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Investors: How to know when to hold 'em and when to fold 'em

Decisions about selling stock are more art than science


One of the more difficult decisions for a portfolio manager is knowing when to sell a stock. In general, if you own a well-run business with a solid history of profitability, the vast majority of the time holding a company through a contracting business cycle is the right call; but not always. And there's the rub. How do you know when it's time to "fold them"?

This decision is more art than science, but we will generally sell a company if we have determined that there is a high risk of a fundamental change to the economics of the business.   This means we believe that the company's profits, and thus capacity to pay and raise dividends, have been meaningfully diminished for an extended period of time.

We had to make these decisions several years ago during the financial crisis.  We owned a couple of U.S. banks in our dividend growth portfolio, and sold them as it became evident that their business economics were severely stressed. That proved to be a prudent decision. In general, the large U.S. banks have not returned to their prior levels of profitability or dividends almost eight years after the crisis.

Recently, we've been undertaking a similar analysis with some energy and commodity companies.  As a result, we removed two businesses from our dividend growth portfolio. As painful as it was to make those decisions, since the price of both companies was down from their prior highs, we felt that there was a high probability that the business economics of these companies had changed and they might not return to their prior levels of profitability for quite some time.  Thus, the money could be put to better use in companies with stronger profits and dividend growth prospects in our portfolio.

In making these "fold them" decisions, one of the things we look for is whether the management of the companies is "surprised" by the changing economics of their industry. Now, the folks running these businesses are quite capable and have deep experience in their industries.  So if they are surprised, then the odds increase that they may not be well-positioned for the changes they may face.
In terms of the banks, they didn't understand the amount of risk they had taken in the structured finance and real estate sectors. They relied on the assumption that real estate prices don't decline meaningfully for any period of time and that the credit ratings agencies had accurately assessed the risks of these new-fangled mortgages. Those fundamental assumptions were unfortunately wrong, and they were definitely "surprised."

In the energy and commodity sectors, companies operate on the assumption that they will experience large swings in the price of the commodities they sell, and their businesses are structured to deal with this. But they also assume that there will be a reversion (recovery) to the average pricing after some reasonable period of time. Take oil for instance.  There is a basic assumption that oil will return to the $50 to $60 a barrel range soon.  If not, many of the investments these firms have made will prove to have been made at prices that are unprofitable.

In our review of recent earnings calls and presentations by energy companies, we have noticed that they are beginning to express some concerns and "surprise" about the depth and length of the pricing decline. Thus we felt that given the heightened risks that prices may not recover as rapidly as anticipated, it was prudent to reduce some exposure in this area and we focused on what we thought were the more vulnerable companies.

Most of the time, industry fundamentals don't change that much, and rough patches are run-of-the-mill cyclical contractions. But periodically industries experience new operating paradigms, and we have to be open to the possibility that things are fundamentally changing.

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Charles Farrell

Charles Farrell is CEO of Northstar Investment Advisors, LLC, and author of "Your Money Ratios: 8 Simple Tools for Financial Security," called "one of the best financial books to cross our desks this year" by the Wall Street Journal in 2009. Farrell previously served as a tax attorney representing privately held businesses on tax, retirement and estate planning matters.

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