Imagine for a moment you’re rafting down a scenic river. This uncharted river has tons of twists, turns, rocks, waterfalls, and bends along its course. We know eventually if we travel far enough, the river will reach its destination — the ocean. Sometimes the water moves slowly and sometimes it moves quickly, depending upon the terrain.
As we’re rafting down this river we have two choices: We can either follow the river’s course through the twists and turns, or we get out and carry the raft to avoid hazards.
Now the most sensible thing to do is to hop-out of the raft when the river gets rough. Unfortunately that’s not easy to predict. With all the twists and turns in the river (and dense foliage) we can’t really see the rough spots coming until we’re right on top of them, with no time to get out safely.
If we get out of the river too early, we end up having to carry the boat and lose time on the way to our destination.
If we stay on the raft we have to ride through the waterfalls, the rocks and all the other hazards. It’s possible the boat could be damaged or we could suffer injuries going through these hazards. But sometimes the water is fastest near the hazards, and we make the most progress while passing through them.
Fortunately, there’s no rule that says we have to stay in the same boat all the way down the river. We can hang out on the party boat when times are good. Or, we can hop into the raft with the professional rafters….those with the most experience and best ability to survive the hazards that lay ahead.
If you haven’t guessed yet, this metaphor is about investing. The destination is financial independence, and the river itself is the investment markets we traverse. The rafts are the index funds and businesses we choose to invest in. Getting into or out of a raft equates to the buying or selling of an investment.
Timing Is Hard
As with any financial transaction, there are always two sides to the equation — The buying AND the selling. The “getting in” or “getting out” of the raft, to use our metaphor.
I’ve already written about buying pretty extensively, but I haven’t written a post specifically about selling.
And selling is on a lot of people’s minds these days. Among the personal finance bloggers I follow, selling is a common theme right now.
Lots of people worry the market is overvalued right now. But who knows…instead of heading down, the market could keep rising for 2 more years. We just never know!
So, how do we know when the river will finally take us over a dangerous waterfall?
Well, many investors try to “read the tea leaves” to divine the course of the market. Some investors try to look at leading economic indicators like rail traffic, manufacturing activity, or even retail sales. But those indicators aren’t perfect either…they can also contain a lot of noise that distorts the truth.
Being able to time the market is a very rare gift. It certainly isn’t among my financial superpowers. Hardly anyone can do it with any kind of proficiency. The investors that appear to do it well, aren’t telling their secrets either.
Want my advice? Don’t bother trying to time the market. You’ll make yourself crazy trying. You’re just as likely to miss “the good parts” of the investing river as you are to avoid the hazards.
It’s not timing the market that matters most, it’s time in the market that matters. I recommend focusing on the ‘why’ to sell instead of the ‘when’.
Long Term Compounders
First off, let me start the discussion on selling by talking about compounders.
Normally when investing, my favorite kind of stock is called a “long term compounder”. I try to find them at a fair price. This is my ideal kind of investment, but they’re also quite hard to find at good prices.
In our rafting metaphor, the long term compounders are the professionals rafters — The guys with the sturdy boat, the big arms, and serious expressions. They might go a little slower than the party boat when times are good, but these guys will survive the hazards.
Compounders are businesses that consistently produce more than $1 in value for every $1 invested in the business. Even better, if these companies can compound value a rate that exceeds the S & P 500, then you’re golden.
If the business can continue to compound value like that, I would probably never sell. Are they all superb businesses? Not necessarily, sometimes they’re poor businesses! But they create incredible value for shareholders.
Berkshire Hathaway would be a prime example of this kind of company. Before Warren Buffet took over the company, Berkshire was a failing textile businesses. After Buffett took the reins, he started redirecting capital to better businesses where it would compound at better rates of return. It ended up working out really well for shareholders.
Imagine how bad you’d be kicking yourself today if you were a early owner of Berkshire Hathaway and then sold for some reason like “the market was expensive”. Yeah, you’d definitely be kicking yourself for that mistake.
So, my rule is: Don’t sell long term compounders if you can help it. As long as they keep compounding, stick with ’em!
