TCS Daily

True Love Waits

By James K. Glassman - August 6, 2002 12:00 AM

If you are having a tough time deciding whether to dump a stock you own, don't despair. You aren't alone. In investing, nothing is harder. Nothing.

Some people offer a simple formula -- such as, always sell a stock if it has dropped 20 percent or if it has risen 100 percent or if its price-to-earnings ratio (P/E) gets above 30. Sorry, but my views are a little more complex. Here are my guidelines:

Always buy a stock with the intention of holding it forever. That's the default position. As Warren Buffett, the most successful investor of the 20th century, once said, "Inactivity strikes us as intelligent behavior." For one thing, if you don't sell, you don't have to pay capital gains taxes. Also, when you don't sell, you have eliminated two out of three difficult decisions: what and when to buy, when to sell, and when and what to buy back. Avoid making such tough choices by looking for stocks, such as International Business Machines (symbol: IBM) or Gillette (G), whose underlying businesses have been around a long time and can be expected to extend their longevity -- rather than buying shares of every pet-rock manufacturer that comes along.

Never sell just because a stock has fallen in price. If you have faith in the businesses you own, then when they fall you should buy more shares -- they're on sale. One popular, but misguided, selling technique is putting a "stop-loss" under a stock. Imagine you bought shares of eBay Inc. (EBAY), the profitable online auctioneer, in late 2000 at $48 a share and set a stop-loss (an automatic sale) at $40. That way, you figure, you can't lose more than 20 percent. Not long afterward, shares hit the target and you sell, but on Aug. 1, after some ups and downs, eBay closes at $55. The problem with a stop-loss is that you get whipsawed. The dip was temporary, but your loss is permanent. A stop-loss makes no sense. If you like eBay (as I do), isn't it a better deal at $40 than it was at $48?

Never sell just because a stock has risen in price. It's the big winners, not the small winners, that produce profitable portfolios. Will Rogers, the great American humorist, once said, "When a stock doubles, sell it." He was asked what to do if it doesn't double. "If it doesn't double, don't buy it." Most investors sell either because a stock has fallen a great deal or because it has risen a great deal. That fact alone would seem to imply that price is a poor standard for making sell decisions.

Never sell because of what is happening within the "market." The stock market goes up and down; always has, always will. No one can predict its movements, and it is a waste of time to try. As Peter Lynch, the best mutual fund manager of all time, once wrote, "Far more money has been lost by investors preparing for corrections than has been lost in the corrections themselves."

Never sell because of what is happening within the economy. Make an assumption about the economy: that it will continue to grow over the long term at about 3 percent, as it has, on average, since the end of World War II. Then don't worry about it. Like future short-term market movements, future short-term economic movements are unpredictable. Don't worry about them. You have enough on your mind.

When you buy a share of stock, you become a partner in a business. That was an adage of the late financial scholar Benjamin Graham, Buffett's mentor, and it may be the most important concept in investing. Your decision to sell should be based not on what's happening to the stock, but on what's going on within the business. A good idea is to ban the words "stock," "market" and "economy" from your investing vocabulary. Replace them with these three words: "business," "business" and "business."

When do you sell? You sell when the business has deteriorated in a significant way. And what does that mean? Turn to "Common Stocks and Uncommon Profits," the 1958 masterpiece by Philip Fisher. It offers the best single statement (Chapter 6) about selling. "It is only occasionally," writes the elegant Mr. Fisher, "that there is any reason for selling at all." And the main one is business deterioration. "When companies deteriorate, they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did."

In other words, consider selling businesses that may begin with a strong market niche -- such as Netscape, which nearly had a monopoly on browser software -- and are suddenly confronted with tough competition. Or consider selling a business that expands unsuccessfully into new markets or that develops a new product that fails. Or consider selling a business that completes a merger that clearly is not working out. I bought America Online (AOL) stock shortly after it declined on skepticism following the merger with Time Warner. I thought the two firms were a great fit. It turns out that the skepticism was correct, and I sold it last year when I gave up hope that two companies with such disparate cultures would ever work well together.

