"Our Favorite Holding Period is Forever"  - Warren Buffett

I love this quote from Buffett – it represents a philosophy that’s a world apart from the frenetic behavior of Wall Street. But many people confuse the meaning behind it. They get upset when they see Buffett selling down, claiming he’s not following his own advice. This is to misinterpret his meaning. When you buy as stock, you should indeed view it as becoming a part owner in a business. You bought it because you believe in its long-term prospects, you got a great price for it and you hope to benefit from your purchase for many years to come. But this doesn’t mean you won’t ever sell it under any circumstances.

Trading Versus Investing

As I explained in my post last week, a successful investor needs to understand that investing and trading are two separate philosophies.. The "stop-loss" is one dangerous concept that investors seem to borrow from the world of trading. But to sell on a stop-loss is to be directed by the price action alone, with no reference to the underlying value of the stock. It goes against everything that an intelligent investor should stand for

"would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have bought on the previous day?" Warren Buffett

So when should you sell a stock? An intelligent investor sells because the price no longer represents an attractive discount to the underlying value. This can happen in one of two ways

1. The price approaches, or rises above, intrinsic value
2. The intrinsic value declines because of a change in the fundamentals.

This still gives plenty of flexibility to adopt your own personal approach. Buffett admits himself that he errs on the side of inactivity, holding great stocks even after they become expensive. Seth Klarman on the other hand likes to sell stocks before they get to a fair value and reinvest the proceeds into new opportunities. Regardless of which model you follow, you need to have a clear strategy for selling stocks that references the intrinsic value.

Taking the Emotion Out

As always, emotion is the worst enemy of the investor. There are two key reasons why investors make suboptimal decisions when it comes to selling:

1. They become emotionally invested in the business and refuse to sell it under any circumstances
2. They have made a loss on their original investment. Aversion to crystallizing that loss causes them to hold on to an investment even where there is little or no upside.

The toughest decision for many investors is selling a company where the fundamentals have deteriorated, thus requiring a re-evaluation of the investment case. The right decision here often involves crystallizing a loss. This is not an uncommon situation, and intelligent investors recognize the need to make these decisions from time to time (after all nobody can accurately predict the future). If you face this kind of decision force yourself to take emotion out of the equation and remember – successful investors are in the business of making money, not in the business of always being right.

The Opportunity Cost

There is another factor that should influence your decision – the opportunity to reinvest your proceeds into other stocks with more upside. This is one of the reasons why Seth Klarman often sells down his holding when the price is 10% off intrinsic value – in order to invest in a stock that is 50% off intrinsic value. The existence or otherwise of these opportunities will affect your propensity to sell existing holdings.

“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” - Seth Klarman

By their nature these "fat pitches" are rare, which is why Klarman’s funds appear so inactive most of the time.

Developing a Process

Most investors intuitively understand the need to have a clear process for buying stocks. But to be a great investor you also need to have a process for selling stocks – this requires constant monitoring of what you have in your portfolio and weighing those stocks up against potential new opportunities. This won’t always result in a sell and buy decision – in fact those decisions should be rare. But when you do make that decision, you can be sure it’s the result of a thorough process, not just a panicked reaction resulting from a temporary price move.