Your Investment Hypothesis No Longer Holds True
Of course, sometimes even long-term compounders stop being compounders. Like stones in the river, time has a way of wearing away at every company. Eventually good leaders retire, new products are invented, and industries change.
For better or worse, anyone who’s invested in stocks should be watching for the day when your investment hypothesis ceases to be true.
Take for example, the recent sale of my Telus shares. When I first invested in Telus, the valuation was cheap, business was healthy, dividends were growing, and compounding at reasonable rates looked possible.
Unfortunately all that changed over the years. I suffered through declining cash flows, growing debt levels, and poor returns on capital. Given the poor state of the business (with little chance of compounding possible), I threw in the towel.
The investment was quite profitable, but it was time to move on. My original investment hypothesis no longer proved to be accurate, so I sold the business at a fair valuation.
When the rocks, waterfalls, and other hazards finally do appear, we want to be in the rafts that are going to survive with few injuries. Financial strength should definitely be a category you consider in your investment hypotheses. Plain and simple.
Undervalued Investments Reach or Exceeds Fair Value
Not all investments are going to be long-term compounders. Sometimes I purchase investments for valuation reasons alone. These are your Ben Graham style cigarette-butt investments — Bonds or preferred shares under par value, stocks so undervalued they’re likely to see a higher valuation once the proverbial dust has settled.
These kinds of investments may be terrible businesses, so the intention isn’t to hold them long term. But how do we know when to sell a stock in the “Undervalued” category?
Frankly, when it’s no longer undervalued. If you did your analysis correctly (before you purchased) you’ll already know what a fair valuation is. Usually there’s historical valuations and industry valuations to compare against with premiums or discounts applied for quality.
To put this in extremely simple terms: When a can of beans goes on sale, you buy the beans at $0.50 on the dollar. When the price of beans goes back up to $1, you sell. You don’t hold onto your mountain of beans hoping they’ll somehow get to $2. That’s just unrealistic. You sell when they’re fairly valued.
Better Investment Opportunities Exist
One of the best reasons to sell an investment is because there’s an even better investment out there. An investment with more moats, better management, higher returns on capital, and any other factor you can think of.
It doesn’t mean your old investment was a bad one, it’s just that they’re better places for you to allocated capital…and this distinction is key: Whenever shifting out assets for better assets, start with the assets that have the lowest projected long-term rate of return. Usually this is going to be cash with a near 0% rate of return. Next up would be something like U.S. treasuries at 1.5%, and so on.
It’s a simple strategy to maximize returns, but we also have to be cognisant of taxes. If you hold business for long periods of time like I do, sometimes this means paying big taxes when you shift investments. It goes without saying, the new investment better be worth paying all those taxes.
If the new investment only has a 1% improvement in the long-term rate of return….well, it’s going to take a LONG time for the new investment to be worth paying the 15-20% you might pay in taxes.
You Need The Money
Last, but not least is the best and final reason why you should sell an investment: You need the money for something else.
Life isn’t just about piling up the biggest portfolio possible. There are other things worth spending money on — like experiences, buying a comfortable home, education, or maintaining your health. Maybe you even want to spend money on frivolous things like nice cars or a boat. Whatever the case, it’s your life and completely up to you.
But PLEASE don’t be a dumbass about how you fund your spending. Just like we did when swapping out investments for even better investments, start by selling investments with the lowest long-term returns, and then working your way up.
In simple terms: Let the winners keep on winning, and only sell the laggards.
More often than not, investors end up doing the opposite of this. They sell the winners because they’re ‘up’, and hold on to the laggards in the hope of avoiding losses.
I’ve made this mistake myself, and it’s completely wrong headed. The winners are winning for a reason.
For someone who wants to reach the end of the river, you need to keep the long term compounders. What should get sold is the investments that run into trouble, or were merely undervalued situations from the start.
A Final Word
I’m going to end this post with a final word of caution to everyone: Don’t use market movements to determine if you should buy or sell. In most cases, that’s like looking at random swirls in the water (from our raft) and making big decisions based upon little eddies. It’s nonsensical.
Instead, look at business returns or metrics like return on capital and other measures of business efficiency.
The market can do a lot of crazy things on any given day. Don’t let crazy old Mr. Market make your decisions for you.