A Case Study in Sell Discipline

 | May 22, 2013 | 10:00 AM EDT
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Today we will delve into two recent stock sales in order to illuminate what I consider to be the two most important elements of "sell discipline." For investors, both professional and individual, sell discipline is given immense verbal respect yet is rarely well implemented in practice.

In my opinion, selling is the single most difficult act in stock trading, because the best time to sell (that is, when the price is highest) is also the moment when the outlook is at its best -- earnings are growing robustly and appear to have years of growth ahead, management is executing crisply, the market opportunity appears open-ended with little strong competition on the horizon. Selling when conditions are lousy is easy ... and you are likely to get a very low price that reflects that lousiness. Selling at the top is very, very difficult, and it requires a true discipline that can take years or even decades to develop.

The first important element of a good sell discipline is embodied in the old saw, "Never get married to a stock." Of course, this means to not become emotional about a holding, Do not get attached in such a way that your emotions cloud the objective evaluation of the stock now.

Our case study today looks at two stocks that provided me exceptional returns and with which I would have been in love if I had allowed emotion to overtake judgment. After holding them for around a year, I sold them last week, with stellar results.

The two sales were Marathon Petroleum (MPC), the refining spinoff of Marathon Oil, a stock I purchased on May 14, 2012, and sold literally (and coincidentally) exactly one year later for a 109% gain, and my 2013 "dividend champion," HollyFrontier (HFC), which I purchased on July 10, 2012, and also sold last week for a gain of 30%. That gain is price change only ... I also collected dividends worth another 7.2% in seven separate declarations over that nine-month period.

The chart below shows the performance of both stocks compared with the price of oil (using the iPath S&P GSCI Crude Oil TR Index ETN (OIL)). With performance like this, how could I ever sell these stocks?

MPC vs. HFC vs. OIL
Yahoo! Finance

The catalysts for the sales illustrate the second and to me single most important element of a sell discipline: You should be selling when the fundamental outlook is just "average" relative to other stocks. Outperformance is driven by fundamentals (meaning earnings) improving at a pace greater than expected by the market. (Do you disagree? Consider if the market could omnisciently forecast future earnings. Stocks would be priced to yield an "average" return against those earnings. The only way to "beat" the market is to guess better about the future actual results.)

The classic mistake in sell discipline is to begin selling when the fundamentals deteriorate, decline or are poor. At that point, you are too late! Every slot in your portfolio should contain a stock that you believe will perform better than expected and better than average. Any stock that is just "average" or unexceptional is a sale candidate, to be replaced by an exceptional, above-average name.

In this case, the estimate revisions turned from a strong upward trend -- meaning the market was progressively expecting better earnings performance than it had previously -- to a flat to down trend. Stock performance is highly correlated with estimate trends, and this flattening out was my signal to research why the outlook was suddenly no longer improving. (Keep in mind, it could be the fundamentals that are changing, or it could simply be that expectations have caught up with reality.) The charts below compare the forward-four-quarter EPS estimate with the stock price. You can easily see the recent change in tone.

MPC Stock Price vs. Estimate Change
HFC Stock Price vs. Estimate Change

Naturally, these red flags were the catalyst to do more digging and understand what was underlying the change in trend. Naturally, you do not want to blow out a stock if the trend change is due to very transitory reasons, or reasons not related to the fundamentals, such as an accounting change. So while you do not want to mechanically just sell, you most also research the trend change with a critical eye, letting "guilty until proven innocent" be your guiding principle. The estimate trend change should lead to a sale 90% of the time.

In these case, for both names the financial conditions for oil refiners are softening at the margin. For instance, when Marathon Petroleum recently reported first-quarter results, it hit gross margin per barrel of $7.92, down 14% sequentially, as crude differentials narrowed. (Crude differentials are the price differences from different sources of crude, such as Brent, Bakken, etc. The location of refining and delivery assets can affect the price a refiner pays for feedstock. Marathon Petroleum's assets are mid-continent and have benefited from new shale oil sources, but as price spreads narrow, the earnings advantage narrows.) Looking forward, crude capacity is set to increase seasonally, and that will further pressure margins.

The estimate trend change was the catalyst for my sell research, but as I mentioned, the most important idea is that every portfolio slot must contain the best name possible. A simple way to consider a stock is with the question: "If I were starting today with 100% cash, would I buy this stock?" If the answer is "no," you should be selling it today and buying the more attractive names. In this case, there is a long list of energy mineral names that have exceptional strong upward estimate trends and trade at attractive valuations. The table below illustrates the "menu" from which I could choose.

Best Energy Minerals Estimate Trends
Factset, First Call Estimates

After some additional research, I ended up replacing Marathon Petroleum and HollyFrontier with Southwestern Energy (SWN) and Philips 66 (PSX). Southwestern is somewhat expensive at 19x forward earnings, but not out of the range I would consider for this growth-at-a-reasonable-price (GARP) portfolio. (The next-ranked name, EQT (EQT), was far too expensive for my tastes at 31x, even though the estimate trend was strong.) Phillips 66 is downright cheap at 9x, although that is the range at which most other downstream oil names trade. Although it is also a downstream name, I feel more comfortable in Phillips 66 because of the location of assets and because of its skew toward distribution rather than refining.

The lessons of this case study should be clear.

1.Don't let the emotional attachment of great past performance, love of a management or anything else prevent you from evaluating a stock coldly and objectively. It is a piece of paper, and it does not know you own it. When it is time to sell, sell it coldly, brutally and unemotionally.

2. Fill every slot in your portfolio with the most attractive names you can find right now, and if a name just becomes average -- so that you would not buy it if you were starting fresh -- then sell it immediately. Do not wait for the fundamentals to become poor. Stocks will go from great to average on their way to poor, so if the direction is not getting better, then it is by definition getting worse.

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