The Case Against Profit-Taking
A question arose recently on one of NAIC’s message boards asking whether the time was right to sell a stock that had gotten a little ahead of schedule in appreciation, and whose return had declined some. “Isn’t it time to get out and take some of the profit?” [My thanks to Ron Cooper.]
The quick and simple answer is “Never sell a stock to take a profit!”
I would hastily add that this does not preclude your replacing a stock with one of as good or better quality, and a better potential for return. But there’s an important distinction between those two concepts.
Good quality companies are relatively few and far between. Assuming the fundamentals of the company you’re thinking of selling continue to be close to what they were when you bought the stock, it makes no sense to sell. When you do, you’ll only have to look for another that looks a whole lot like the one you’re selling; and you’ll pay the commissions for the round trip (sale and purchase) as well as the taxes on the gain.
If the price of the stock is so high that your potential return is too low to suit you (probably under 5 or 6 percent), then you can feel fairly confident that the company gives no reasons for the investing public to doubt its judgment. It’s proven itself to be a good quality company—the kind that you’ve always looked for. So you won’t lose money by holding it. You just may not make quite as much. So there’s no urgency at all to sell unless and until you have in mind another company whose fundamentals are at least as good, and whose market price leaves more room for gain.
Target prices are typically set by people who have no clue what the actual value of their stock is. They have simply set an arbitrary price somewhere above its purchase price so they can make a decision about selling it and capturing that profit, should the price go up to that value.
We know what the true value—rational value—of our shares are. And it’s a moving target. As the earnings grow, so does the reasonable price go up because it’s related to how many times earnings someone would pay for the stock (its PE). We set no target price; but we do set a target return. So long as we can reasonably expect close to that return, there’s no need at all to think of selling.
The bottom line: As a long-term investor, your goal is to accumulate a portfolio full of winners and be able to comfortably sit back and let those companies you own a piece of earn money for you. If you sell all your winners, you’re left with a portfolio full of losers! Is that where you want to be?
People are trying to assimilate the information given to them by their broker and by what they are learning in a fundamental investing class.
The broker wants to give them a target price for three reasons.
First, it gives him a very important role in their ability to invest.
Secondly, it generates commissions for him both on the sale of the owned stock and on the purchase of a new stock.
Lastly, when you sell you mentally lock in a winning decision. We tend to forget the bad decisions and choose to remember the good decisions.
So the target price make him an integral part of their investing decisions, makes him money, and gives the investor a feeling of success.
I have friends that insist on day trading. For them I suggest they pick a stock that has good historic fundamentals, a bright forecast future, and the currnt price is below its rational value. I figure if they are buying a quality stock that is currently undervalued by the market (rational value) they should be able to hold the stock until it goes back up a little.
The saying goes In the short term the stock market is a voting machine, but in the long term it is a weighing machine. Short term prices vary with the fear and greed in the market; long term growth varies with the fundamentals of a company.
I’m hoping to introduce them to fundamental analysis and give them some basis for day trading. They still have to look at the time they spend, brokerage fees, taxes, and year end tax accounting costs. If they “discover” short term trading isn’t very successful when you factor all of these in, they are already familiar with fundamental investing basics and it’s easier to draw them into long term fundamental investing.
There are many people who actually enjoy the rush that goes with the risk of dat-trading, even if the odds are against them. It’s doubtful you’ll every convince these people that they should “convert” to investing from their gambling. (Fortunately for us, they tend to drive the fluctuations that permit us to pick up good companies at bargain prices.)
But I believe that the majority of people now “investing in the stock market” would choose to commit their nest eggs to that practice if they were only aware that a more dependable way to earn money with their money were available to them, as it is.
On the other hand, if you refuse to sell a stock when it’s trading at far above a sustainable Price/Earnings (PE) level then you will never benefit significantly from PE expansion. If you rely entirely on earnings growth to produce price appreciation, I believe you will have virtually no chance of doing better than a low-cost index fund investment.
-Jim Thomas
Jim,
Of course you’re right. But the issue isn’t a “pass/fail” issue. It’s a matter of degree.
As a practical matter, I have always suggested in my classes and written comment, that your first exposure to the prospect of replacing an overvalued stock is when the return and risk exceed your thresholds, whatever they might be. For me, I will take a look at the possibility when the return goes below 10% and the risk above 50% (U/D = 1:1). Those figures will be based upon the modest estimates of earnings growth and forecast PE that I used to buy the shares.
The next step is not to replace the shares but rather to look at the actual growth and the actual PE to see if either or both are substantially higher than my original estimates. If so, I will then raise my growth and/or PE estimates——usually to no more than half of the difference between my original estimates and what’s actually happening.
When I do so, the return and risk will generally come back into a range that’s acceptable. And I will be able to have the benefit of keeping the shares longer and enjoying the growth I bought the shares for.
The next exposure is, again, when the return and risk fall below my thresholds again. And, again, I’ll do the same analysis, raising the growth and PE figures to no more than half the difference.
At some point, the return and risk will be below my thresholds and there won’t be any more room to amend the judgment. At that point, it makes sense to me to replace the shares. But, under no circumstances will I sell a good company without having another to put the money into immediately.
To me, this process milks the most out of PE expansion and I don’t get out before I have gotten the most out of the stock.
It’s baby steps.
They have to understand the concept of “quality” before we look at P/E expansions and contractions.
At a recent educationa fair I ask the audience if they’d heard of Ellis Traub’s “Barbed Wire Fence.” Virtually everyone knew this admonition.
I then asked them why you recommended it; no one knew.
They didn’t understand the potential return was locked in step to the forecast fundamentals which are based upon the stock’s prior peformance. Poor quality equates to poor predicatbility so that projected rate of return is not very reliable for a poor quality company.
They need a solid understanding of quality and why it’s important before we start introducing them to offensive portfolio management.
When explaining portfolio management using the SSG in whatever flavor/name you use, showing them that price follow eps and the area between the eps and price bars shows the relative change in P/E ratios lays the foundation for offensive portfolio management.
It’s easier to explain how the stocks price can get ahead of what the company’s eps is and that you might consider replacing a quality stock with another quality stock whose price has slipped below its rational value.
JMHO.
Jim,
Your comment about a stock portfolio’s return not being able to beat that of an unmanaged index fund without taking advantage of harvesting the P/E expansions begs a discussion Ellis posed to me before:
Paraphrasing, With all of the bad sotcks in the index, picking a portfolio of say 20 quality stocks should be able to out perform that index.
In the book, Winning the Investment Marathion, H. Bradlee Perry discusses this by saying the fast growers falter and damage the return.
IIRC, he was speaking of sectors rather than specific stocks, but the idea was the same.
IOW’s you MUST sell the stock before the price makes its deep decline. The problem I see is that by the time the fundamentals suggest a serious problem, the price has already declined.
I’m intereted in hearing thoughts on the subject.