Don't ignore a declining stock price. It could be a signal that something is going wrong with the business you own. Examine the business carefully. If nothing has changed, hold on or buy more. If something has changed, put the stock on probation, or sell it outright.

Notice the word "changed." You can't decide when to sell a stock unless you know why you bought it in the first place. Before you can develop a sell discipline, you need a buy discipline. Every stock in your portfolio requires a rationale. When that rationale fails, or is severely jeopardized, then sell.

Look, for example, at a company called DeVry Inc. (DV), which operates for-profit technical, business and graduate schools around the country. For the last five years the company has grown at a torrid pace, increasing revenue by an average of 15 percent a year and earnings by 24 percent. But as the economy has slowed, so has DeVry's enrollment. As a result, the stock price has fallen by half in the past year. If you own DeVry, should you sell it?

The key is whether the economy is the major reason DeVry's enrollments are sluggish. If it is, then holding DeVry makes sense, because the company has a superb balance sheet, with $78 million in cash and no debt, and can hang on until the economy turns up. As H. Bradlee Perry of David L. Babson & Co., the Cambridge, Mass., investment firm, writes, "No business grows in a straight line every quarter, and investors shouldn't expect it to. . . . Short-term variations in the economy, financial conditions, customer attitudes, weather and myriad other factors do produce fluctuations in the pace of quarterly (and even annual) sales and earnings growth."

But what if, in DeVry's case, the problems are, in fact, fundamental? The Value Line Investment Survey notes, "Students appear to be hesitant to commit to a technology-focused education, given widespread industry layoffs, particularly within the telecommunications sector." That may be a telling observation: DeVry probably needs a more diversified curriculum, but I'm prepared to bet that the slowdown in its earnings is mainly a reflection of the economy.

Also, we're not talking about a basket case here. DeVry's earnings last year were 82 cents per share, up 25 percent. This year the best guess is 94 cents, a rise of 15 percent. And DeVry's P/E, at 21, is about its lowest in a decade. For now, I would hold the stock but keep a close watch on the business. Again, it's the business, not the economy, that should command your attention.

There are two other reasons to sell:

First, you may need to rebalance your holdings (see my column of June 23). If one sector or stock soars in value, then your portfolio can become skewed. That was the problem many investors faced in the late 1990s, with the run-up in technology stocks. Try to rebalance by buying new shares in laggard stocks and sectors; otherwise, sell your big winners and use the proceeds to buy new shares of the big losers.

Second, sell if you develop the slightest doubts about the integrity of management. Accusations of deceptive bookkeeping are rampant these days, and, while some have validity, others are baseless claims spread by short-sellers who profit when stock prices fall. Although it is difficult for investors to assess many of the charges, they should err on the side of toughness. Treat any dubious management as guilty until proven innocent.

Finally, I get a lot of questions these days about stocks that have plummeted to a few bucks (or cents!) a share. Hold or fold? The question to ask is whether you think a company like WorldCom (WCOME) or Kmart (KM) has a bright future. It goes back to the first rule of investing: Buy with the intention of holding forever. Sorry, but I doubt these two particular companies will survive. It may turn out that their assets at liquidation are worth more than the market can guess right now, or that this time, against all odds, a retailer competing with Wal-Mart Stores (WMT) can emerge from bankruptcy as a powerhouse. But there are too many good companies out there to waste money on such gambles.

Remember that "buy and hold" is a strategy. It is not one of the Ten Commandments. Certainly, there are times to sell, but patience is an investing virtue. Here's an analogy: Say you buy a house for $200,000 that you expect to live in for the next 20 years. Now, say that because of rising interest rates and a soft economy, the value of the house falls to $150,000 (you know this because your neighbors sold their similar house for that price). Should you sell, take a loss and look for another house? That seems a foolish strategy. Instead, if you love the house, continue to own it.

The same with stocks: Buy ones that you intend to love for a long time -- and stick with them. But remember that a stock represents a business, and, when its management or its products fail you, sell -- without delay and without sentimentality.



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