When is the Right Time to Sell a Stock?

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

Matthew Coffina, CFA 23 February, 2015 | 11:32AM
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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.

Before You Sell

Question: Matt, what are the key things that investors should keep in mind before exiting a stock position? Is a big sell-off or run-up in the stock enough to raise a red flag indicating that you should get out?

Coffina: The key thing to keep in mind is how a stock's price compares to its intrinsic value. This is true both on the upside and the downside. Say some news comes out that a company's margins are going to be much higher than other investors previously anticipated, than you previously anticipated, and the stock runs up 20%. Is that a time to sell? Well maybe the fair value estimate on that stock is actually up 30%, in which case it could be an even bigger bargain than it was before the news was released.

Similarly on the downside, it depends on why the stock sold off and what the new fair value estimate is. If intrinsic value doesn't change and the stock goes down for no good reason, that might actually be a time to consider buying more, rather than selling just because the stock is down.

Stop-Loss Orders

Question: What do you think about using a stop-loss order and cutting your losses after 20%, for example?

Coffina: That's not a good strategy in general. Peter Lynch once said, "Show me somebody that has a stop-loss order of 10% below their purchase price, and I'll show you someone that's guaranteed to lose 10%."

Stock prices move for all sorts of reasons. We have flash crashes every once in a while where the stock price is down for no reason at all. The stock price might recover within an hour. But if you had a stop-loss order sitting out there, it's quite possible that your shares will be sold at that low price, and then you won't have an opportunity to buy back.

Similarly, stocks often make their biggest moves after hours when earnings are released and other news comes out. In those circumstances, a stop-loss order won't help you at all. The stock could open 20% down, and then a 10% stop-loss order is going to cause you to sell your shares for a 20% loss. That's not really going to save you any money.

Protecting the Downside

Question: One of Warren Buffett's stated rules is that he never wants to lose money. How should investors think about protecting the downside and making sure they're not going to ride a stock all the way down?

Coffina: I don't think Buffett meant that you should avoid any temporary losses in stock value, because that would be an impossible mandate even for the greatest investor of all time. I think Buffett is really talking about a permanent erosion of intrinsic value, which is to say that you buy a stock for $100 a share and the actual fair value estimate of that company falls to, say, $80 a share and never recovers. That would be a permanent impairment of capital, and that's what we want to avoid.

I think the best way to avoid that is to look for companies with wide and expanding economic moats. On the other hand, try to avoid companies whose competitive positions are deteriorating, what we would call companies with negative moat trends. These companies are in a very weak competitive position, their economic moats are shrinking, and they are likely to see a decline in intrinsic value over time. As Buffett says, time is the friend of the wonderful business and the enemy of the bad business.

Admitting Mistakes

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—recognising 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 recognise 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 recognise 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 recognising 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.

Too Good to Be True?

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 got away from you? When is the right time to sell those?

Coffina: Those are very tough situations as well. Warren Buffett says that his favourite 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 (overvalued), 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.

Note: This Q&A was adapted from a 2013 interview and reviewed for clarity and content.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Matthew Coffina, CFA  is a stock analyst at Morningstar.