When to sell a stock 💰
Simple rules to make effective decisions
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Hi there investor!👋🏻
Today we will discuss one of the most difficult questions in investing:
When to sell a stock.
To get a better nuance of these questions we have to make some categorizations of different companies.
To simplify this, we will use 3 simple terms inspired by Peter Lynch’s categories from a Quality perspective:
Steady-growing quality business
Fast growing quality
Turnarounds
I will not include cyclical companies, or asset plays in this article, as this is outside the universe of a quality investor.
Steady-growing quality business
Categorized as businesses growing their revenue and EPS by +4-8% annually for the last 5-10 years. The growth is steady, and the businesses are often strong with a long track record of steady business. Usually, these businesses have a ROIC of above +12% that has been sustained for a while. Think of L’oreal, Colgate Palmolive, and Coca-Cola.
Some examples:
Fast growing quality
Categorized as businesses growing their revenues (and sometimes EPS) by +8% for the last +5 years. The growth is strong and is likely to be sustained due to an increase in demand for the product(s) or services the business offers. The ROIC does not have to be high but should be increasing as the business model starts to pan out. Think Evolution AB, Dino Polska, and Adyen.
Some examples:
Turnarounds
Steady- or fast-growing quality companies going through a rough phase with a large sell-off. This is typically a company that has seen high growth and steady business over multiple years, but some narrative for the future makes the stock price crash 40-70%. These companies might have had poor management teams making poor decisions, resulting in poor fundamental development, loss of market share, and pricing power. Think about PayPal, Meta Platforms, and Spotify.
Some examples:
Example #1: PayPal — A story of high multiples and decreasing take rates.
Read our full article on PayPal here.
Example #2: Estee Lauder is a fallen steady grower
Example #3: Evolution is on a -52.5% pullback from its all-time highs
Now, let’s move into some rules for selling businesses in the 3 different categories.
Keep in mind, none of these rules are strict, there CAN be reasons that justify a business having a temporarily high PE for example. We must not be too categorical and try to understand the situation behind the numbers without being naive.
Let’s get into it 👇🏻
Selling a steady-growing business
A few rules to consider when selling a steady grower.
Sell if the PE/PFCF goes well beyond the 10-year median (The upside quickly disappears in a steady grower when the multiple gets too high).
Sell if the PE/PFCF goes well beyond the multiples of its industry peers (Unless you can justify the premium with increasing market share or similar).
Sell when growth stagnates while expenses keep on growing (This will result in a margin squeeze, which is not particularly attractive for WS).
Sell if the management starts making poor acquisitions (Remember that most acquisitions are poor investments).
Sell if the business loses market share for 4 consecutive quarters (This means that the competition is eating your lunch).
Sell when dividends stop growing and the payout ratio is getting above 60%.
Sell when there is no product innovation while other new entrants in the industry innovate and steal market share.
Selling a fast-growing business
A few rules to consider when selling a fast-grower.
Sell when the PE is above 2x its projected sales numbers (PEG of +2)
Sell when gross margins contract, especially if this is due to competition.
Sell if the management starts taking on too much debt (Interest coverage of <7x)
Sell when YoY sales fall dramatically due to fundamental changes in the market/competitive landscape (E.g. sales go from steady 20% to 10% in a short time period).
Sell when the business is no longer profitable (Unless the business is making justifiable investments that will provide much better returns in 5 years).
Sell when the projected sales numbers are getting out of hand (Euphoria has now kicked in, try to have your feet firmly planted).
Selling a turnaround business
A few rules to consider when selling a turnaround:
Sell when inventory grows faster than sales—a clear indicator that the business cannot sell its product. Just look at Estee Lauder.
Sell if debt suddenly rises—this is a clear red flag. A turnaround involving a lot of debt increases the risk for investors significantly.
Sell when everyone knows it’s a turnaround story — When the turnaround story is obvious, most of the upside is already priced in.
Sell if what management deems a temporary problem persists in multiple quarters (E.g. regulatory issues, pricing issues, market share loss).
Sell if management turnaround measures are not effective in changing the business's per-share economics after four quarters. For example, implement a new product and marketing strategy with poor economics. Great managers will provide noticeable change within one year.
That’s it for today!
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Great reading. I have 12 rules on selling. Let me know what you think. https://arvy.ch/when-should-you-sell-twelve-rules-show-the-way/
Great article. Thank you