Conditions For Selling a Stock

An important aspect of being a disciplined investor is having predefined conditions for selling stocks. Here I will discuss the conditions under which I would consider selling a stock in my portfolio. Note that the decision of whether to sell would only be made after investigating the reasons underlying the relevant condition(s) for a given stock.

1. The dividend is suspended, cut, or frozen. As a dividend-growth investor, I want the stocks in my portfolio to have sustainable and rising dividends. If a stock has its dividend suspended, cut, or frozen, then it no longer fits the basic definition of a dividend-growth stock and is inconsistent with my investing strategy. It is extremely likely that I would quickly sell any stock that has its dividend suspended or cut. Those are major red flags that are almost always indicative of problems with the company's fundamentals (see the next condition). For a dividend freeze, I would attempt to determine whether the freeze is likely to be only temporary (e.g. for just one year), in which case I might decide to hold or sell a portion of my position. If there is a lot of uncertainty and it looks like the dividend might be frozen for the foreseeable future, then I would probably sell my entire position. I would treat anemic dividend growth (< 2%) in the same way as a dividend freeze. For example, General Mills (GIS) has occasionally frozen its dividend in the past. If it were to freeze its dividend again (ending its current 8-year dividend-growth streak), then I might hold because dividend growth would probably resume at some point in the near future. Moreover, in the company's 113-year history (including that of its predecessor firm), General Mills has never suspended or cut its dividend, which indicates to me that the dividend is a high priority for the company.

2. The company's fundamentals are deteriorating. Dividend growth is powered by earnings growth, which only happens if a company is doing well. If it looks like a company's fundamentals are deteriorating and unlikely to improve in the near future, then I would likely sell. An important consideration would be whether the deterioration appears to be either short term or long term. Short-term deterioration, such as poor earnings for a quarter or two, would not necessarily lead me to sell. Every company has a bad quarter now and then, so I would investigate the reasons for the poor performance and attempt to determine whether it is just a temporary hiccup or reflects a more serious problem. Note that I do not consider missing analysts' estimates to be poor performance. A company can be doing fine and still miss analysts' estimates, which tend to be wrong more often than they are right. Long-term deterioration, such as poor earnings over several quarters, would probably lead me to sell, especially when accompanied by other noticeable problems (e.g., spike in the payout ratio, sharp decrease in revenue, sudden increase in debt, bad news that compromises the company's business, etc.). However, I would also consider macro-economic factors, such as whether the economy is in recession and dragging down the earnings of most companies.

3. The company is changing through a merger, major acquisition, split, or spin-off. These actions are not necessarily negative, but warrant further investigation. For example, if the company I own is merging with or acquiring a weaker company, then I might question the soundness of the decision and decide to sell, especially if the other company is unrelated to my company's main businesses (i.e., I don't want to see what Peter Lynch calls "diworsification" -- a company making itself worse by trying to be too diverse). If the company I own is being acquired, then I would likely sell simply to take advantage of the easy capital gain that would arise from the premium offered by the acquiring company. If I think the acquiring company would be a good addition to my portfolio, then I can always buy it later. Regarding a company split, whether I sell would depend a lot on the specific circumstances of the situation. I would likely hold through the split (unless I am convinced the split is a bad idea from the start), then evaluate each split-off company separately and decide whether I might want to sell one or both of them. For example, Abbott Laboratories (ABT) will be splitting into two companies by the end of 2012. I plan to hold through the split and then evaluate each company on its own afterwards. I would treat a company spinning off a part of itself into a separate company in the same way as a company split.

4. The stock has become extremely overvalued. Regardless of how a company is doing, its stock price might not accurately reflect the company's performance. If I think a company's stock is extremely overvalued relative to its earnings, sales, and other metrics, then I would likely sell all or a portion of my position and then re-establish a position later when the price is more reasonable (assuming the company's fundamentals are still good). What do I mean by extremely overvalued? I do not have a set of strict criteria, but I would be concerned with a P/E ratio above 25 and other metrics that are well above the historic norms for a particular stock, especially if there is no recent growth spurt that justifies the higher metrics. I would also consider whether the market itself seems to be overvalued. A market bubble that pulls several of my stocks into overvalued territory would be motivation for selling multiple stocks, even if it puts me largely in cash for a while.

5. Important information was overlooked when the stock was bought. Although I research every stock before I buy it, there is always the possibility that I overlooked some important information that would have altered my buying decision. For example, maybe I misinterpreted the company's financial condition or dismissed something that initially seemed trivial but later turned out to be a major red flag. Mistakes happen and it makes sense to sell if the company is not in the condition that I originally thought it to be. Hopefully I would be able to detect those mistakes quickly and avoid losing money.

6. A large capital loss can be realized to offset taxable income. Due to market fluctuations, I may have a large unrealized capital loss on a stock even though the company is doing fine. I might consider taking advantage of this situation by selling the stock, then waiting 31 days before re-establishing my position (to avoid a wash sale). Assuming I am able to buy back in at a price similar to my sale price, then the market value of my position would be unchanged. Why would I do this if I end up with the same stock at nearly the same market value? The reason is that I can use the realized capital loss to offset up to $3,000 of my taxable income, thereby lowering my taxes. If the stock rebounds to my original purchase price, then I would have an unrealized capital gain that makes up for the realized capital loss, whereas if I had just held onto my original position, my unrealized capital loss would simply disappear. Thus, in each case I would break even, but by selling and buying back in, I would get a tax deduction. For example, this is sort of what I did near the end of 2011, although it had the dual purpose of offsetting my taxable income and getting rid of a few stocks that I had foolishly bought before I implemented my dividend-growth investing strategy. In that situation, instead of buying back into those stocks later, I used the money from the sales to buy other stocks that fit with my strategy. I am not sure how often I will try this tactic, but it is something I will keep in mind. Of course, this can be done only if I have stocks with unrealized capital losses.

In summary, those are the conditions under which I would consider selling a stock. As I continue to learn more and become a better investor, I may come up with different views of these conditions or add some new conditions to the list. However, I think the present list represents a useful starting point and makes part of my investing strategy more concrete and disciplined.