should never be the primary driver of your investment decisions. But if you determine that a stock should be sold, timing the sale can make a big difference in your after-tax return.
If the stock is a loser, selling sooner for a short-term loss is preferable to waiting for the loss to become long-term. The reason is because long-term capital losses must be used first against long-term capital gains, whereas short-term losses can be used first against short-term capital gains. Since short-term capital gains incur greater taxes, it is better to have short-term losses that can be used to neutralize the greater taxes due on short-term gains.
If the stock is a winner, waiting for a long-term gain is preferable. An investor who sells a $40 stock with a $20 short-term gain must find a new stock that outperforms the sold stock by 21.2% just to offset the taxes! In contrast, selling the same stock with a long-term gain requires that a replacement stock outperform by only 8.1% to reach breakeven. Consequently, if at all possible, hold your winning stocks for at least 366 days and preferably much longer if the fundamentals and managements remain outstanding.