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When Should You Sell a Stock For Profit

Buying is easy, but as soon as we do, our emotions take over, making selling one of the most challenging aspects of investing. I discuss when to sell a stock - for a profit or a loss.

Hello and welcome to your weekly Lockstep Investing Newsletter.

This week we cover the following:

  • When to sell and when to hold: Knowing when to sell is one of the harder parts of investing. We look at a case study to better understand when to sell a stock.

  • Loss aversion: In memory of the recently passed Daniel Kahneman, we look at our bias towards avoiding losses, which might explain why selling a stock is so difficult.

Ready for your weekly dose of investing wisdom?

Let’s dive in!

INVESTING CHRONICLES

Investing is hard and the best way to improve your own investing is through others. So, under “Investing Chronicles”, I’ll share my learnings from my 18+ years in the stock markets.

Several longstanding Lockstep Community members recently contacted me concerning Legacy Housing Corp (LEGH), a company that has been a part of my portfolio since its inception, following its disappointing fourth-quarter (Q4) 2023 results. Understandably, these members wanted to know if it was time to sell LEGH.

By addressing their concerns, I aim to provide a response that will benefit you as well by tackling one of the most challenging aspects of investing - Knowing when to sell a stock.

When to Sell a Stock for a Profit: A Legacy Housing Case Study

Company Description

Established in 2005, LEGH is the sixth-largest producer of manufactured homes in the United States. Specialising in the construction, sale, and financing of these homes, the company primarily operates in the southern United States, with over 50% of its sales originating from Texas, 12% from Georgia, and 9% from Louisiana.

Targeting customers with household incomes below $75,000 per year, representing over 50% of all US households, LEGH constructs homes in its three factories, sells them through independent retailers and company-owned outlets, and offers customised financing solutions.

How the Company Earns Its Money

LEGH generates revenue primarily from product sales (manufactured homes) and its financing business. As of Full Year (FY) 2023, 76% of its revenue stemmed from product sales, 20% from financing, and 4% from “other” sources.

LEGH’s revenue more than doubled from 2016 to 2022, meaning it has been growing at roughly 15% per year, which is not bad!

A Terrible Fourth Quarter (Q4)

In 2023, LEGH experienced a significant decline in revenue, down over -26% Year-on-Year (YoY), with Q4 2023 revenue dropping over -50% compared to Q4 2022. The poor Q4 results are due to 1) lower housing demand caused by higher interest rates and 2) a significant one-off gain in Q4 2022 due to a change in revenue recognition.

Consequently, the company’s share price fell from over $25 to under $20 per share, prompting concerns. I bought LEGH at $16.51 per share, and given the bad Q4 2023 results, is it time to sell the stock, secure my gains, and deem it a victory (albeit a minor one)?

When to Sell an Investment

I believe there are only three valid reasons to sell a stock:

  1. Overvaluation: When the share price appreciates to a level where the company is significantly overvalued.

  2. Opportunity Cost: When better investment opportunities are available elsewhere.

  3. Change in Investment Thesis: When the original reason for investing no longer holds true.

Let’s have a look at each and see if any apply to LEGH:

1. Overvaluation

I was initially attracted to LEGH because it was significantly undervalued relative to its peers. Besides being a relatively small, unknown business, the company had issues with late filings of its financial reports, which the market punished by selling its shares down! After some digging, it was clear the late filings were due to non-material issues, and the market overreacted, providing an opportunity to invest.

Over time, management resolved the financial reporting issues. As a result, the share price appreciated, from my initial purchase price of $16.51 per share to a high of $26.50. Even with this significant gain in value, LEGH was still only worth 12x operating profit while profit had been growing.

Therefore, I should NOT sell because it is overvalued.

3. Opportunity Cost

Another reason for selling is that better investments are available than the one you are currently in.

For a while now, I have held almost 5% of my portfolio in cash, and with the indices at all-time highs, I am not overly confident that now is the time to look for new investments.

Therefore, I am NOT selling because I need the money to invest in better opportunities elsewhere.

3. Change in Investment Thesis

This brings us to the final reason for selling - Perhaps the investment thesis is no longer valid.

Why Do You Need an Investment Thesis?

For those acquainted with my investment approach, I emphasise the importance of having a clear reason for investing before purchasing shares. This planning becomes crucial when faced with inevitable setbacks, enabling you to steer clear of emotionally driven decisions – a pitfall in investing.

