When You Should Sell a Net-Net?

Many investors say that selling stocks is much more difficult than buying them. This certainly can be true. Much more is also written about how to decide when is the right time to buy a certain stock. It’s just that much easier to hunt for bargain stocks and buy them than to know when the parties are over and it is time to sell.

How long should you hold a stock? Warren Buffett (Trades, Portfolio) once said: “Our favorite holding period is forever.” This may be true with wonderful businesses, but net-nets are rarely if ever great companies. Investors buy these stocks because they are cheap. Occasionally, net-nets are valued under their intrinsic values and when they are selling clearly below their net current asset value, they should offer adequate margins of safety. This was the reason Benjamin Graham started to buy these stocks – and made this style of investing famous.

Then when is selling a net-net stock the right move? There is definitely no one right answer. Graham himself liked to buy these stocks at two-thirds (or less) of their net current asset value and sell them when they passed NCAV. When a stock stayed stagnant, he held it for at least two years.

Likewise, another legendary net-net investor, Walter Schloss, simply sold when the stock reached its intrinsic value, which for him was usually when the market capitalization climbed to the net current assets level. This is a clear and effective strategy that takes the emotion out of the act of selling.

However, in 21st century global market, it is difficult to give a single selling rule for all stocks. Many things in business can change much faster than they could in the 1950s and 1960s. There are many activists and small investors looking for net-nets all over the world. Corporate governance, accounting and market rules are not the same everywhere. Many things that sharply increase or decrease the share price can happen much faster.

Yet the biggest mistake of many investors is that they sell net-nets too early. If the stock has risen by 30-50% in a few months, there is great temptation to sell it to realize a quick profit. You should remember that the net-net stock was initially dirty cheap and when something positive occurs in the company, the upside possibility can be enormous. Don’t cut the future of three-, five- or even 10-bagger stocks too early. By doing so, long-term returns easily become more modest. Often this means that the investor does not have the nerve to implement this strategy as required. Keep in mind that the return on these winning stocks must compensate for the losses of the loser stocks — and with net-nets investors will also have losses.

With any net-net stock, you should at least hold it long enough for the research you did to be relevant. Maybe you anticipate a turnaround, some activists are playing with it, there is new and improvement management, or something else. Whatever the reason you bought the stock, you should at least hold it for enough time that those things can have an influence on its performance and price.

What time frame is enough? You never know. Usually it is at least one year. Often it can be two or three years — particularly if there is no visible catalyst.

As the share price rises to the NCAV level, the stock is still on average quite cheap. Most of these stocks would be very cheap even if they were priced at tangible book value. In this case you should make a new valuation and find out why the price has risen. Often you will find that there has been a clear, positive change in the company’s profitability or in the balance sheet. The net current asset value of the company may also have risen to a new level. In the best case, the company’s value can multiply within a few years. These cases are not uncommon for net-net stocks.

One useful way to sell is to do it in parts. For example, sell one half of a holding when the company reaches its NCAV level. In this way, an investor can lock in a good profit and reduce the risk of loss. But at the same time, they still retain the possibility of higher profits is the stock price rises further. This is the preferred and effective method for most net-net stocks.

Waiting can be the most difficult thing if nothing happens with the stock for a long time or it loses some of its value. But, if the basic fundamental analysis is correct and remains valid, investors should be patient. Remember, if you liked a stock in the first place, you should like it more if it goes down. Often, the success of these companies is based on a surprisingly unpredictable event. The company can be sold with great profit is some activist investor comes in and improves the business, or the business environment of the company undergoes a major change.

There are still some things to keep in mind when considering stock sales. When the share price changes (up or down), check whether the new price level of the company still gives a sufficient margin of safety. In addition, evaluate whether there has been any change in the company’s business. If a stock at its new price level still provides the required margin of safety, it is frequently wise not to do anything. Smart passivity is too often the most undervalued investment activity. In many cases, therefore, the best investment decision is to do nothing. If the business instead worsens, but the value of the stock has already risen sharply, then it may be a good time to sell immediately. It is always possible that the price of a stock will still rise, but trying to sell at a price peak is an impossible strategy.

The best investment is often a company whose NCAV increases with its share price. In this case, it is possible that after a few years, the investor will own a much more valuable company, which will still offer the same margin of safety as when it was purchased. Unfortunately, this is a rare case.

There are also some situations in which a net-net stock must be sold in short order.

1. You have made a mistake in your analysis at the time of purchase.

You can later find out the surprising negative things that you might not have noticed when you first analyzed the company. Likewise, a change in the business may invalidate the original analysis. Then you need to quickly re-evaluate the situation and act accordingly.

If you notice the risk of a large loss (the chance to lose more than 50% of invested capital), you should immediately sell the stock, regardless of how long you have owned it or how much it may be at a loss.

2. You need money for another better net-net investment.

In this case, the new investment clearly should be better. Investors are easily tempted to jump from one position to another, especially if the current stock ownership feels boring. This should be strongly avoided, and changes should only be made when they rationally appear to be well justified.

There are also some special cases that affect the sale of a stock. The first is if the stock has been acquired below its net cash value (cash and cash equivalents less all liabilities), and the company no longer has much operational business, but is basically “sitting” on its cash pile. In this case, it may be reasonable to sell a share when it reaches its net cash value because it hardly has any other business value. Similarly, if a company’s business has long been unprofitable or the business typically is rarely valued over its tangible book value, then selling at that price may be the most sensible solution.

Remember when selling net-nets:

 Do not sell too early or precipitately (especially if the share price has risen quickly) – prefer to sell in parts. Be prepared to hold the shares for at least one to three years. Make a new analysis if the share price has risen or dropped sharply.

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