When's the Right Time to Sell a Stock? (Part 2)

Investors should compare share price to intrinsic value and also consider their alternatives before making a move, says StockInvestor editor Matt Coffina.

Morningstar Editors 04.02.2015
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One of the biggest questions stock investors have is when to sell. To shed some light on the subject, we sat down with Matt Coffina, an equity strategist at Morningstar and editor of the Morningstar StockInvestor newsletter.

Question: If you do decide that a company's story really has changed, and you think the shares do look overvalued, how do you decide exactly when is the right time to pull the trigger and sell?

Coffina: That can be one of the hardest things for investors to do--recognizing when they were wrong and when it's time to move on. We need to be careful about what psychologists call "loss aversion," where investors often don't want to recognize a loss or admit that they're wrong. It could be very damaging to your wealth to stick with a company that's not quite what you thought it was just because you don't want to recognize that loss. You could end up with a much worse loss down the road.

I think the availability of alternatives is really the key variable here. Every investment decision is relative. When you decide to own one stock, you're also deciding not to own any number of other stocks, cash, bonds, options, or whatever else. If we have a better opportunity, then that is the best time to sell and put that capital to work in something better. For a company with a deteriorating competitive position that could be worth less in the future than what it's trading for today, you'll be better off in cash today than recognizing that loss later.

The good news is that there are almost always opportunities in the market somewhere. Even if your stock is trading slightly below fair value, if you can find another stock trading at an even deeper discount to fair value or a higher-quality business, a business that is more likely to increase in intrinsic value over time, it can make sense to make that trade.

Question: We've talked a lot about businesses where the story isn't working out. But there are also some instances where the company may still be performing very well, but the stock price has really run up and the market has unrealistic expectations. How do you think about those situations, where you still think the business is great, but the valuation has gotten away from you? When is the right time to sell those?

Coffina: Those are very tough situations as well. Warren Buffett says that his favorite holding period is forever. He would rather never sell the stocks that he owns, but there can be circumstances where even a great business--one that is growing its intrinsic value, reinvesting capital at high rates of return, growing earnings, growing dividends, and so on--gets to be overvalued just because investors are too excited about the name.

I think this is where the Morningstar Rating for stocks comes into play. If a stock is rated 1 star, that would be a good time to consider moving on to other opportunities. And again, it comes down to relative valuations. If you have one great business trading at a 30% premium to fair value and another of equal quality trading at a 10% discount to fair value, that could be a good trade to make.

But that said, investors never really need to feel obliged to sell a high-quality stock. You don't need to ever sell to have very good returns in the market, and the reason is that fair value estimates tend to increase over time. Great companies tend to grow earnings and raise their dividends and so on, which means that a very high-quality company is likely to be worth much more five and 10 years from now than it is today.

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