Abhimanyu’s Dilemma—The Art of Selling
In the investment world, a lot is said about timing a stock purchase. In comparison, very little time is spent on selling. Indeed, the earlier chapters of this book have information about buying. This chapter discusses the process that investors should go through to decide whether or not to sell.
First, the author advises investors to have a selling plan for stock before buying. Once an investor has purchased without a plan, he will be subject to the psychological distress of stock ownership that may provoke irrational behaviour. A plan can help avoid a bad decision.
Once a stock is bought (probably at a discount to intrinsic value), he recommends holding it for at least two years. Although he admits that the number is rather arbitrary and that he has no empirical data to back it up, he argues that a few months is not enough for a company’s value to change considerably (the intrinsic value could not have decreased by such a large amount) and 5-6 years is too long to have money tied up because of opportunity costs. The only time Pabrai believes an investor should sell within two years:
1) The company's intrinsic value can be estimated over two years with a high degree of certainty
2) The price proposed is higher than that estimated value.
Note that in any such event, the future becomes uncertain after the stock purchase, Pabrai advises investors to hold (since rule 1 above is not met) because he believes the clouds of uncertainty tend to dissipate over several months. To demonstrate this point, he cites an example of a theoretical gas station whose future cash flows become uncertain, as well as a real example he experienced in his fund.
Furthermore, after three years, if the security fails to reach its intrinsic value, Pabrai argues that the investor is likely to miscalculate its valuation or that its intrinsic value may have declined. On the other hand, if the stock appreciates below 10% of its intrinsic value, he strongly recommends investors should consider selling. If a stock's price exceeds its intrinsic value, he recommends an immediate sale (with the sole exception of tax considerations, if necessary)