When should you sell shares?
Plenty of people will tell you what to buy but few weigh in on when to sell.
Mentioned: Automatic Data Processing Inc (ADP)
There are lots of opinions about investments that people should buy. There are also lots of opinions about what to avoid. We hear these opinions in the media, from investment professionals and from our friends and families. Some of us have even had the pleasure of receiving unsolicited opinions from complete strangers.
The one thing that nobody ever tells you is when to sell something in your portfolio. I get this question a lot from subscribers to Morningstar Investor. They ask me if they should sell shares that our analysts think are overvalued. They ask me for signs to look for when determining if a position should be closed. Today I am going to attempt to answer that question.
I am going to try to answer that question using my own portfolio as an example. I am not doing that because anyone reading this should do what I do or because anyone should hold the same positions. I think personal examples are helpful as they cut through the theoretical way in which so much investment guidance is provided.
The real world and investing textbooks are miles apart. The real world is messy. It is full of emotions as we face the temptation of instant riches from a can’t miss investment and the fear that the market is on the precipice of disaster. The more we can mix theory and the real world the better the chance we have of reaching our goals. I will get to the real world. First the theory.
Why do we want to buy undervalued shares?
Buying significantly overvalued shares lowers the chances of good investing outcomes. Investor expectations are baked into share prices. High share prices means that investor expectations are high.
Those expectations may be completely unrealistic or they may be an accurate assessment of a bright future. The former often means shares will fall significantly when the market comes to the realisation that the future prospects don’t look quite so bright. In the later, simply meeting high expectations will result in average returns. Those expectations have already been priced in.
The beauty of buying undervalued shares is that the expectations are easier to beat. If investors are too gloomy about the future exceeding those low expectations generally results in strong returns.
Individual shares and the market in general tend to gravitate between periods of being overvalued, undervalued and fairly valued. That is because investors tend to be driven by emotions. Sometimes we collectively get overly excited about shares. Sometimes all we see is doom and gloom.
These swings in emotion tend to be reinforced by changes in prices. And the price changes exacerbate these swings. Our confidence in future returns goes up after periods of strong returns. More investors jump into shares which causes them to climb even higher. When prices fall it reinforces negativity. More investors expect the drop to continue and they sell shares. The market falls further.
More on valuation in this episode of Investing Compass.
If buying undervalued shares increases the chances of good investing outcomes and buying overvalued shares decreases them does that mean that overvalued shares should be sold? Not so fast.
Don’t take your cues from professionals
A professional investor in charge of a managed fund would likely argue that the right decision is to sell overvalued shares to buy undervalued shares. Many individual investors take their cues from how professionals invest. This ignores the vast differences between the two sets of investors.
Trying to replicate the approach of professionals means we are giving up our biggest advantage as individual investors – taking a long-term approach.
Fund managers may say they are long-term investors but many of their motivations are decidedly short-term. Underperforming the index for even a single year can cause investor outflows. This focuses fund managers on relative performance over shorter time periods.
Fund managers are also agnostic about after-tax outcomes. The tax is paid by the end investor and won’t impact the performance of the fund. This indifference to tax removes any impediment to selling an overvalued share that has appreciated significantly.
Individual investors are different. Our focus should be on achieving our goals. For most investors the year-by-year performance against an index is irrelevant. Trying to avoid short-term underperformance is not a reason to dump a great holding. It also allows us to focus on the outcomes that matter. That is after-tax returns. Constantly generating capital gains through short-term trading is not a recipe for success.
My own portfolio as an example
Any decision to buy or sell should start with goals and an investment strategy designed to accomplish those goals. My goal is to generate income over the next 30 years. My investment strategy is reflective of that goal.
My strategy is to create a stable and growing income stream by investing in shares and ETFs. Identify securities with above average, sustainable and growing dividends by focusing on quality companies with sustainable competitive advantages, strong financials and low business risk.
It would be remise not to add that the following list does involve some selection bias. These holding didn’t make it into my top 10 by chance. They all performed relatively well which is why they became top 10 holdings. This is a snapshot in time. This list does change based on fluctuations in prices. I am not adding to the positions that have longer holdings periods.
There is nothing wildly overvalued in my portfolio but there is also nothing that is shockingly cheap. This is however just a snapshot and shares tend to fluctuate between periods of being undervalued and overvalued over time. We can use ADP (NAS: ADP) as an example. Between 2016 and 2020 the shares were overvalued by at least 27%.
