BI > SEPTEMBER 2004

Selling a stock is rarely easy. But the decision to sell examines the same factors used to select the stocks in the first place. Most NAIC investors become reasonably comfortable with stock selection fairly early in their NAIC experience. The same discipline can be extended to the decision process for selling stocks -- answering the challenge of reason.

Although the thought processes are similar, the decision to sell a stock can be more challenging than buying one. NAIC investors experience the discovery and ownership of growth companies. We tend to be very patient long-term investors, with holding periods measured in years. Selling can be fairly infrequent. And there's absolutely nothing wrong with that. In my opinion, though, sometimes we tend to get a bit carried away with the commitment to buy and hold, perhaps ignoring opportunities to practice effective portfolio management.

For relative newcomers to investing, the process is even more difficult because buying a stock is still an unfamiliar activity.

Buying the first stock for our family portfolio was a nightmare of sweaty palms, loss of appetite and some fainting spells. I waited until 15 minutes before the closing bell to buy that stock, and the outcome for the day wasn't pretty. I vividly recall that my wife came home from work and put our celebratory New York strip steaks back in the freezer. We dined that evening on hot dogs and beans -- by candlelight.

Fast-forward a few years to the first significant sell decision that we faced.

We had purchased shares of a technology stock in the mid-1990s that had performed extremely well. We needed some cash, and this stock was now taking up a humongous chunk of our portfolio. I had performed countless Stock Selection Guides on the company and double-checked all my figures. The expected returns for this stock were the lowest for the whole portfolio. I performed a few more SSGs while standing on my head just to make sure I was fully conscious.

Even the most optimistic assumptions for expected sales growth and profitability resulted in expected returns of less than 0 percent. I stretched my expected price-earnings ratios to levels that few stocks ever attain, and the price was still in the sell zone on my stock studies. I punched up my online brokerage account and started the transaction. My eyes kept diverting to our portfolio summary displaying those handsome annualized returns. I entered the number of shares and the ticker symbol in the box on my screen. Incredibly enough, the pulldown menu actually did include a sell option.

Pangs of guilt engulfed me again.

This stock had been very good to us. It was like a member of the family. This was tantamount to selling one of our children. Or was it? I took several deep breaths. The next selection displayed a summary of the transaction I had started.

I took a walk to get a drink of water and eased back into the office to find that my computer was still awaiting my next instruction. The dreaded Sell button was highlighted and ready to make it so. I thought about waiting for the price to nudge upward enough to cover the $19.95 commission.

A burst of adrenaline and a familiar feeling returned. Memories of that first stock purchase flashed before me. I resisted the urge to check the ticker tape one last time and lunged at the Enter key. "Would you like a confirmation?" the Web site asked as if to taunt me further.

The pangs returned. Of course, the stock price had proceeded to increase in the meantime.

This may seem a little overly dramatic to some of you. But chances are that many of you can relate to these emotions and you find the decision to sell to be most challenging.

More than 10 years of NAIC-style investing have taught me that it does not have to be like this. Pure and simple, the decision to sell a stock need not cause such suffering and angst. Selling can be done very effectively, but it's important to have a reason for taking action. The reason should be developed with long-term considerations.

The Foundations of Reason

I have studied the works of George Nicholson, David L. Babson, Brad Perry, Phil Fisher, Benjamin Graham and several other legends of investing. There is hope and refuge. It is possible to minimize, or control, the influence of emotion in the decision-making process. It is possible to heed certain guidelines hewed from decades of experience in portfolio design and management.

NAIC literature frequently gives seven reasons for selling a stock:

1. Sell because an issue of equal or better quality offers the potential for higher returns.
2. Sell because of an adverse management change.
3. Sell because of declining profit margins or a deteriorating financial structure.
4. Sell because direct or indirect competition is affecting the prosperity of the company.
5. Sell because a company has great dependence on a single product whose cycle is running out.
6. Sell to increase quality or decrease quality as circumstances dictate.
7. Sell companies that have become cyclical and have low-growth-rate issues because prosperity is about to succumb to recession.

Three Reasons To Sell

This seems a little too complicated to me. Here are three reasons to sell that incorporate all the seven listed above.

The foundation of the three reasons is based on our understanding of why we select stocks in the first place. If we really believe that stocks become undervalued and attractive for purchase, we must also believe that they occasionally become overpriced and candidates for sale.

Our approach to investing is centered on the development of long-term expectations for the companies we own. When we study companies for purchase, we essentially answer two questions:

1. Is it a quality company?
2. Is the price right? Are the expected returns sufficient?

How do we characterize a quality company?

