Investors are often their own worst enemies...
They can't help but screw up their returns.
And one of the biggest ways they do this is by selling winners too soon.
Legendary investor Peter Lynch once wrote, "Selling your winners and holding your losers is like cutting the flowers and watering the weeds."
My team and I rarely like to sell a business that we know is great. In general, the best thing to do as an investor is play dead. You should stay out of your own way when you have done your research and picked the right stocks.
However, there are two main times when you should sell a winner...
First, you should sell a stock – winner or loser – if the reason you bought it is no longer true.
Say you bought a retailer because of its impeccable brand. But after a few months, there were widespread reports about quality issues with the company's products.
Just like that, the brand is tarnished. So it would make sense to move on.
The second reason to sell a winner is because you see an extreme setup with the stock.
This exact scenario recently played out in my Retirement Millionaire newsletter in November. We parted ways with one of the best companies on the planet – Costco Wholesale (COST)...
For years before buying the stock, we described Costco as the "one that got away."
We knew it was a fantastic business... We had seen long lines every time we visited one of its locations. We talked to neighbors and friends who were more than happy to pay the membership fee – even after prices went up.
Despite all this, we never recommended the stock. It always seemed too expensive.
Then, in June 2022, we finally got a buying opportunity. The sentiment around retail was terrible at the time. And even though Costco never traded at dirt-cheap valuations, we decided to pull the trigger because it was probably the best deal we were going to get.
It was the right move. Shares exploded after we bought in...
But like I said, we recently sold Costco in November. And that was because of its extreme valuation.
In short, investors ran up shares until the stock was priced near perfection.
Costco was trading for a staggering 57 times earnings – an all-time high by a mile. Take a look...
Costco is such a tremendous business that it deserves a higher multiple than other stocks. But its valuation got out of hand.
A back-of-the-napkin calculation tells us that Costco would have to grow earnings roughly 50% more than what we project it to over the next few years for this valuation to make sense.
It's trading at multiples that have typically been reserved for speculative tech and biotech stocks. But unlike these tech companies that boast zero marginal costs, Costco can't just snap its fingers to grow earnings...
It would need more land and physical stores to earn its valuation, which would require a lot of capital. It would also have to increase the low prices that draw folks into its stores.
Now, it's possible shares will continue to drift higher. Costco could get even more expensive before anything goes wrong.
But we'd be betting on something like a speculative frenzy if we kept holding. And that's not the type of wager we like to make.
Instead, we walked away with a 101% gain – because fundamentals matter. Costco was trading for an extreme valuation, so we moved on.
The risk was greater than the reward.
So while the best investors will do their best not to cut their flowers, there are still exceptions when you need to do a little pruning and sell.
If the thesis around the company is no longer true or you see an extreme setup, it may be time to head for the exits.
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