The most successful investors go into an investment with an exit strategy in mind. We see evidence of that all over, from names like Warren Buffett, George Soros and Benjamin Graham through to Peter Lynch and John Templeton.
Yet, Warren Buffett once said, "Our favourite holding period is forever," which, at first glance, appears at odds with his actions, because Buffett sells, as in 2007 when he disposed of his shares in PetroChina Company Limited (NYSE: PTR). Private investors could easily misinterpret that quote and hold grimly onto shares through all events. Doing that is not such a good idea.
What Buffett really meant
I can understand Buffett's desire to hold investments forever; it must be hard finding new homes for the billions he's managing and more convenient if the original investment kept on performing. But the truth is a number of criteria can trigger a Buffett sale.
Perhaps a fuller statement could be "our favourite holding period is forever… but, in practice, we will sell if any of a number of conditions is met".
To draw on a trading maxim, we should 'plan our trades and trade our plans', which means defining the exit criteria before investing and acting on that by selling when conditions call for it.
Beware 'buy and hold'
The buy-and-hold argument is compelling. Most great investors have advised us to take a long view with investments, to sit on our hands, to let winners run, and that the greatest returns come not from buying or selling, but from holding on.
In essence, I think it is good advice. But I think it can be misinterpreted to mean 'buy and hold… and never sell'. The results of such interpretational error can be calamitous for investors.
Imagine how buy-and-hold-forever investors might have fared holding the likes of AMP Limited (ASX: AMP), Aristocrat Leisure Limited (ASX: ALL), Alumina Limited (ASX: AWC), Bluescope Steel Limited (ASX: BSL), Lend Lease Group (ASX: LLC), Suncorp Group Ltd (ASX: SUN), Tabcorp Holdings Limited (ASX: TAH), Qantas Airways Limited (ASX: QAN), Paperlinx Limited (ASX: PPX) and Macquarie Group Limited (ASX: MQG) through the last decade.
All these stocks are trading at significantly lower prices today that they were 10 years ago.
Buy to sell
The reason for any investment is to get back more than what you put in. So it makes sense to have selling at a profit in mind from the beginning. It also makes sense to aim for achieving as much return as possible, which suggests that it's a good idea to run your winners.
So if anything threatens that outcome, it might be time to sell. For example, you don't want to be holding grimly on to cyclical companies as they roller-coaster up and down economic cycles, or clinging to once-bright investments that have stopped growing, or collecting a steady dividend stream as the share price steadily declines, thus annulling your gains. There's no point in any of that.
When to sell
Warren Buffett sold his investment in PetroChina because of valuation. In other words, he thought the share price overstated the intrinsic value of the company. He didn't cling to any idealistic notion of being a buy-and-hold-forever investor. No, he saw overvaluation as being a threat to his seven-fold gain on the shares, so he sold them and took the money without a second thought.
Here are some reasons that I'd consider selling a share:
- The business model changes.
- Deteriorating cash flow.
- Rising debt.
- Something happens to cast doubt on the directors' integrity.
- The investment shows a large profit.
- Return on Equity falls below 10% with no sign of improvement.
- Net profit margin falling consistently or significantly.
- Better opportunities elsewhere.
The Foolish bottom line
As well as selling out altogether based on pre-determined exit criteria, many investors reduce their holding, or top-slice, as share prices rise. That locks in some of the profit thus reducing the risk of reversals wiping it out. Running the remainder for further gains at reduced risk is then an option.
Overall, it's important to focus on when to sell shares as much as it is on when to buy them. Having an exit policy in place beforehand puts you in control of that.
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Motley Fool contributor Mike King doesn't own shares in any of the companies mentioned. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.
A version of this article, written by Kevin Godbold, originally appeared on fool.co.uk. It has been updated by Mike King.