A Better Strategy for Selling Investments

When I entered the research business in 1996, I worked for firms that were highly geared toward trading and short-term gains. These ideas were cemented in me by my interest in technology – where everything is a gamble – and because I made my first significant profits as an investor in start-up tech firms, such as Amazon.com.

These were all successful speculations... and cutting losses was critical to my success. The technique became something of a religion to me.

However, as I've gained more experience as an analyst (and as an investor), I've come to appreciate how difficult it is to beat long-term, compound returns. Take Exelon, the Illinois utility, for example.

We bought Exelon at $21 per share five years ago in my investment advisory. This year, the company is likely to pay a $2-per-share dividend... thus – we're making nearly 10% on our original investment from the dividend alone. And each year we hold the stock, we stand a very good chance of watching our rate of return continue to increase. I wouldn't be surprised if Exelon stays in our portfolio for another five years. By then, we'll probably be earning 20% per year on our original capital.

You cannot enjoy the benefit of long-term, compound returns like these without making long-term investments. You have to be able and willing to buy equity that's capable of compounding capital for 10, 20, and even 30 years into the future.

Speculations never last this long. If you treat all of your best investments as though they're merely speculations, you will only rarely keep a company as good as Exelon long enough.

So how do you decide whether a stock should be treated as a speculation or a long-term investment?

Mohnish Pabrai, the keynote speaker at last year's S&A Alliance Conference in Aspen, Colorado, is one of the world's best investors.

Since 1999, he has produced average annualized gains around 28% a year – a truly awesome performance. A disciple of Warren Buffett, Pabrai is a long-term investor, who makes a relatively small number of large investments. Pabrai typically holds eight to 12 stocks – meaning a loss in any single stock will substantially hurt his overall results.

He's done the best thinking I've seen about how to handle investments that decline in price.

The first thing to consider is whether you're dealing with an investment or a speculation. Cutting your losses quickly is an absolute necessity for all speculations. So... how can you know you're truly dealing with a long-term investment?

Here are Mohnish's tests:

No. 1. Is the stock a business that I can readily understand and evaluate with a high degree of confidence?
No. 2. Can I know the intrinsic value of this business... and how is it likely to change over the next few years?
No. 3. Does the stock trade at a substantial discount to its intrinsic value?
No. 4. Would I be willing to invest a large part of my net worth into this business?
No. 5. Is the downside minimal?
No. 6. Does the business have a moat?
No. 7. Is it run by able and honest managers?

So... when stocks meet these criteria... when a company is a long-term compounding machine... how does Mohnish handle a substantial decline in price?

"Businesses are living entities that go through ups and downs just like humans do... It is best to give businesses time to adapt to change... Any stock you buy cannot be sold at a loss within two to three years of buying it, unless you can say with a high degree of certainty that current intrinsic value is less than the current price."

Following Mohnish's advice, I will endeavor to keep my long-term investments for at least two to three years. If I decide to sell before two years, it will be because a company has experienced a material reduction in intrinsic value... not because its share price alone has changed.

Thus... going forward... I will not use pre-set trailing stops for my long-term recommendations... companies that I believe are worth holding for years and years – like Intel or Budweiser. If you're an investor with a long-term horizon, I advise you to do the same.

Good investing,