When To Sell A Stock A Quality Stock



Selling your stocks at the right time is arguably the most challenging part of investing.
There are times when we are wrong and we must exit at a loss – that is hard and emotionally challenging!

 


There are times when we buy strong stocks that perform very well. We tend to sell these too prematurely because we doubt that the strength can last. And we miss out on the long term compounding effect of that stock.

 


Then there is the pain of watching a winning trade turn into a loser because we fail to exit at all!

 


Knowing when to sell a stock is an interesting predicament. But it is a question we must all ask ourselves as investors and be prepared for.

 

As a stock investor, what can be better than learning from the best of the best. This is why I enjoy reading about the position-selling decisions of those managers that consistently out-performers. From what I gather, investment managers sell stocks for four main reasons:

  1. they decide that there was a mistake in the investment thesis in the first place;
  2. Deteriorating Fundamentals – Narrowing moats, competition and disruption, Growth
  3. they decide there was a mistake committed by the management from a shareholder perspective (often relating to capital allocation, diworsification);
  4. Hefty valuations.

 

What better investment manager to look at than Terry Smith, manager of the outstanding Fundsmith fund; a fund that has produced returns of 20% per annum over the past decade.

For Fundsmith, selling is an extremely important decision as it has a low turnover strategy and hardly sells out of position. Smith believes in the concept of ‘doing nothing’ as he trusts the business he is invested in to do the heavy-lifting.

 

Below is a summary of the voluntary sales (excluding impacts from acquisitions or spinoffs) at the Fundsmith Equity Fund since its inception, along with the reasons behind the sales:

 

  • Kimberly-Clark (NYSE:KMB) – Incremental return on capital
  • 
Domino’s Pizza (NYSE:DPZ) – Valuation
  • McDonald’s (NYSE:MCD) – Valuation, Lack of growth
  • Schindler (XSWX:SCHN) – Valuation
  • Serco (LSE:SRP) – Poor Capital allocation (acquisition)
  • 
Sigma-Aldrich (SIAL) – Poor Capital allocation (acquisition)
  • 
Waters (NYSE:WAT) – Reinvestment opportunity
  • 
Swedish Match (OSTO:SWMA) – Competitive threat (Narrowing Moat)
  • 
Domino’s Pizza – Valuation
  • Choice Hotels (CHH) – Poor Capital allocation (new investment)
  • 
Procter & Gamble (PG) – Competitive threat
  • JM Smucker (SJM) – Margin, return on capital
  • Imperial Brands (LSE:IMB) – Growth potential, Bad Management , Thesis of Cuban cigars not playing out
  • 
Nestle (XSWX:NESN) -Poor Capital allocation
  • 3M (MMM) – Poor Capital allocation
  • Colgate Palmolive (CL) – Growth
  • 
Clorox (CLX) – Valuation

 

Looking at Fundsmith’s historical sell decisions, they have been based around Poor capital allocation, unsatisfactory growth and narrowing moats. In short, the majority of sales are due to deteriorating fundamentals.



If we had to quantify this, it appears that Fundsmith sells stocks when metrics like margin, the total return on total capital, the incremental return on incremental capital, top-line growth and valuation (e.g., free cash flow yield) head in the wrong direction.

 

It is worth to note that the sale Smith regrets the most appears to be Dominos Pizza. A high valuation here drove the decision. Hence, one key lesson can be learned: never sell a good company with good fundamentals and a profitable business model just because it seems overvalued.