“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” — Philip Fisher
“Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously. ” — Howard Marks
There are many approaches used by value investors to identify investment candidates but the obvious common theme is that one makes purchases only when the offered price is significantly below a conservative estimate of intrinsic value. In times of significant pessimism, there are often far more investment candidates than one would wish to add to a focused portfolio. This was the case for a number of years following the 2008-09 financial crisis, not only in retrospect but as a function of the opportunities clearly available at the time. During such times of abundance, the purchase decisions are mainly a function of which opportunities within an investor’s circle of competence offer the greatest prospective returns with acceptable business risk. Making such bargain purchases, assuming the availability of the necessary cash and the right mindset, is usually an enjoyable experience.
On the other hand, the decision to sell can frequently be agonizing for various reasons. If a business unexpectedly deteriorates, one must determine whether the relationship between the lower stock price and lower intrinsic value still justifies ownership. Numerous psychological pitfalls await investors who must decide whether to sell an unsuccessful investment. Often times, the best approach is to pull the band-aid off quickly and move on.
The more interesting question, and the subject of this article, is when one should sell a successful investment. This question is almost certainly timely for most readers as markets reach new highs and signs of investor optimism becomes more and more common. In retrospect, we know that the pendulum referred to by Howard Marks reached its most pessimistic limit in early 2009 bringing with it the greatest opportunities for success. We cannot know today where the pendulum is exactly located but it seems to be drifting more toward the optimistic end of the spectrum. This necessitates careful consideration of when a successful investment has run its course.
Motivations for Selling
There are obviously a number of motivations that would lead an investor to sell a successful investment. Many of the reasons are somewhat beyond the scope of this article. It is possible that an investor seeks to raise cash for personal reasons such as increased consumption or purchasing a personal residence. Such needs may be immediate or on the horizon. Clearly it is not advisable to hold common stocks, regardless of valuation, if the time horizon for the remaining period of ownership is very short. In such cases, with cash being necessary, one simply sells the investment, pays the required tax, and moves on.
Aside from time horizon constraints, an investor will often consider selling in order to fund the purchase of another investment. This is the more interesting scenario for purposes of this article. When does it make sense to sell a successful investment in order to purchase something that is perceived as “better”?
Assess Prospective Returns
Perhaps it goes without saying, but when tempted to sell a successful investment it is necessary to revisit the valuation again in considerable detail. It is possible that an advancing stock price is in response to an unexpected positive development that was not considered in the original investment thesis. Investors are subject to both good and bad luck. When good luck takes the form of an unexpected positive surprise, it wouldn’t make sense to immediately sell and abort the benefits of that good luck.
Assuming the valuation has been revisited and the investment is indeed trading above a conservative estimate of intrinsic value, it is still important to consider the prospective returns of the investment from its current price level. For example, a month ago, we posted an article on Markel trading above $800 per share for the first time. Since that time, the stock has advanced an additional 10 percent and currently trades above the $840 intrinsic value estimate provided in the article. As no obvious new developments have taken place over the past month, the stock appears to be trading about 5 percent above the intrinsic value estimate.
The intrinsic value estimate was based on requiring a 10 percent annualized prospective return over the next five years. Although the stock recently traded at $875, it still offers the possibility of 9 percent annualized returns over the next five years, holding all other aspects of the valuation constant.
Consider Tax Consequences
Warren Buffett has often discussed the major benefit Berkshire Hathaway realizes by investing policyholder “float” in securities. Float represents funds that Berkshire holds in anticipation of payment to policyholders, in some cases in the distant future. However, Berkshire also benefits from another type of “float” represented by deferred taxes on appreciated securities. Effectively, Berkshire is able to invest deferred taxes that will eventually be payable to the government.
All investors have the same opportunity to benefit from retaining highly appreciated investments with large deferred tax liabilities. For example, consider an investor who purchased Markel shares at $400 approximately four years ago. Of the $875 share price, $400 represents the cost basis and $475 represents embedded capital gains. The current effective top Federal income tax rate on long term capital gains is 23.6 percent. Assuming residence in a state without income taxes, the investor would have to pay taxes of around $112 per share leaving him with $763 to invest in new opportunities. In contrast, holding on to the Markel shares will allow the investor to keep all $875 invested.
Continuing this example, if the investor retains Markel shares at $875 and the share price compounds at 9 percent over the next five years, the ending share price would be $1,346. At that point, taxes of $223 would be owed on the capital gain (assuming no change in tax rate policy) and cash raised on sale would be $1,123.
If the investor instead sells Markel today and reinvests the $763 proceeds, it will be necessary for the new investment to compound at nearly 10.1 percent to match the after tax proceeds realized by holding on to the Markel investment. At that rate of return, the new investment will be worth $1,234 in five years. Of this amount, $471 will represent a capital gain and taxes of $111 will be owed to the government resulting in net proceeds of $1,123.
(As an aside, one must also overcome transaction costs, both explicit in the form of commissions and implicit in the form of bid-ask spreads. We have ignored transaction costs for purposes of simplicity.)
The Hurdle May Be High
As we can see from the example, the tax friction associated with selling a successful investment and purchasing a new one can be considerable. In this case, it would be necessary to find an investment offering a return 1.1 percent higher than Markel in order to make the switch pay off. Furthermore, one would need to be satisfied that the level of business risk is similar or, better yet, lower. Markel also could have upside above and beyond the intrinsic value estimate if the company succeeds in emulating Berkshire Hathaway’s business model.
It might still make sense to sell Markel and find another investment if it can be done in a tax exempt or tax deferred account. In such cases, the tax friction disappears, but the other issues remain. Ultimately, each investor must make an educated decision when it comes to the question of selling appreciated securities. It goes without saying that frequent activity on a short term basis is almost always ill advised. The same is often true in the long run, as Philip Fisher pointed out.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Markel. Since publication of the article on Markel on June 18, fifteen percent of the Markel shares held on that date were sold in tax exempt and deferred accounts and invested in Berkshire Hathaway with no plans to sell the remaining Markel shares. See also general disclaimer.