Legendary investor Warrant Buffett believes there are only three practical situations in which it is time to sell a stock – when something better comes along, the company’s economics has changed, or a single holding gets too big.
Buffett is the chairman and CEO of Berkshire Hathaway and is one of the most successful investors in history.
He is affectionately known as the “Oracle of Omaha”, and his investments are closely followed by analysts, fund managers, and retail investors.
Throughout his investment career, Buffett has spoken on the art of selling several times, and there are three instances in which he believes is the best time to sell a stock.
These three situations, and why Buffett believes they are a good time to sell, are listed below.
1. When something better comes along
Buffett believes that a good time to consider selling a stock is when an opportunity comes to buy a company you understand and trust will do well.
“In my first 20 years of investing, my decision to sell was primarily based on the fact that I found something else I was dying to buy,” Buffett said.
His reasoning lies in the notion of opportunity cost. Having shares in one company is at the expense of having them in another.
It means you may need to sell shares in a company you like to maximise the rewards in another company that you believe is even more terrific.
An excellent example of this is when Buffett switched his investment from the Commonwealth Trust bank to Sanborn Maps.
In 1959, Buffett Partnership Limited (BPL) had an opportunity to become the largest holder in Sanborn Maps, so it sold its block of Commonwealth for $80 per share and bought into Sanborn Maps for $50 per share.
While Commonwealth had an intrinsic value of $135 per share, Sanborn Maps had an intrinsic value of $125.
BPL’s capital was assured a better performance in Sanborn Maps – at the buying price of $50 per share – than if it had stayed in Commonwealth.
2. When the economic characteristics of a company change
Buffett hardly ever sold his securities, and he famously once said that “our favourite holding period is forever”.
However, one of Buffett’s exceptions to his rules – which indicate a good time to sell – is when the economic characteristics of a business change in a significant way.
Some significant changes include a shift in the management and operations of a company and if the company loses the economic or market advantage it once had.
In 2014, Buffett sold off one of his most prominent investments of all time – the newspaper The Washington Post.
Buffett’s reasoning for selling was that the internet had changed the world of news reporting. The Post no longer held the competitive advantage it once had when Buffett purchased it in 1973.
3. When a single holding gets too big
Another good time for Buffett to sell was when a single holding in a company became too big, increasing the risk of underperformance or losses.
The smaller your portfolio is, the more you can afford to put in a single stock.
In his early years of investment, when he managed a smaller portfolio relative to what he has today, Buffett had a 40% rule, which stipulated that he would have no more than 40% of his investments in one company.
For example, in 1967, Buffett put 40% of his partner’s investments in American Express, which amounted to $500 million.
Over time, his portfolio grew, and this investment eventually took him over his 40% rule. He cut down on his position to maintain some diversification to limit the risk of underperformance.