The company recognizes opportunity and delivers growth. The sales and earnings growth rates compare favorably with those of their competitors. Quite often, these leaders will not only capture large portions of market share, they'll also do so with leadership profit margins. They have strong balance sheets, solid track records and a high degree of predictability.

How do we know an attractive price when we see it?

It boils down to expectations. Based on our forecast for sales growth and expected margins, we use the relationship between price and earnings to establish a stock price expectation for the future. Combining this with dividend yield expectations, we build an expected (annualized) return for the next several years.

The reasons for selling are the opposite of buying -- combined with some portfolio-design considerations and the realities of life:

1. Sell because you need the money.
2. Sell because quality or fundamentals are in decline.
3. Sell because you have an opportunity to strengthen the portfolio.

The first reason is clearly a personal consideration.

There are few more powerful reasons than needing the money. Life happens. We're perpetually presented with opportunities to spend money on life's necessities. We're also presented with opportunities to celebrate life and enjoy vacations or retirement doing things that restore energy. When the opportunity presents itself, it's OK to determine the stock in our portfolios with the lowest expected returns and convert it to the currency of cash. Whether aimed at philanthropy, some peaceful moments or some form of pride of ownership, maximize your returns here, too.

What is meant by fundamentals in decline?

If the company quality deteriorates, you should consider selling. The decline in quality can stem from a change in management or a perceived threat to continued growth. It can also be caused by external competition and deterioration in margins, which reduce our expectations (and expected returns).

David L. Babson & Company's Brad Perry points out in his book Winning the Investment Marathon that the first and most important reason for selling is that a company isn't living up to expectations. NAIC investors must continuously ask themselves, "Does the company lack the strengths and favorable long-term prospects I saw when I bought the stock?"

But it pays to be patient. Perry cautions, "Investors should not rush to judgment when a hitherto strong company hits an air pocket."

One of the steadier and historically reliable gauges of quality is found in the Standard & Poor's Earnings and Dividend Rank. Most NAIC investors will find that this grade published on S&P's company reports can be an effective way to monitor the quality of their holdings. The stock rank is one of the data points available from NAIC's online Stock Selection Guide data -- making it fairly easy to stay in touch.

The S&P stock rank, which ranges from A+ to D, provides a potential method for keeping track of the overall quality of your club or personal portfolio (see S&P's Earnings & Dividend Rank). Do you remember the days when you were maintaining a grade point average? The progress report you brought home to Mom and Dad was your report card. You may also recall an occasion or two when you wished you could have eliminated one less-than-stellar result and replaced it with something stronger. But here's a secret: When it comes to investing and portfolio management, it's OK to "fix" your grade point average.

In the accompanying table we've charted a GPA for the top 20 most widely held stocks in this year's Better Investing Top 100. Note that an A+ or A nets a score of 4.0, A- delivers 3.7 and a B+ quality rank is scored at 3.3. The average grade for these 20 stocks is 3.78. (B = 3.0, B- = 2.7, C+ = 2.3, C = 2.0, D = 1.0)

The GPA for NAIC's online model Challenge Club would check in at 3.71. Taking a closer look at the top eight finalists in last year's club performance survey reveals a collection of portfolios with an overall average GPA of 3.75.

I expect that as we build a report card for some of the more successful investment club portfolios, we'll discover that GPAs of 3.75, give or take a few points, will be the norm.

What's the GPA of your club or personal portfolio?

I'm often asked what the most important thing a stock watcher for an investment club could report. I'd recommend that investment clubs monitor the quality of each holding the members report on. The Challenge Club uses a quality metric that ranges from 0 to 100, but the S&P grade can be just as meaningful.

For example, a club member could report that S&P reduced the stock rank on Cardinal Health from A+ to A since the last meeting. The club members can then explore why the rating was lowered. But the important thing will be that the club is aware of the shift in quality.

Building Better Portfolios

The third reason for selling a stock is -- quite simply -- because the action you take makes the portfolio better. This can either be an improvement in the overall quality (GPA) or a boost in the overall expected return of the portfolio.

Brad Perry points out that stocks can become grossly overvalued by our stock analysis yardsticks. Companies do become temporarily overpriced.

In an overvalued situation, the expected return can be low single digits or even negative. In these instances, it can make sense to sell the overpriced holding and replace it with a stock that has a higher expected return. The average expected return for the portfolio can therefore increase. This is a valid reason for selling.

The wrong reasons for selling include stagnant prices that lead to impatience. Home Depot is one example of a company whose stock price stagnated and remained flat for an extended period during the 1990s. Using portfolio methods based on SSG results, investors could have seen that the expected returns were continually improving as earnings advanced. Although it's always easy to be a Monday morning quarterback, patience would have paid off in this situation.

