TCS Daily

When to Sell a Stock?

By James K. Glassman - September 14, 2005 12:00 AM

My biggest mistake in 25 years of writing newspaper and magazine articles about the stock market started innocently.

My intention, in a February 23, 2003, column for the Washington Post, was to show readers how to analyze a stock and decide whether to buy it. The mistake was to choose a single, real-live company as an example and then to render a personal judgment: that, based on the evidence amassed, I myself would purchase the stock.

I ignored something I knew very well: that readers take the judgments of columnists about specific stocks far, far too seriously. Despite issuing admonitions, I should have known that many of my readers would rush out and buy what I said I was buying myself.

The stock was the Shaw Group (SGR), a company that provides engineering services, as well as pipes, to power plants around the world. Shaw went public in 1993 at $14.50 a share, and, after gaining a reputation as growth stock, soared to $63.50 by mid-2001. "But growth slowed," I wrote, "and disappointed investors dumped their shares." That was understandable; the company had problems. The question I was considering was whether the market had "become too pessimistic."

My judgment was that it had and that Shaw was a bargain. The company "is risky, no doubt," I wrote, "but the price reflects that risk - and then some." So I said I would buy the stock. And, indeed, I did, shortly after my article came out.

Unfortunately, Shaw immediately took a dive. From $10.67 when my article was written (and $10 when I bought my own shares), Shaw fell within a couple weeks to $8.58. As you can imagine, I got lots of e-mails from frightened readers. Should they sell?

To the contrary, I bought more. Shaw rallied to $12 by early July but, within another month, had dropped below $7. It was sickening. Still, I held on and told inquiring readers so - at the same time urging them to use their own judgment and not follow my lead.

Then, in mid-2004, Shaw began to rise, closing the year at $17.85. A few months later, shares were over $20. I decided to sell.

Why did I dump my shares of Shaw? More important, why should anyone sell shares of any stock? That's the toughest question in all investing.

You should buy a stock with the intention of holding it forever, or at least until the Twelfth of Never. As Warren Buffett, the most successful investor of the 20th Century, once said, "Inactivity strikes us as intelligent behavior." Great companies have their ups and downs, but, over long periods, thanks to the power of compounding, their values soar. Despite the disaster of 2000-2002, the average company on the Standard & Poor's 500-Stock Index has returned 13.2 percent annually over the 20 years ending Dec. 31, 2004.

Also, if you don't sell (assuming you have made a profit), you don't have to pay capital gains taxes. Plus, when you don't sell, you have only one difficult decision to make (what and when to buy), rather than three (the additional ones are: when to sell, and what and when to buy with the proceeds).

Most people sell for one of two contradictory reasons:

1. The stock has fallen in price. If you have faith in the businesses you own, then when their prices fall, you should buy up more shares. They're on sale. Instead, many investors cut their losses by selling, often by putting a "stop-loss" under a stock. I bought Shaw at $10 a share. Imagine if I had decided to sell the stock if it dropped 20 percent, to $8. I would have been whipsawed, missing the run to $20. All stocks are volatile, and there's a decent chance you will lose 10 percent or 20 percent before you make 50 percent.

A decline in a stock's price can certainly be a signal that something is wrong, but it is not an alarm bell that should panic you into selling. Instead, check the company's fundamentals; if they're sound, hang on.

2. The stock has risen in price. It's the big winners, what Peter Lynch calls the "four-baggers" (stocks that quadruple or more), not the small winners, that produce profitable portfolios.

Say you bought Legg Mason, Inc. (LM), the Baltimore-based financial firm, in 1999 for $20 a share. Less than two years later, it doubled, to $40. Many investors would be tempted to sell, and, indeed, Legg Mason hit the skids and didn't breach $40 again until 2003. But on Aug. 19, 2005, shares were trading at $106 (all prices adjusted for splits). That's a five-bagger in six years.

The movement of a stock's price -- either up or down -- is no reason to sell it. Nor is the performance of the economy. It's a good bet that over long periods, the U.S. economy will grow at roughly its robust historic rate. And don't worry about what the stock market as a whole is doing either. The market, too, bounces around but goes higher over time. And no one can guess when the bounces will occur anyway.

So when should you sell?

The best answer was provided by the elegant Philip A. Fisher, who died in 2003 at the age of 96 after a 74-year career as a money manager. In his important book, "Common Stocks and Uncommon Profits," published in 1958 and currently available in a paperback edition, he wrote, "It is only occasionally," he wrote, "that there is any reason for selling at all."

The occasional reason? According to Fisher, it is the deterioration of a company's underlying business. "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, sell if something has gone wrong -- not with the economy or the market, but with the business itself. A key product has failed, or new competition has driven down prices, or management gets distracted.

Also, realize that you can't know when to sell a stock unless you know why you bought it. For instance, I am a big fan of Starbuck's (SBUX), but I would sell shares in an instant if I heard an announcement that the company was branching out from coffee and entering the hamburger business. In coffee, Starbucks has almost no competition. In hamburgers, it would be up against four or five experts.

There are other reasons to sell. You might, after all, need the money. Stocks are long-term investments (that is, you should plan to hold shares for five years or more), but emergencies come up, and your cash reserves might not be sufficient.

Also, consider selling if a stock has risen so much that it makes your portfolio lopsided. I had this pleasant problem with the Apollo Group (APOL), a for-profit education company whose shares rose from $15 to $90 between 2000 and 2004. If the other companies you own rose, say, 20 percent over the same period, then, of your total holdings, Apollo could have represented one-fifth or more. That's too much. The solution is to sell some Apollo and use the proceeds to buy more of your other stocks. Or, avoid capital gains taxes by donating Apollo shares to charity.

Finally, sell when you have the slightest doubts about the integrity or focus of management. When a company is accused of deceptive accounting, for example, examine the charges and, if they seem serious, sell the stock. Don't wait for the jury's verdict.

So why did I sell Shaw? Not because I had doubled my money. And not because I was worried about the economy or the stock market as a whole.

I sold Shaw for a couple reasons. First, despite the rise in the stock, the company had consistently failed to earn as much as I thought it would. That is, its business wasn't as good as I thought it would be. When I first wrote about Shaw, it carried a price-to-earnings ratio of 5; in May, the P/E ratio was 28. Earnings did not keep pace with the rising stock price. I knew why I had bought Shaw: it had problems, but it was cheap. It still had problems, but it was no longer a bargain.

Second, I was bothered by the activities of Shaw's CEO, Jim Bernhard, who became chairman of the Louisiana Democratic Party. Bernhard may be a talented guy, but he also appeared to be a headline-seeker; I want the person who runs my company to work only for me.

Writing an entire column about a single stock -- and then recommending it at the end -- is an endeavor I have learned not to repeat. Still, the Shaw story turned out fine. I made some money, and so did many of my readers, and, right now, on Aug. 19, Shaw is trading below $17, a decline of four bucks since I sold it. My only worry is that in the next few months, Shaw will double again and again and....

A version of this article originally appeared in Kiplinger's Personal Finance. Of the stocks mentioned, Glassman owns Starbucks.


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