Perhaps this was an opportunity to sell and look for undervalued opportunities. Yet despite being overvalued the company still fit my criteria. It has lower levels of business risk and financial risk as demonstrated by the Medium Uncertainty Rating from our analyst. The company also continued to raise the dividend – something that has now happened for 48 straight years.
The sources of sustainable competitive advantage still applied as customers faced high switching costs of moving their payroll services to a competitor. In short, nothing about my original thesis had changed. The company still aligned with my investment strategy. Unless either of those conditions no longer apply I wouldn’t think of selling.
The downsides of selling are considerable. The first is tax. We can use an example to illustrate the impact that taxes have on returns. If an investor is fortunate enough to buy a company that has doubled in price we can explore the tax consequences of selling.
- Purchasing a share for $1000 and selling it for $2000 with a holding period of less than a year at a 37% marginal tax rate results in capital gains of $370. That would require the new investment opportunity to outperform the sold share by 18.5% to just break even assuming the taxes are paid separately. If the taxes are paid out of the gains and only $1630 is reinvested the return would have to be 22.69% to break even.
- If the same scenario is run with the long-term capital gains discount applied to shares held for more than a year the taxes would be $185. In that case it would require the new investment opportunity to outperform the sold share by 9.25% to just break even assuming the taxes are paid separately. If the taxes are paid out of the gains and only $1815 is invested the return would have to be 10.19% to break even.
That is a high hurdle rate and it does not include any transaction costs associated with the trades.
There are other reasons to not sell. As investors we want to truly understand the businesses that we own. The more we understand a business the less likely we will panic and sell when the price plunges in an irrational way. Longer holding periods gives an investor an opportunity to truly understand a business.
There are downsides to this of course. Investors can form attachments to certain positions. Being a good investor means trying to remain as rational as possible while acknowledging that complete rationality is impossible. Forming an attachment to a share is a form of irrationality. However, when combined with a clearly defined investment strategy a long-holding period is a more reasonable approach than the trap of constantly churning a portfolio. A trap that many investors fall into.
This means accepting that a position may underperform for years. This is done with the confidence that over the long-term a great company will be rewarded. It is done knowing that what matters is after tax returns adjusted for inflation. And it is done knowing that other factors besides performance may play a part in achieving your goals like lower volatility or generating income.
Valuation is one input into a buy and sell decisions
The last point to make about valuation levels is that simply reacting robotically to changes in the relationship between price and fair value is to ignore common sense. Investing is both an art and a science. It is hard to estimate the fair value of a share. It involves making a series of assumptions about an unknowable future. At Morningstar this is done using a consistent methodology and the rigor of peer review. Yet it is still a glimpse into the unknown. This is why a margin of safety is so important in investing. It accounts for the unknowns.
Our analysts do this for 1600 shares globally. Only a small fraction of which will end up in my portfolio. I am not running a quantitative fund where I buy all of our undervalued shares and automatically sell out of them when they become overvalued. I am selecting a relatively small number of shares based on several attributes. The relationship between price and fair value is only one.
Looking over my top 10 holdings I find some measures of consistency. They all have moats. They all have the two lowest levels of our Uncertainty rating. They all pay dividends. This is despite the fact that I bought all but two of these positions long before I worked at Morningstar and used our ratings as an input into my decision making.
All we can do as investors is make sure we have established the foundation needed for successful outcomes. We need to establish and document our goals. We need to write down an investment strategy that gives us a good chance of reaching those goals and select an appropriate asset allocation. Then we buy investments that fit our strategy and monitor them to make sure they continue to align with that strategy.
Then we wait. Which is easier said than done. Waiting involves resisting the temptation to constantly tinker with our portfolio. Waiting is not changing a strategy based on the latest headlines and predications from commentators. Waiting means ignoring the false signals we receive from the constant fluctuations in prices. Waiting involves patience and discipline. Two qualities in short supply.
Warren Buffett famously said his favourite holding period is forever. I’m not Warren Buffett but I’ve found the best approach is to set a high bar for myself by having a default of never selling a position. This doesn’t mean I will never sell anything. It does mean that I will think long and hard before doing it. This is my way of preventing myself from falling into the trap of over trading.
Any questions or comments please email me at [email protected]