The required patience is sometimes quite difficult to muster. My experience has been that having a set of historical SSG results for the company, including a track record for the quality rating, can make it easier to be patient. Some NAIC investors evaluate companies like Pfizer in this manner today. Pfizer's stock price is virtually at the same levels as five or six years ago, but earnings have continued to improve.

The key to the whole selling decision process is using common sense. Continuously review everything involved in the process from a long-term perspective. This is rarely easy. The media focus is perpetually on what happened today, and most published forecasts are very short-term in nature.

This third reason boils down to trying to make the portfolio better from a long-term perspective. Of course, no clubs have meetings at which the partners convene around the kitchen table and declare, "Tonight our mission is to make our portfolio worse." (Although my club partners sometimes wonder about nominations I make from time to time.) The objective is to study and update our awareness of the portfolio holdings so that we make it stronger for the long run. The key principle in taking care of any portfolio is balance. As suggested here, one of the first considerations should be, Does the portfolio have enough quality?

Other questions to ask include: Are our expectations for reward high enough? How many companies are enough? Do we have some new candidates that have the right characteristics? Would buying a new stock strengthen the portfolio and support effective diversification?

So many questions. But the answers are not nearly as challenging as it may seem.

One of the best practices I've witnessed during club visits is a systematic approach to evaluating the portfolio before and after making any decision or group of decisions.

Click to enlarge.

The accompanying portfolio design guide is an example of such a process. Note that a number of portfolio characteristics are displayed on the table. The goal of the club meeting is to make decisions that will favorably affect the most important portfolio design features. The effort should be a continuous campaign to maintain the overall quality and expected returns for the portfolio.

Nearly all the investment clubs that I participate in have adopted an approach similar to this for evaluating buying and selling decisions.

A Viewpoint on Moderation

Some selling decisions are strategic and can be healthy in taking care of our portfolios. But how much of a good thing is too much?

In Winning the Investment Marathon, Perry says a turnover rate of 10 percent to 15 percent per year is an appropriate amount of selling activity for a long-term portfolio that concentrates in high-quality stocks. Perry bases this on his observations of the more successful fund managers he's watched over decades of investing.

You can calculate your club or personal portfolio turnover rate by adding up the market value of all sell transactions during a calendar year. Divide the resulting sum by the total value of all portfolio assets to arrive at the turnover rate.

Better Investing conducted a quick, nonscientific sampling of NAIC investors a few years ago in an attempt to quantify turnover rates for some of our investment clubs. We discovered that many clubs reported zero turnover. The average for clubs that responded was about 5 percent.

Are NAIC investors generally too unwilling to sell stocks?

Some investors become emotionally attached to their holdings, or think of selling as admitting a mistake.

Investors who focus on high-quality companies and have long-term goals should heed the advice of Walter Bagehot, the wise editor of The Economist for many years: "Overactivity is a very great evil."

The SSG-based methods discussed here won't naturally lead to unusually high levels of turnover. It is also essential that any decisions include an assessment of transaction costs and capital gains impact. All the NAIC stock analysis and portfolio management tools include modules that "challenge" incumbent stocks in our portfolios with replacements.

I tend to think of these decisions in the broader context of their impact on the total portfolio and not just as a stock-versus-stock situation.

NAIC investors learn that patience and the development of expectations are important. We also help people to understand that even when they do massive amounts of homework, price declines will happen.

We believe that for every five companies we build expectations for and purchase, three will basically conform to our expectations. One will exceed our expectations; this is the one we talk about at the neighborhood barbeque or at the hair salon.

And one company will greatly underperform your expectations; this is the one nobody hears about.

This challenging notion of making sell decisions comes down to three fairly simple elements. The situation becomes a lot less intimidating and mysterious if we maintain our focus on these straightforward reasons for selling a stock:

1. Because you need the money.
2. Because the quality of an individual holding is weakening.
3. Because the decisions make the portfolio better.

Selling a stock isn't easy, but it can be easier when we think about why we bought the company in the first place -- and we bring our expectations, common sense and reason to bear on the challenge.

The essential factors for long-term investment success are quite simple. Investors need to focus on a few basic principles. Complexity breeds confusion -- and often failure -- in the seemingly volatile, difficult field of investing. It doesn't have to be like this when we lean on NAIC stock analysis and three basic reasons for making decisions about our portfolios.

Mark Robertson is director of online resources and senior contributing editor for BetterInvesting. He serves as a member of BetterInvesting Magazine's Editorial Advisory & Securities Review Committee. Mark can be reached at Robertson_Mark@comcast.net.