When to sell a position and boost returns?

Buy, hold, sell

During the live webinar masterclass on Tuesday evening, we received this question:

You covered buying and holding a stock, but when is the right time to sell?

Due to a lack of time, I was unable to cover this question fully during the webinar. So here goes ⬇️

If we look at the process of investing, you can break it down into the following steps:

• What to buy?

• When to buy it?

• How much should we buy?

• How long should we hold?

• When to sell?

• How much do we sell?

We’ll dive into the last 2 questions in this article. I think there can be different reasons to sell a position. I believe it’s best to think about them hierarchically. Here are 5 reasons to sell ranked from worst to best. This means the number one reason to sell is at the end of this article.

Why sell?

5. Because the price keeps dropping

Thanks to the Dutch East India Exchange (the first stock market in Amsterdam), we have the pleasure of buying and selling stocks in our public markets today. However, most businesses are private (only 13% of US companies with over $ 100 million in revenue are public¹). Imagine you own a small local HVAC business. There is no constant pricing for your business. No “price can drop”. Selling on price alone is a bad move.

We need to understand WHY the price is dropping.

4. Because a famous investor or insider is selling

You can copy a position, but you cannot copy someone’s conviction.

In addition, you have no idea WHY that person is selling. Maybe he/she need liquidity. Perhaps they are selling because of the other 3 reasons we’ll discuss below. You need to do your analysis and come to your conclusions.

When talking about insiders, they can sell for many reasons. I think an insider buying shares provides a stronger signal than an insider selling shares.

"Insiders might sell their shares for any number of reasons, but they buy them for only one” - Peter Lynch

3. Valuation

This one is tricky.

If you follow the teachings of Professor Damodaran (the dean of valuation), he will tell you that if you value a company, and it touches the upper limit of your valuation range, it makes no sense for you to hold on. You consider the company overvalued now.

The problem here is that valuation by definition is imprecise. You’re placing bets in an uncertain environment.

My general rule is this:

The higher the quality of the company, the less you should consider valuation for selling. (You could say it’s the opposite for the buying, entry price matters)

Why is that?

• The company can keep performing much longer than you initially figured (competitive advantage period)

• The company is known for creating businesses out of thin air. There is hidden optionality within the company; you just cannot put a value on it

• You might be wrong in your initial valuation

Yes, but I can sell and then buy back the shares when the price drops, right?

Be careful:

That’s 2 decisions you need to make. What will you do if the business keeps performing and the price gradually keeps growing? I find it better to pretend as if you’re buying a private business. Do you still like the business even though the price has gone up?

Now I’m not going to lie.

I have sold on valuation in the past.

Here’s what happened.

INMODE

After the COVID crash, I bought a company called Inmode (Ticker: INMD) for 17 USD. In the following year, the price rose to 90 USD. I started trimming my position and sold everything over 2 months.

Why?

From a financial perspective, Inmode was a solid cash-generating company, but it plays in a very competitive space, with few competitive advantages. In a matter of a mere 18 months, it went from a P/E of below 15 to a P/E of 50 to 60.

That’s not sustainable.

You need to consider not only the absolute pricing at a given moment, but also how it arrived at that point. And more importantly, how high-quality the company is.

Note: I did buy back in below 30USD, but have since sold out of Inmode. I lost the belief that the company would be able to turn around its current struggles.

ADYEN

I will give you another example of a company called Adyen. (Ticker: Adyen or Adyey)

I bought the company right when it dipped in 2023, when it had a forward P/E of 25, and I still hold it today. It now trades at a forward P/E of about 50. The difference with a company like Inmode?

It’s a much higher quality company, still growing at double digits every year, and together with companies like Stripe, one of the leaders in its industry.

I believe Adyen can still build new business and new products to keep that growth going.

Note: Although I use P/E in this sense, if you’ve read my past articles, the P/E is just a shortcut to valuation. Be careful.

2. You’ve found something better

I consider this the second-best reason to sell a position, but it’s hard. In theory, it means you know the opportunity cost for each position. Meaning, you think you can get a 10% return on one company, but you’ve found another you think can make you 15%. Then you should swap out one for the other.

Easy peasy.

But in reality, there are a lot more factors to consider.

Maybe you think it has great value in the short term (3 years), but it will not be able to compete in the long term. What is the type of company? Maybe company 1 is a fast grower, and company 2 is an asset play, and you like multiple “types” of bets in your portfolio (like I do).

You see, while this is the second-best reason, it’s hard to implement.

1. The thesis is broken

When you buy a company, you’re looking at different future scenarios, and you’re betting on some of them to play out. This might mean you consider a certain revenue or earnings growth rate in the coming years. You consider a certain capital allocation strategy. You imagine management not doing stupid things.

But while ignoring the price in the market, maybe a company does the exact opposite of what you expected. Maybe you lose faith in the management. Usually, when bad decisions are made, the price in the market follows.

Your initial thesis is broken, and it's time to leave the company.

In our previous article, I shared the Last Minute Buying Analysis template. For any company you buy, you should write down why you buy it and what you expect. Then you can test if the company itself (disregarding price) is meeting your expectations.

This is by far the best reason to sell.

The Wisdom of a Poker Champion

Define an exit strategy in advance

We’ve covered decision-making in the past.

1 mistake I made and 7 easy tactics to make better decisions in investing

But Annie has written another book called “Quit: The power of knowing when to walk away”, and one of the key insights is to define an exit strategy in advance. When would you sell the position before buying it?

The best investors I know sell fast when things don’t go their way. They don’t mind taking a 10 or 20% loss in the short term if they see initial signs of their thesis not playing out. What’s a 20% loss if you aim to find multibaggers over multiple years?

Most investors hold on to certain positions for too long. It’s normal. Loss aversion kicks in, and taking a loss feels a lot more painful than the equivalent gain for an equal win.

How much do you sell?

We covered when to sell. But how much?

I’m a big fan of trimming a position instead of selling outright. Investing is a process. Building and trimming positions.

It’s a simple risk mitigation strategy in case you’re wrong.

• You’re buying a full position slowly, and the company hits disaster: The impact will be less significant.

• You’ve lost confidence and are trimming a position, but suddenly, the company hits a big win: You still see some of the upside.

Stock investing is about embracing uncertainty. I love the superinvestors who build a portfolio of 3 stocks, and buy and sell outright. I would be careful in emulating these people. Adapt your investing process to your personality.

Have a great weekend.

May the markets be with you, always!

Kevin

1. https://www.advisorpedia.com/chart-center/number-of-public-companies-v-private-us/