Seth Klarman – When To Sell & Why Stop Losses Are Crazy – Margin of Safety

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Most investors are aware that Warren Buffett bought six shares in Cities Service as an 11 year old. He picked up the shares for $38 each and sold them at $40 per share making a small profit. But to Buffett’s regret the shares eventually rose to more than $200 per share over the following years and Buffett had learnt a valuable lesson on the importance of patience in stock market investing. The other problem facing the young Buffett is the same problem that most investors face and that is, while we might be great at finding bargains, when is the right time to sell your shares.

Seth Klarman provides some great advice on when is the best time to sell in his book – Margin of Safety. Here’s an excerpt from that book:

Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.

To deal with the difficulty of knowing when to sell, some investors create rules for selling based on specific price-to-book value or price-to-earnings multiples. Others have rules based on percentage gain thresholds; once they have made X percent, they sell. Still others set sale price targets at the time of purchase, as if nothing that took place in the interim could influence the decision to sell. None of these rules makes good sense.

Indeed, there is only one valid rule for selling: all investments are for sale at the right price. Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when to sell—or buy— depends on the alternative opportunities that are available. Should you hold for partial or complete value realization, for example? It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains. By contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly undervalued and if there were no better bargains available.

Some investors place stop-loss orders to sell securities at specific prices, usually marginally below their cost. If prices rise, the orders are not executed. If the prices decline a bit, presumably on the way to a steeper fall, the stop-loss orders are executed. Although this strategy may seem an effective way to limit downside risk, it is, in fact, crazy. Instead of taking advantage of market dips to increase one’s holdings, a user of this technique acts as if the market knows the merits of a particular investment better than he or she does.

Liquidity considerations are also important in the decision to sell. For many securities the depth of the market as well as the quoted price is an important consideration. You cannot sell, after all, in the absence of a willing buyer; the likely presence of a buyer must therefore be a factor in the decision to sell. As the president of a small firm specializing in trading illiquid over-the-counter (pink-sheet) stocks once told me: “You have to feed the birdies when they are hungry.”

If selling still seems difficult for investors who follow a value investment philosophy, I offer the following rhetorical questions:

1. If you haven’t bought based upon underlying value, how do you decide when to sell?

2. If you are speculating in securities trading above underlying value, when do you take a profit or cut your losses?

3. Do you have any guide other than “how they are acting,” which is really no guide at all?

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