The Trouble With Taking Profits

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- By Geoff Gannon

Warren Buffett (Trades, Portfolio) said that there was one part of how businesses worked that he didn't believe and wasn't prepared for till he saw it in action himself. He called it the "institutional imperative." And he said this institutional imperative was: "the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so."


I've spent over 12 years now mostly in the company of other value investors. The virtual company, that is. It's rare that a day goes by without me conversing by email or Skype with some reader of my blog, listener to my podcast, or others, about investing. Very often - most often, I'd say - we talk about some specific stock they don't yet own but are considering buying or a stock they own and might sell.

Today, I want to talk about that second category: a stock you own and might sell.

I've read a lot of books about investing. And I spend a few hours of every day thinking about investing myself. So, I didn't expect to see behaviors that surprised me. But, I do see a pattern of behavior with value investors that does surprise me. And that's what I'd like to talk about today.

It's a well-known behavioral pattern.

Officially, it is known as the "disposition effect." That's an unmemorable name, however. So, I'm going to call it the "tendency to take profits." In my experience, it hits value investors like an itch the second their stock is meaningfully in the black - that is, the second they are showing a paper gain they could crow about. If a stock is up 30%, that's often enough to get a value investor itching to sell.

Why?

I'm not sure exactly. There are a few possible explanations. One is the simplest: People like doing things. People don't like not doing things. Investors have a very strong tendency toward considering their options and they really don't like to be left in limbo. Personally, I have to say I really enjoy only buying about one stock a year. But, this is one of the parts of my approach to investing that gets the oddest looks from others. The idea that you could write about investing, think about investing, research stocks, etc., all year long and in 11 months out of 12 months make no change to your portfolio seems really weird to people.

I don't have anything against action I feel pretty sure will add value. But, looking back at my own past actions - it's rare for me to have an impulse to sell one stock and replace it with another and for that impulse to be proven definitely and materially correct over the long-term. Honestly, what I buy doesn't much outperform what I sell. This wasn't always obvious to me. I used to do more tracking of my portfolio performance versus something like the S&P 500. And so, if what I bought outperformed the market over the time I held it - I tended to think my purchase was a good decision. However, when I went back and really analyzed the decision in terms of my subjective opportunity cost rather than everyone's objective benchmark - the results were a lot less clear.

See this article for details: "Over the Last 17 Years Have My Sell Decisions Really Added Anything?"

This might just be because I think a lot about buying businesses that have good competitive positions. If I was more interested in "deep value" type stocks, this pattern might not hold. But, the pattern tends to be that if I correctly identify a stock as having a strong competitive position - a "moat," an industry "tail wind," improving economies of scale, etc. - that correct assessment wouldn't just get me good returns over the one to three years during which I actually owned the stock. The same insight would be paying off in years five, six, seven, eight and nine. Those are years in which I've often already sold the stock.

Now, it's true that selling one stock to buy another works sometimes for me. But, mostly it's from the "value" component of the two stocks having a big difference.

I'll give you a "live" example now and you can decide for yourself. I own a stock called BWX Technologies (BWXT). It has a P/E of 32. I didn't buy it at anywhere near today's price. It's a $64 stock today. I bought it at more like $27 before a spin-off that also gave me another business I sold for $10 a share. So, I guess you could say I bought this stock - the BWX Technologies part - at something like $17 a share and now it's at $64 a share. That part scares value investors. The P/E of 32 is scary. But, a stock going from $17 to $34 to $51 to now $64 isn't necessarily a reason to sell something. It's not how much profit you are showing in the stock - it's how expensive the stock is now versus what you think it's worth now. BWX Technologies now has a P/E over 32. And it also has some net debt now. We can all agree: It's expensive.

Compare this to a stock I might replace BWX Technologies with. There's a publicly traded collection of car dealerships in the U.K. called Vertu Motors. I'm not saying this is definitely the stock I'd replace BWX Technologies with. But, it's a possibility. As of this moment: It's the kind of stock I might replace BWX Technologies with. It's probably close to the top of the possible replacement list.

Well, Vertu has no net debt. And it's trading at something like a P/E of 6. So, the rough estimate here would be that BWX Technologies is about five times more expensive than Vertu Motors.

Selling out of BWX Technologies and buying Vertu Motors may make sense, because I would be selling out of something with a P/E of 30 and getting into something with a P/E of 6.

I don't think Vertu's future is as clear as BWX Technologies' future though. So, I'm not sure the two deserve anything like the same P/E ratios. But, it's possible Vertu deserves to have a P/E ratio two to three times higher than what it has now and BWX Technologies deserves to have a P/E ratio that is just 2/3 of what it has now. So, maybe Vertu deserves a P/E of 12 to 18 and BWX deserves a P/E of 20 to 25, but no higher. If that were true, then obviously Vertu would be a lot cheaper than BWX Technologies right now.

That's the kind of swap a value investor should make. And that's the right way to think about selling a stock. You sell something that is clearly expensive - its P/E ratio is 1.5 times or 2 times the level of the overall market. And you replace that expensive stock with something that has a P/E that is two-thirds or even one-third the level of the overall market. That kind of huge "trading up" in terms of getting more value for your money makes sense.

But, when I talk to people about a stock like BWX Technologies that isn't where the conversation goes. The conversation goes something more like this: "Didn't you buy both BWX Technologies and the other part of Babcock together for like $27 a share and then sell the other part for $10 a share. So, isn't it like you bought BWX Technologies at $17 a share? And, if you bought it at $17 a share, I can understand why you'd hold it till maybe $34 a share (a double). But, now you're holding it when it's closing in on something like $68 a share (a quadruple). Certainly, you didn't originally think you were buying something at 25% of intrinsic value. So, isn't BWX Technologies overpriced, and shouldn't you sell it?"

Now, my own feeling on this is a little extreme. But, I'll tell it to you anyway. I don't think you should ever sell a stock just to sell a stock. I think you should only sell a stock to replace it with another stock. I do sell stocks in anticipation of buying a new stock - and so, I sometimes have cash lying around if I don't pull the trigger on the new buy right away. But, I don't sell a stock just to get out of it or "take a profit."

Why not?

One, stocks as a group outperform cash. And not by a little bit. It's by a lot. So, if the average stock out there would normally return 8% a year and the average bank account out there would normally return 3% a year - you'd have a 5% annual drag from holding generic cash instead of a generic stock. It's true that stock you own could be really, really overvalued. But, I just used an example of a stock with a P/E of 30+ and I'm still not sure this argument works. Would I really be better off holding cash for the long-term (let's say five years) rather than holding BWX Technologies? It's true the P/E multiple might contract from 32 to 20. But, it's also true the stock's earnings per share might grow about 10% a year during much of this time. So, when we do the math, we'd have to be pretty confident the multiple contraction is coming soon (like in the next three months to three years) to argue that we'll be better off getting out of even a really expensive stock like BWX Technologies.

The other problem - and this one is the much bigger problem for me - is that selling a stock to "take a profit" essentially means reversing your early decision. The stock you're selling isn't a generic stock. Would I sell the S&P 500 today (if I held it) to hold cash for the next one, three or five years? Maybe. Yeah, I might be open to that. I don't much like the S&P 500 at today's price. I wrote in a recent blog post that I think - as of 2018 - we are now in an actual bubble in U.S. stocks.

But, I didn't "pick" the S&P 500. I did "pick" BWX Technologies. And I had reasons for picking it. I thought it had an amazing competitive position. The company is in a monopoly/monopsony situation (bilateral monopoly) where I felt the U.S. Navy effectively needs BWX Technologies to stay in business and be its sole supplier for nuclear related activities like building nuclear reactors for all of the Navy's submarines and aircraft carriers and BWX Technologies in turn needs the Navy to keep ordering these reactors. The visibility for nuclear reactor demand from the U.S. Navy is very high. We have planning that goes out like 25 years. These are all things I liked a lot about BWX Technologies when I first bought it.

Stock picking is essentially handicapping. So, yes, the average stock with a P/E of 6 will probably outperform BWX Technologies with a P/E of 30. But, it's not likely to outperform it by 5 times. There's probably a quality difference between Vertu and BWX Technologies offsetting some of that price gap.

When I first bought BWX Technologies, I thought it would have pretty quick and very predictable EPS gains for years to come. That hasn't changed. My assessment of the business hasn't changed. So, I wouldn't be selling a generic stock with a P/E of 30. I'd be selling a part interest in a business I thought had a clear and good future for as far as the eye could see.

That's what I mean about having to reverse yourself when you sell a stock. You are - in part - betting against your own initial analysis of the business. If BWX Technologies is really still such a good business, then it can compensate future holders of the stock for a lot of the downside of buying such an expensive stock. It's possible a really good business with a P/E of 30 could outperform a generic business with a P/E of 20. And I knew that when I first picked this stock.

Selling is something I struggle with. But, it's something I've gotten better with over time to the extent I decided on three things...

One, never sell a stock within the first year of buying it. The general principle here is to hold a stock at least long enough for your original thesis to play out. For example, I bought Frost (CFR) believing its earnings per share would rise as the Fed Funds Rate rose. I shouldn't sell the stock while the Fed is still raising rates. Otherwise, I'm not letting my original thesis play out. I'm cutting it short. The guiding principle is: don't sell a stock before you let the original thesis play out. The ironclad rule is: don't sell a stock within a year of buying it. If you do that, you're a trader. For example, I have a big position in NACCO (NC) and people always ask if I'm going to trim it. I'm open to trimming it eventually. But, I just bought it last October. I won't re-visit the stock till October of 2018. Worrying about selling at an especially opportune time in the first 11 months of owning a stock is giving in to a trading mindset instead of an investing mindset. Two, don't sell a stock to "take a profit"; sell a stock to buy a cheaper, better stock. In other words, don't "take profits" just "swap stocks". And finally, there's number three. This one for me has been the hardest. It's simply: focus on what you're buying instead of what you're selling. In other words, let your buy decisions dictate your sell decisions - never the other way around.

If I research Vertu Motors a lot and discover I love this stock at this price - then, yes, I'll sell out of BWX Technologies. But, I won't let myself think "Oh, I should really sell out of BWX Technologies now that it's so expensive - let me scour the globe looking for something cheaper to replace it with".

That's letting the tail wag the dog. If you buy right, selling mostly takes care of itself. This is largely because even if the price is now wrong - the stock you own is too expensive - the quality will still be there. The greater danger is owning the wrong business rather than owning the right business at the wrong price.

So, if you like the businesses you already own - then, stick with the status quo until proven otherwise. You own the stocks you own for a reason. You liked them once better than any other stocks out there. So, have the faith to stick with them till you find something that excites you as much as those stocks once did (when they were cheap).

Most importantly, learn to love inaction. And strike the term "profit-taking" from your vocabulary. Locking in a paper gain - turning it into a realized gain, that doesn't matter. All that matters is opportunity cost. Is the stock you're adding to your portfolio going to outperform the stock you're dumping from your portfolio. That's the only "gain" that matters.

Disclosures: Geoff owns NC, CFR and BWXT.

Listen to Geoff's Podcast

This article first appeared on GuruFocus.


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