Each investment carries its unique thesis, and while LEGH’s financial reporting issues presented an opportunity, they were not the sole reason for my investment.

LEGH’s Investment Thesis – The US Housing Deficit

The United States currently grapples with a significant housing shortage.

Since the 2008 housing crisis, the pace of new home construction has lagged far behind the demand. Estimates suggest a deficit ranging from 1.5 to 6 million homes nationwide, depending on the source. Moreover, Texas - LEGH’s primary source of income - has one of the most significant deficits in the country.

As housing prices continue to increase due to supply constraints, more households are priced out of traditional housing and are turning to manufactured homes like LEGH’s. Consequently, companies like LEGH should benefit from a multi-year tailwind driven by sustained demand for homes and manufactured housing in its region.

Is the Thesis Broken?

Despite the disappointing Q4 2023 results, growth doesn’t happen in a straight line, and there will always be obstacles to overcome, such as the current high-interest rate environment. But thanks to my investment thesis, I do not have to act on impulse. Instead, I stepped back, removed emotions from the equation, and comprehensively reassessed my investment.

After meticulously examining the annual report, thoroughly analysing competitors’ recent performances and even talking with the company’s CEO just last week, one thing has become abundantly clear – there’s no need to panic.

The US housing shortage persists, and people will always want homes. Interest rates will come down, and when they do, LEGH should be well-positioned to capitalise on that demand pickup.

My Next Move

Experiencing a decline in the value of your investment is always painful, but such decreases can present opportunities. After doing my homework, I feel confident in my work and believe LEGH is a high-quality company in an industry with a significant tailwind behind it.

Therefore, instead of selling, I am looking to increase my investment in LEGH and will likely buy more shares if the share price retreats to $20 per share or below.

Interestingly, I’m not alone in this sentiment, as directors, and per my conversation with the CEO last week, the company itself is also buying shares.

Summary

Investing is inherently emotional because it involves our money!

Buying is easy, but as soon as we do, our emotions take over, making selling one of the more challenging aspects of investing. It is critical to have a game plan for selling to minimise reacting from a place of emotion and instead act with logical reasoning.

My approach to selling involves the following:

  1. Sell when a company becomes significantly overvalued.

  2. Sell when better investment opportunities are available.

    OR

  3. Sell when the original investment thesis is no longer valid.

LESSONS LEARNED

There is no faster way to learn about investing than through the Greats. Here, I share lessons from the best investors and thinkers.

Last week, Daniel Kahneman, a luminary whose profound contributions to behavioural economics earned him the 2002 Nobel Memorial Prize in Economic Sciences, passed away. Among his many works, “Thinking, Fast and Slow” is an invaluable resource for enhancing critical thinking skills.

Although not the easiest to read, it’s a book I hold in high regard, with the conviction that it can elevate anyone’s cognitive prowess.

Given this week’s discussion on the best time to sell an investment, it’s fitting to delve into one of Kahneman’s and his colleagues, Amos Tversky’s notable theories: Loss Aversion.

Loss Aversion – Pain is more acute than pleasure

Individuals experience the sting of losses more intensely than the pleasure derived from an equivalent gain. According to Kahneman and Tversky, the pain of a loss can be twice as potent as the joy from a comparable gain.

This phenomenon helps explain our actions when investing. Investors, including myself, tend to hold onto losing positions much longer than we know we should because of the fear of experiencing a painful loss. In contrast, we often sell out of our winners to lock in gains to avoid future losses.

Our discussion on Legacy Housing in today’s Investing Chronicles is a fantastic real-world example. LEGH’s share price has increased from where I bought it, and because of a bump in the road and the share price retreating, the instinct is to sell, lock in the gains remaining, and call it a victory in fear of losing more.

This is the wrong way to act!

Instead of a knee-jerk reaction, we need to step back, analyse the situation and make better decisions based on research rather than emotion. At the risk of sounding like a broken record, hopefully, it is clearer why having an investment thesis is so important.

Closing Thought

Unfortunately, biases cannot be totally overcome, but we can arm ourselves with tools to help reduce their impact, and knowing they exist is the first step. “Thinking, Fast and Slow” introduces us to our behavioural biases and is a step toward becoming better investors.

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