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4 Reasons to Sell A Stock

For value investors, determining when to buy a stock is relatively straightforward.

The recipe for a successful purchase is described in the value investor's "Bible", and Warren Buffett's favorite investing book of all time, Benjamin Graham's The Intelligent Investor.

The recipe is thus... One, determine a "fair value" for the security, based on its current and expected future free cash flows, discounted to an acceptable rate of return. Two, buy the security at a substantial margin of safety to that fair value. By doing this, you protect your investment against unexpected, adverse developments, and your own mis-judgements when calculating future cash flows.

Easy, right? Yeah right!

What is less discussed, but just as important, is when to sell a stock.

In this article, we'll look at the 4 main reasons when a stock should be sold. Let's get to it!

Reason 1: The Stock Has Reached (Or Exceeded) Your Estimation Of Its Fair Value

This is the reverse corollary of Graham's reason for buying a stock. If you buy at a reasonable margin of safety to your fair value estimation, and the stock reaches your fair value, two things have happened. One, you've probably made a lot of money! And two, your estimated potential of future gains from the stock are quite low - potentially even negative.

In this case, it is undoubtedly time to sell.

Reason 2: There Is A Fundamental Change To Your Investment Thesis

Building on reason #1, it is important to emphasize is that it is okay for your fair value estimate to fluctuate over time!

For a stock like Apple (AAPL), new products can be tremendous positive game changers in an estimation of future cash flows. It has been reasonable to consistently raise fair value targets for Apple over the past decade.

On the flip side, adverse developments such as changing industry conditions, deteriorating margins, or the loss of major customers can and should cause a reduction in a fair value estimate. Take the case of Magic FormulaŽ stock NeuStar (NSR), which could conceivably lose its largest source of revenue, the NPAC number portability contract. It is now reasonable to assume a much lower cash flow contribution from that contract going forward, driving a fair value estimate for the stock down.

In either case, the relationship of the CURRENT stock price to your CURRENT fair value estimate is what is important in determining whether to sell. If adverse developments drive your fair value estimate down to or below the current stock price, it is time to sell.

Reason 3: You Need Cash For A More Attractive or Immediate Opportunity

Without a doubt, reasons #1 and #2 will be the most common explanations for selling a stock.

But another important one is simple: you need the cash.

There are loads of scenarios where selling a stock to raise cash is necessary or recommended. Selling stock to finance a large life expense, like the down payment on a home, or a child's college tuition, are some examples. Retirees will sell assets gradually to fund their retirements. And so forth...

However, it also makes perfect sense to sell a stock to raise cash for another, more attractive, investment.

For example, say you own stock "A", which trades only about 3% below your fair value estimate, and that you are fully invested (e.g., you carry a small cash balance in your portfolio). After doing some research, you've determined that stock "B" has good growth prospects, strong competitive advantages, solid financial health, and trades 30% under your fair value estimate.

In this scenario, your money stands a greater return potential in stock "B" than in stock "A". Time to sell and roll over the proceeds!

Reason 4: For Tax Loss Harvesting

The final reason to sell a stock is a bit nebulous but still important. By selling stocks at certain times, an investor can minimize the amount of taxes owed on investment proceeds.

I wrote about tax loss harvesting last month. Put simply, you can deduct investing losses from investing proceeds, and you can even report investment losses up to $3,000 in aggregate. At the end of the year, it makes sense to sell some losers to offset the gains from any winners earlier in the year, dulling the tax bill come April. In effect, your loss is lightened by the tax savings, and you can always buy the stock back back 30 days later if the price is still attractive.

Conclusion

While Benjamin Graham makes when to buy sound easy, and these 4 reasons cover most scenarios for when to sell a stock, as always it is easier said then done. The real "trick" is coming up with that reasonable "fair value" price that is so important to the tenants of value investing.

That's what we aim to do with every Top Buy pick from the Magic FormulaŽ screen - find this price that all investment decision is then based around. The MagicDiligence Membership is month-to-month, low cost and low risk. Give it a try and see the most attractive stocks of the Magic FormulaŽ today!

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