Know When to Bail On Your Stock Picks

Ask professional stock pickers to describe their discipline for selling, and they'll typically give one or more of these reasons: We sell when other investors come around to our way of thinking and the stock reaches the price we expected. Or, we sell when new, negative information invalidates our thesis. Finally, we sell if we can find stocks with greater potential.

Straightforward as that sounds, selling can be extremely difficult, in part because it's a psychological minefield. We sell some winning stocks too soon for fear that our well-earned gains will evaporate. We hold on to other winners too long because we've fallen in love with the companies that have made money for us. Maybe worst of all, we often hold on to losing stocks for no better reason than an unwillingness to admit we were wrong. As investing legend Philip Fisher wrote decades ago in Common Stocks and Uncommon Profits: "More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason."

Selling tips. Given the potential pitfalls, what can you do to improve your chances of selling successfully? A mental exercise we've found useful to combat psychological stumbling blocks is to imagine being forced to liquidate your portfolio and start over from scratch. Which stocks would you buy, and how much of each would you own? Then compare this hypothetical new portfolio with your current one. If there are stocks in your current portfolio you wouldn't buy today, ask yourself why on earth you're holding them at all.

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Also critical to knowing when to sell is keeping an up-to-date estimate of what you believe a stock is worth. But don't focus on that value relative to what you paid for the stock. Instead, consider it in relation to the price at which it currently trades. If you bought something at $30, you believe it's worth $55, and the stock trades today at $50, you need to ask yourself whether capital devoted to a company with an expected upside potential of 10% might be better invested in something with a much higher expected return. If the answer is yes, it's time to sell.

Finally, always remember why you bought in the first place, as different types of ideas can expire at different times. Three examples in our portfolio that illustrate this point are Anheuser-Busch InBev (symbol BUD), Microsoft (MSFT) and BP (BP), all of which we recommended in earlier columns.

Given InBev's strong position in the stable beer business and its fine management (among the best we've seen in any industry), we can project earnings and cash flows years into the future. As a result, we believe we may be able to hold this stock for a long time.

Our investment horizon is much shorter for technology companies, even one as dominant as Microsoft. But we don't have to be able to predict Microsoft's fortunes five to ten years into the future to justify owning the shares today. We simply believe that both the consensus earnings estimates and the price-earnings ratio that investors are currently placing on those earnings are too low and that both are likely to expand significantly over the next 12 to 18 months, at which point we will likely sell our position.

Our horizon for BP is even shorter. We bought the stock betting that its crippled well in the Gulf of Mexico would be capped sooner than most investors expected, that the environmental damage would be less than feared, that the cleanup and legal liabilities would be at the low end of estimates, and that the company had the assets and cash flows to meet all eventualities. We've made a healthy profit over our average cost of $29 a share. And while we haven't sold yet (as of early August), we're ready to get out once other investors bid up the price as they recognize the validity of our analysis. And we will do so without remorse -- or any other psychological baggage.

Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight.