When Should you sell a stock?

The companies provided in this blog are for educational and illustrative examples only. Nothing contained in this blog should be taken as an endorsement to buy or sell a specific investment. 

The simplest way to decide when to sell a stock is to ask yourself: Do I still like this business today? If the answer is no, it might be time to let it go. Generally, selling is a smart move when you realize you’ve made a mistake in your judgment. Maybe you overestimated the company’s competitive advantage, or you’ve discovered that you don’t understand the business or its industry as well as you initially thought. Another red flag is when management begins making capital allocation decisions that don’t align with the best interests of shareholders.

Let’s explore two detailed examples that highlight when it’s wise to sell a stock.

Overestimating a Competitive Advantage: When a Negative Event Impacts a Company's Position

Let’s look at a2 Milk as an example. At first glance, it seemed like a stellar company. Between 2013 and 2020, their sales skyrocketed from $79 million to $1,617 million—a compound annual growth rate (CAGR) of roughly 54%. Even better, EBIT margins improved significantly, jumping from 7.7% in 2013 to 31.4% by 2020. On paper, everything looked fantastic.

Then came the COVID-19 pandemic, which fundamentally disrupted the trajectory and competitive position of a2 Milk. A significant driver of a2 Milk’s growth, particularly in revenue and margins, was its demand in China through the Daigou channel. Chinese citizens, for example, would purchase a2 Milk products—particularly their infant milk formula (IMF)—directly from retail stores in Australia and ship them back to China. 

This approach bypassed traditional, complex distribution channels, enabling a2 Milk to boost its EBIT margins. Retail purchases meant higher pricing, and with no shipping costs to China, profitability soared. However, when the pandemic struck, this key channel faced significant disruption. 

The pandemic negatively impacted revenues, and although sales are growing again post-recovery, the Daigou channel has been impacted indefinitely. As a result, even if a2 Milk manages to regain its pre-pandemic sales levels, it won’t achieve the same profitability. 

Why? Without the Daigou channel, a2 Milk now has to rely on more traditional distribution methods to reach its customers in China. These methods come with higher costs, meaning that generating the same level of sales will require significantly greater effort and expense, ultimately eroding profit margins. 

This example significantly impacted a2 Milk’s business value and serves as a strong case for when to sell a stock. Sometimes though, when negative events like this occur, they might present a good buying opportunity—if the market overreacts. However, the key question for an investor is this: Is this a short-term setback, or does it affect the long-term trajectory of the business? 

If it’s a short-term issue, it could be a smart move to buy during the dip, provided its selling for less than your estimate of its intrinsic value. But if it’s a long-term concern, it’s best to stay away. In a2 Milk’s case, this was clearly a long-term issue. The company’s heavy reliance on the Chinese market exposed it to risks that materialised during the pandemic. Additionally, local Chinese competitors have since taken market share in the IMF product category, while other competitors have expanded into the specialised a2 milk category, intensifying the competition. 

Bad Management: Diversifying Away from Core Business

If you invest in a business, like a restaurant chain, and notice management is allocating funds to projects outside of its core operations, it's a red flag that you might be dealing with bad management. Let me explain this with an example from Cracker Barrel.

Cracker Barrel, known for its country-themed restaurants serving breakfast, lunch, and dinner, also operates gift shops. In 2019, the company decided to buy a stake in a company called "Punch Bowl Social." However, just a few months later, in March 2020, Cracker Barrel sold its stake in Punch Bowl to refocus on its core business.

The reason why Cracker Barrel’s acquisition of Punch Bowl Social didn’t create any value is because Punch Bowl Social operates in the nightlife industry, which is completely unrelated to Cracker Barrel’s core restaurant business. It was outside the scope of management’s expertise. When management decided to diversify away from their core operations, they quickly realized they didn’t understand the nightlife sector and ended up losing shareholder wealth in the process.

If you see management making investments like this that seem unreasonable or out of touch with the company’s strengths, it’s often a strong sign to consider selling.

Conclusion 

Sometimes, you’ll identify a great company with management that seems honest and capable, only to see them later make a large, costly acquisition. You won’t always know how it will play out right away, so it’s essential to keep track of the company after your initial investment. 

No one is immune to making mistakes in investing. Even the best investors, like Warren Buffett, do it. 

Take the case of Berkshire Hathaway’s investment in CORT Furniture back in 2000. CORT had made a fortune leasing furniture to startups during the tech boom, but Buffett and Munger underestimated how vulnerable those profits were after the crash. New platforms like eBay and Craigslist made it easier and cheaper to buy used furniture, eating into CORT’s sales. 

In this example, Buffett overestimated CORT’s competitive advantage and future profitability. The lesson here is simple: always evaluate and don’t be afraid to acknowledge mistakes. If you misjudged a company’s competitive strength or the competency of its management, be humble enough to sell.