Number Three Rule for Selling an Investment.

The first two rules I follow are easy to understand and easier to measure than rule number three. 1) If a dividend is cut or suspended, the math is easy. Sell is my most often action. 2) If a position grows to more than 5%, then it is likely a very good investment, but the math tells me to sell at least a portion to lock in profits. 3) The third factor is a bit more difficult to determine. The third rule focuses on competition and outside forces.

The third question I ask about any investment that I own or that I am considering is “has competition or any noticeable outside force altered the investment landscape?” So, for example, I would not want to buy a coal company given the transition away from that energy source. I also am very hesitant to purchase Coca Cola® (KO) or Pepsi (PEP) stock due to the increasing sentiment against soft drinks and junk food. Competition can dramatically impact a business. Blackberry was the phone of choice when I was at Conney Safety Products. But it wasn’t long before Apple’s iPhone and other smartphones with wonderful apps and without a keypad ate Blackberry’s lunch and dinner.

Another competitive factor is the internet-based shopping opportunities. Competition from Amazon certainly had a huge impact on retail and malls. Boston Store tried to provide internet shopping for their customers, but their model was awful. (I know this because Cindie had a job at Boston Store pulling orders from the store. It was an incredible waste of time to try to find the stock on the floor.) Anyone who bought J. C. Penney Company, Inc. (JCP) in February 2012 was paying more than $40 per share. The last dividend JCP paid was April 5, 2012. (Remember rule number 1!) You can now buy 50 shares of JCP for $37 or less than 75 cents per share. The list of failed businesses that failed to adapt is endless: Sears, Sports Authority, Casual Corner, Kids R Us, Toys R Us, ShopKo, Zayre, Kodak, Circuit City, Blockbuster and Pan Am all come to mind. One way to see the demise is to walk through a business and see who is shopping there. If the store is dead and the competitors are busy, you have data that can help you avoid a disaster. Another way is to look at what others are buying and why they are buying the service or product.

Retail, however, is not dead. Target (TGT), Wal-Mart (WMT), TJX (TJX), Dollar General (DG) and Kohl’s (KSS) are still in the game. While these still have a tough challenge, they seem to be making the right business decisions including in providing value, online shopping and same-day shipping.  

One of the questions that Warren Buffett asks is related to the defensive position of a medieval castle. “Is the moat wide?” “A wide economic moat is a type of sustainable competitive advantage possessed by a business that makes it difficult for rivals to wear down its market share. The term economic moat was made popular by the investor Warren Buffett and is derived from the water-filled moats that surrounded medieval castles.” Investopedia Link

Disney has a wide moat. It is difficult to replicate the brand.

If you see invaders climbing the walls of a business, it is time to sell. Don’t postpone the inevitable. The corollary is also very important: Don’t buy “cheap” shares because they are cheap. Wise investors already sold. You are buying damaged merchandise and there is no return policy.

Full disclosure: We own shares of TGT, WMT, TJX and KSS. We also own shares of Home Depot. It is hard for Amazon to ship much of what HD sells. Lumber, doors, windows and garden plants are a real hassle for UPS.