Many investors focus most of their attention on stock selection. That’s no wonder, with media headlines touting the next meteoric stock opportunities and companies whose shares you should pick up in the hope of hefty returns. Selling stocks rarely makes headlines. So when should an investor divest their holdings in a company?
Long-term quality investors buy high-quality businesses and hold on to the shares for a long time. Nevertheless, there are circumstances that warrant selling your holdings in high-quality companies.
The Sifter Fund strategy specifies five situations in which we will sell a stock in our portfolio. The first four circumstances involve changes in the company’s business and the fifth relates to its share price or, in other words, a decline in its expected earnings yield.
We will sell shares when:
- the company’s revenue model or competitive advantage is permanently damaged,
- there are significant changes in the senior management of the company,
- the company is sold or it carries out a significant merger,
- we identify a better business to replace the existing portfolio company,
- company’s expected earnings yield has declined too low over a five-year time span
1. Sell the stock when company’s revenue model or competitive advantage is permanently damaged
We call this the crumbling fortress scenario. It means that a previously strong, high-quality company has encountered a permanent problem. This happens from time to time. We believe this is what happened to Intel, which was previously a long-term investment in Sifter portfolio. You could also say the same about General Electric and mobile phone company Nokia, although we at Sifter never owned those particular stocks.
The key principle of the Sifter Fund is to own very strong, high-quality businesses. This is why we see the crumbling fortress scenario as a strong sell signal.
We want to anticipate future problems and we’re prepared to sell our holdings immediately when a company no longer satisfies our criteria. Our view is that holding shares in a crumbling fortress is not worthwhile even if you could buy them cheap.
Interested in long-term quality investing? Download our 20-page guide: Long-term quality investing. Our guide explains how time and high-quality companies work in an investor’s favor.
2. There are surprising or significant changes in the senior management of the company
We also take a negative stance toward situations involving changes in senior management, and such overhauls can lead to the decision to sell our holdings in a company.
For example, in 2018, the new CEO of Texas Instruments was ousted due to a breach of the company’s Code of Conduct. Nevertheless, our assessment of the company did not lead to the decision to sell our holdings in TI because the vacated position was taken by the legendary previous CEO Rich Templeton.
Surprising changes in senior management can be related to health, misconduct or a CEO being offered a more attractive post. Regardless of the details of the circumstances, these changes always lead to at least temporary uncertainty that puts the strength of the company’s culture to the test. However, this criterion is not as serious as the crumbling fortress scenario.
3. The company is sold or it carries out a significant merger
This situation is fairly uncommon but always a possibility. For companies in Sifter’s portfolio, this has happened twice during the past year.
In the summer of 2020, this is what happened with Varian Medical, an equipment manufacturer specializing in cancer treatments, when a subsidiary of Siemens made a tender offer at a 25% premium. We sold our holdings in Varian because we believed that the company created by the merger no longer fulfilled Sifter’s quality criteria.
In our experience, large mergers often lead to a new strategy that may erode the company’s previous competitive advantages.
Similar circumstances arose in March 2021 when the Annual General Meeting of S&P Global Inc. confirmed the planned merger with IHS Markit. We believe the original competitive advantage and revenue model of S&P Global is diminished by the merger and we began selling our holdings.
4. We sell the stock when we identify a better business
The key principle of Sifter Fund is to own stocks in a small selection of companies (approximately 30) and to replace investments when we identify a better alternative.
We continuously look for new investments among more than 65,000 listed companies. The Stocksifter tool we have developed automatically rejects more than 99% of these companies, with only some 100 potential investments around the world being chosen for more detailed qualitative analysis each year.
We only invest in 3–5 new companies per year.
These comparisons and changes are successful because we know the ranking of our portfolio companies and have the ability to make comparisons between companies.
For example, in spring 2021, we replaced our long-term investment in the Japanese pharmacy company AIN Holdings with another Japanese company, Nitori.
A key reason behind the change was that our comparison indicated that Nitori is the higher-quality business between the two. We believe that Nitori will be a better investment in the long run.
Read more about Nitori from our Quarterly Report Q1/2021.
5. Sell the stock when company’s expected earnings yield has declined too low
This is the price matters scenario, which emerges when, in our opinion, the share price has risen too much relative to the company’s capacity to make money in the long term.
The share price plays an unusually small role in Sifter’s investment philosophy. We believe it is more important to own shares in high-quality businesses for a long time instead of trying to anticipate changes in share prices. Consequently, we never set short-term or long-term price targets for stocks.
All of the Sifter Fund’s companies are ranked according to their risk-adjusted earnings yield. When the price of a company’s share gets too high, the change in its earnings yield pushes it down the ranking and makes it a potential candidate for divestment.
It may subsequently be replaced by a different company that has equally impressive qualitative strengths but a substantially higher earnings yield.
Sometimes, the price of a stock gets much too high, which means it is no longer consistent with the fundamentals of the stock. One example of this is the robot vacuum maker iRobot, whose share price saw a meteoric rise as a result of market speculation.
There is no room for emotions when it comes to selling stocks
You have to be careful not to fall in love with a stock. A frog won’t turn into a prince, no matter how long you wait. If a company’s business becomes weaker, the share price will inevitably be pushed down.
If you realize that one of your investments is getting on the wrong track, you should sell your holdings in that company. The sooner you sell, the better off you will be.
This is what we do at Sifter. We sell our holdings in a company when we believe its capacity to make money in the future is diminished or when we find a better company to replace it with. This sounds simple, but the truth is that analyzing companies and their capacity to make money is a full-time job, even for a professional.
The careful selection, monitoring and replacement of companies will reward long-term investors.
Interested in long-term quality investing? Download our 20-page guide: Long-term quality investing. Our guide explains how time and high-quality companies work in an investor’s favor.
Santeri Korpinen
CEO, Sifter Capital Oy
