Know When to Fold 'Em: Why Selling at the Right Time Is So Hard

Know When to Fold 'Em: Why Selling at the Right Time Is So Hard

You got to know when to hold 'em, know when to fold 'em,
Know when to walk away and know when to run.
You never count your money when you're sittin' at the table.
There'll be time enough for countin' when the dealin's done.

Kenny Rogers makes it sound simple in "The Gambler," but when it comes to "knowing when to fold 'em" in investing, determining when to sell a stock can be much more difficult than picking a stock to buy. There are many reasons for this; here are a few.

  • Emotions. Despite their honest efforts to leave emotion out of investing, investors often find themselves selling too soon based on a knee-jerk reaction to bad news that doesn't change the company's long-term prospects -- or refusing to sell due to an attachment to a stock despite a deterioration of its long-term outlook.

  • Anchoring and other biases. As detailed in a series of articles by Fool contributor Brian Stoffel, investors can often be their own worst enemy by focusing on data points that shouldn't factor in investment decisions. If a stock has dropped by 50% in the past year, many shareholders will be thinking, "The stock is so cheap now that it can't drop any more," and, "I'll sell when it gets back to the price I paid." Looking backward instead of forward can be a dangerous mistake for investors.

  • Drawback of buy and hold. The benefits of a long-term buy-and-hold strategy have been widely popularized by investing greats like Warren Buffett and Benjamin Graham. Buy-and-hold investing has helped many investing greats achieve staggering success, and it spares average investors from many of the brokerage fees, capital-gains taxes, and other transaction fees that can erode their returns. While this strategy has proven successful countless times, investors' efforts to stay true to this philosophy can keep them from selling when they should.

In short, it's not easy to identify when it is time to sell a stock.

Focus on the investment thesis

Every investor has a slightly different take on what criteria drive the decision to sell a stock. While Warren Buffett has famously said that his "favorite holding period is forever," there are certainly instances where selling a stock is necessary. Here are a few examples using stocks recently sold from my personal portfolio.

The investment thesis is broken. Every successful investor should develop a simple investment thesis prior to purchasing shares of a company. As more information becomes available over time, this thesis may prove to be broken as a result of unexpected changes in the competitive or macroeconomic environment, management failures, or simple investor error. One example of a broken thesis is an investment in Itron based on the company's ability to take advantage of "inevitable trends" of rising demand for water and scarcity of energy resources. The thesis made sense initially, but it hasn't turned out well thus far as the company bounces near five-year lows while the overall market has surged to all-time highs.

Competition and government budget tightening have prevented top- or bottom-line growth despite the ongoing long-term view that Itron's smart-grid capabilities will be a part of the growing need for smart meters. To make matters worse, there is no known timeline for when to expect a return to the growth that the investment thesis was based upon. Potential doesn't necessarily translate into investment success, as is clearly the case with Itron.

Management integrity is questionable. There are few reasons to invest in a company at which there are questions regarding management's integrity. There are too many good companies out there to justify the added risk that fraud or other unscrupulous acts will drag down the shares' performance. This approach sounds easy enough in theory, but in an era where anonymous articles written by biased short-sellers can allege just about anything with a minimum amount of support, it can be difficult to separate short attacks from serious concerns about management integrity.

A good example of this is Ebix , a company that has been the subject of quarterly short attacks for years. While many of the attacks have been pretty weakly supported, the fact remains that the company has acknowledged that it "was notified that the U.S Attorney for the Northern District of Georgia had opened an investigation into allegations of intentional misconduct."For investors who looked past the anonymous attacks, a terminated merger as a result of ongoing SEC investigation should be sufficient reason to look for investment alternatives without the added drama of potential accounting issues.

There are better options available. Most investors have limited funds to invest and limited time to devote to researching companies, so the decision to sell a stock often comes down to the simple conclusion that there are better alternatives for those finite investment dollars and research hours. Investors may find that a company that has limited opportunity to grow, struggles to keep up with the competition, or carries more risk than alternative investments may not be worth a coveted space in a portfolio.

I recently made this determination with longtime holding Dolby Laboratories . Dolby is a well-run business led by a visionary founder (with significant insider ownership). It requires minimal capital and continues to be an innovative leader in its field. These qualities, combined with a pristine balance sheet, had staved off the urge to sell for a couple of years as the underlying business essentially treaded water; the company still struggles to grow revenue from mobile devices and other products enough to offset the decline in revenue from sagging PC sales. The result? Another quarter of year-over-year declines in both revenue and earnings. With no catalyst in sight to reverse this course, there are a number of more compelling investment options available with a higher likelihood of market-beating returns.

No mention of valuation

Among the reasons to sell discussed in this article, I intentionally left out valuation. While valuation is certainly relevant in making investment decisions, I'd argue that trailing-12-month metrics are much less useful than a company's future value. This is a lesson that almost has to be learned the hard way; I just learned it when I decided to sell Netflix within the past year based on valuation concerns.

In reality, the original investment thesis for Netflix was still intact thanks to tremendous subscriber growth and the added benefit of award-winning original content. One look at all of the positive news on the company (and its stock chart!) makes the decision to sell based on trailing valuation metrics look like a big mistake thus far. In this case, it seems it would have been much wiser to "hold 'em" rather than "fold 'em."

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Brian Shaw has no position in any stock mentioned above. The Motley Fool recommends Dolby Laboratories and Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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