The line, “Sell, Mortimer! Sell!” comes from the iconic 1980s movie, “Trading Places,” where the film’s heroes, played by Eddie Murphy and Dan Aykroyd, get the better of villains Randolph and Mortimer Duke while trading orange juice futures contracts—which is yes, a real thing. In the pivotal scene, Murphy and Aykroyd have duped the Dukes into thinking they received an advance copy of the government crop report indicating there will be an orange shortage, meaning the price of orange juice will go higher once the report is officially released. The Duke brothers, believing they have an information edge, place bets on the price of orange juice going up. When the actual crop report is released it indicates instead that oranges are plentiful, the price of orange juice futures drops like a rock and the Dukes realize they’ve been had. In the panic to unload their position Randolph Duke directs his brother to, “Sell, Mortimer! Sell!”
Investment managers seemingly tend to focus disproportionately on buying stocks versus selling them. This is partially borne out by what is covered in the financial media. Rarely do you see an investor on television or in the press talk about what they have been selling. There is much greater focus on what investors are buying, ideas they find interesting now. Perhaps this is simply an attempt to focus on the positive and avoid disparaging companies that are on the “sell” list. However, even if this is true, it is likely only part of the reason. I suspect it is because investment managers typically put more energy into the decision to buy a stock than to sell it. After all, it is far more glamorous to find the next Amazon than it is to make a wise sale.
An interesting research paper was recently released that supports this conclusion, dryly entitled “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.” The paper was based on the study of institutional portfolio managers covering 783 portfolios with an average portfolio valued at approximately $573 million. The researchers studied 4.4 million trades (2.0 million sells and 2.4 million buys) between the years 2000 and 2016. Among the findings was that “while investors display clear skill in buying, their selling decisions underperform substantially.” Amazingly, the study found that the selling decisions by managers underperformed a no-skill strategy of selling a randomly chosen asset from the portfolio by 0.5% to 1.0% over a one-year period after adjusting for risk. The professional investment managers would literally have had better performance if they simply threw a dart to decide which stocks to sell!
How is this possible? How is it that the professional managers involved in this study, who I suspect are generally representative of the larger population of professional investment managers, did worse than selling stocks at random? The researchers believe they have an answer, indicating that the managers had a greater propensity to sell positions with extreme returns, as the best and worst performing assets were more likely to be disposed of. A similar propensity was not found on the buying side of the equation. The researchers believe that when raising cash for new purchases, managers simply looked at what had gone up or down a lot and made a quick decision to sell. This is in contrast to what was a more thoughtful, process-driven decision in determining which stocks to buy.
However, all the news regarding the sales process wasn’t bad. Despite the poor overall record with sales, the researchers found that when selling decisions capitalized on information from earnings announcements, the sales outperformed a random strategy. This makes sense, as a sale driven by information regarding the company’s operating performance versus simply the price action of the stock should result in better decisions.
Overall the results of this study are pretty interesting. I’m not going to get too deep into the details about how it was conducted, and certainly there will be those who take exception to the way the study was carried out. However, the general conclusion seems plausible. Investment managers typically spend more time thinking about buying stocks than selling them, and when sales are made based largely on historical price action, the results are disappointing. A more systematic approach of selling based on specific information from earnings announcements generally results in better outcomes.
I will say, and I think the other members of the investment team at Provident will agree, that a buy decision is often much easier to make than a sell decision. Our buy decisions are typically based on paying a fair-to-attractive price for a company we believe has good growth prospects. Selling means a stock has achieved or exceeded our approximation of its fair value, or that we have found a stock we believe has a more promising future. However, that simplifies things a bit. Selling can mean admitting a mistake on a buy decision—not always an easy thing to do. Or selling can mean getting rid of a stock that has been a big winner over the years—also not necessarily an easy thing to do. Selling can be further complicated by tax considerations for those stocks held within taxable accounts.
We strive to adhere to a consistent process when making both our selling and buying decisions. Each quarter we convene after earnings have been reported to discuss currently-owned stocks as well as potential new names for client portfolios we select as “challengers.” Each stock in client portfolios needs to earn its place in the portfolio every quarter. This is not to say when assessing each company we only consider short-term results. We continue to focus on a company’s prospects over the longer term. The information that comes with quarterly results, however, can provide an indication of when long-term prospects have changed. This process has served us well over time and we feel it adds more rigor than decisions based largely on extreme price moves. The recently-released study would suggest that this process is a step in the right direction toward making good portfolio decisions.
James M. Skubik, CFA