When To Sell Stocks: Look For The Game Changer Moment

We spend a lot of time analyzing and trying to figure out what stocks to buy, but I think as investors we don't spend nearly enough time on figuring out when to sell a stock. The easy answer if you're into value investing is to sell when stock reaches it's intrinsic value or some pre-determined internal return you are seeking, which requires a great deal of internal discipline. A lot of times it just doesn't work out that way as macro/micro events may force you to come to a road where you have to decide to hold on or part ways. Hence, I wanted to share some thoughts on what I call the Game Changer moment for a company when some critical event occurs that can take a company and its stock down a road that is hard to recover from.

The hardest thing about a Game Changer is recognizing it because often emotion clouds our judgment. We may love a company and stock so much that a little bad news may seem like no big deal when in fact it is a signal to shut up, don't ask questions, sell and walk away. I myself have felt victim many times and always try to learn from them.

My worst investment decision was when I bought Mega Brands 5 years ago. I bought it at $23. It's a toy company that makes the Lego-like building blocks. The numbers were great in my model and I thought it would be a firm with a good long-term durable competitive advantage. I mean who doesn't buy toys for their kids? Mega Brands purchased another company that specialized in magnetic snap-on toys and was very popular. The purchase was working well when one day, the Game Changer happened. It was disclosed that 3 kids had died after accidentally swallowing some of the parts which had come apart. They were defects in the magnetic parts. As a result, there were lawsuits, which were not large but they were visible in the media. At the time I decided that these events were not significant to bring the stock down plus I "loved" the business model. I mean it's a freaking toy company! What's the worst thing that could happen? Well the stock moved down from the $20's to the teens. Soon after there were problems with materials from China that contained traces of lead. I kept holding on to the stock because I believed management which had demonstrated a great ability to manage capital would get through this. This was 5 years ago I continued to hold the position and earlier this year I sold the position at a loss of 88%. I didn't see the Game Changer in this case, which when death is involved, it never ends up well. I let my emotion cloud my decision making.

My other investment flop was Bombardier. I held it in 2001 because the company was generating tangible wealth according to my model. Then 9/11 occurred. I realized this was a Game Changer and that flying would change forever. I sold at $15 on September 12th. There was no thought, guilt, no emotion nor second-guessing. I cut and run. The stock has never been anywhere near since. It was a Game Changer with a happy ending for my portfolio.

So what constitutes a Game Changer? I've tried to list a few triggers that I keep in the back of my mind that would force me to sell unconditionally and systematically:

  1. Monster competitor enters the market (e.g. Wal-mart in groceries, Apple in consumer electronics)
  2. Accounting irregularities (e.g. Enron, Nortel, World-Com, Madoff, auditors resigning from accounts, and now Hewlett Packard). As soon as you hear anything related to accounting issues. Sell.
  3. Outright fraud (see Accounting Irregularities)
  4. Government intervention/rule change/ (e.g. Shoppers Drug Mart with prescription fees, Nationalization of co's, industries, taxation of Canadian Income Trusts)
  5. Geo/political event that shocks the world (9-11, Finanical crisis)
  6. Health event (Mad-Cow, H1N1, tainted milk/formula in China, toxic toys, Lysteria etc). Anything where death is involved.
  7. Environmental Disaster (BP spill, although the stock recovered a year or so later, the initial days of the disaster were not great for the stock).

These are some that I've seen but I'm sure there are others out there. Anything sudden that can change the direction of a company is open to being a Game Changer. I don't want to be around to see how the story ends. This is the beauty of investing in stocks. We can move on.

Having these in the back of your mind as you look at companies helps to take the emotion out. The human tendency is to somehow rationalize that these types of events are just "flesh wounds" and can be overcome which there is a possibility, but the road will be long and the stock price will be come down and basically languish for years. Think about it, a stock that falls 50% will need to increase 100% going forward to get back to break-even. How often does that happen? Not very often.

The secret to great investing is not only to grow your capital but also preserve it. The sooner you can recognize the Game Changer and react, the more likely you will preserve a good chunk of your capital.