Knowing When to Sell a Growth Stock

Knowing When to Sell a Growth Stock

Hailed by The New York Times as a "guru to Wall Street's gurus," value investing expert Bruce Greenwald takes some time to offer his insight and advice to The Motley Fool. A professor at the Columbia Business School, Greenwald has also authored multiple books, including Value Investing: from Graham to Buffett and Beyond.

If we can't value growth stocks, or rely on price-related multiples, how do we know when to sell a franchise business? Greenwald shares his views and discusses why many investors -- including Warren Buffett -- miss out on the right time to sell.

Full transcript below.

Bruce Greenwald: The bad news is that...

It's what, really, people like Warren Buffett, who have pioneered the process of investing in these franchise businesses -- and it's only the franchise businesses where growth has value, because that's where you earn above the cost of capital.

I mean, if a market grows with no barriers to entry, you just get a lot of entry. It drives prices down, and it eliminates the profitability, so you have to have the barriers to entry.

What they always said is, you can make a sensible buy decision. It is incredibly difficult to make a sensible sell decision. That's because you have to pick a price at which to sell. I get a price from the market today, and I can calculate, just as I did for Nestle and other things, a return at that price.

But when I decide to sell Nestle, I've got to pick a price to sell it at. That, of course, gets into all the problems of at what point it's overvalued or not. There, I think what you have to do is not hold on too long. That's the temptation.

That's what kills Buffett when he won't sell Coca-Cola at $80 a share. It's what kills him when he holds onto the Washington Post for too long.

It's a very difficult decision to make, but I think the evidence is that you've got to be pretty conservative about it so that if the dividend return for Nestle, for example, plus the buyback return, goes down to 3.5, even though the overall return may be reasonable relative to returns on fixed income, you're still going to have to sell at that point.

But I think what we've learned in, as I say, as much the tech bust as the current crisis, is you cannot effectively put numerical values on stocks, or have price-related multiples on stocks, that are growth stocks.

If you'll let me, I'll do just one more example that shows you.

Matt Koppenheffer: Sure. Yeah.

Greenwald: People got really excited about newspapers when they got down to, like, 8 times earnings.Eight times earnings is an earnings return of about 12.5%. They were distributing 80% of that, so it was a 10% cash return, either buybacks or dividends.

In spite of what investments they were doing, those businesses were shrinking at at least 5% a year in terms of their earnings power, and they had no good alternative investments. They tried and failed, and the basic businesses were shrinking. You had all the loss in operating leverage, because you had this big, fixed-cost infrastructure to fill and sell newspapers, and a shrinking revenue base against it.

Koppenheffer: Not an ideal situation.

Greenwald: Yeah, not an ideal situation. But let's say it was 7% a year, which means it takes 14 years for it to fall in half. You start with 10 and subtract seven, that's a 3% return, which is a substandard return in a very high risk investment.

When people are excited by the multiple, which has never been as low as eight, if they do the return calculation, they'll understand that the multiple is almost completely uninformative, that you have to look at the implied returns. That's what I think people have learned to do in these franchise stocks.

More stocks fitting the mold
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Matt Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola. 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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Originally published