Buffett's Selling Formula

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Warren Buffett built his fortune by identifying companies with strong economic moats and holding them for extended periods, sometimes 30+ years.

But knowing when to sell has been equally important to his success, because even exceptional companies aren't permanent holdings.

In "The New Buffettology" (2002), Mary Buffett (Warren's former daughter-in-law who worked closely with him for over a decade) explains that Warren sells in four key situations:

• When stocks become overvalued compared to bond returns.

• When better investment opportunities emerge elsewhere.

• When fundamental business changes destroy competitive advantages.

• When predetermined target prices are met.

These four situations have guided Buffett's selling decisions throughout his career, helping him capture gains at the right time and redeploy capital more effectively.

Buffett uses a simple calculation to determine when stock prices become too high relative to their economic value.

Here's how it works:

1. Estimate the company's total per share earnings for the next ten years.

2. Calculate what you would earn if you invested the stock's current price in bonds instead.

If the bond investment would produce more money over those ten years, the stock is overpriced and selling makes sense.

Coca-Cola Example

Consider Buffett's Coca-Cola ($KO ( ▼ 0.39% ) ) position in 1998. The company was earning $1.42/share and had grown earnings at 12% annually for the previous decade. Based on this growth rate, an investor holding Coke for ten years could expect the stock to generate ~$24.88 in total earnings.

In 1998, Coke traded at $88/share, which meant paying 62 times its annual earnings.

An investor paying $88 for Coke stock would receive $24.88 in total earnings over ten years. But if that same $88 went into 6% corporate bonds, it would generate $5.28/year, totaling $52.80 over ten years.

The choice becomes clear. Would you rather earn $24.88 or $52.80 on your $88 investment? The bonds would produce more than double the income, making Coke overpriced at that level.

Mary Buffett notes that for Coke to justify such a high price, it would need to grow earnings at 30-40% annually, or bond rates would need to fall to 2-3%.

The same analysis works when stock prices are lower, for example, at $28.40/share (20 times the $1.42 earnings). That $28.40 in bonds would generate only $17 over ten years ($28.40 × 0.06 = $1.70/year × 10 years), while holding Coke stock would produce the expected $24.88. At this lower price, the stock clearly offers better value than bonds.

Sometimes it makes sense to sell an underperforming investment to redeploy the capital into better opportunities.

Mary Buffett observes that Warren will exit positions when more attractive opportunities emerge, but she cautions against the mistake of "selling flowers to buy weeds."

If you already own a company with a durable competitive advantage and skilled management, hold it until the market offers an extremely high price. Short-term price swings shouldn't concern you when you own a great business.

Consider how Warren and Bill Gates built their wealth. Both men held the same stock for more than twenty years, letting compound growth work its magic. They understood that switching between investments often destroys returns, even when new opportunities look appealing.

Even so, underperforming businesses that lack competitive advantages can tie up capital that would grow faster elsewhere.

The key is evaluating whether you're upgrading to a superior business or simply chasing the latest trend. Since true upgrades are rare, patience remains the best strategy for exceptional holdings.

Buffett watches for changes that could transform a durable-competitive-advantage company into a price-competitive business or make it obsolete. When the economics of a business shift, even great companies can become poor investments.

Different types of businesses reveal problems at different speeds.

Manufacturing and retail companies are easier to monitor because changes show up quickly in quarterly sales figures. When consumer preferences shift or new technology emerges, the impact appears immediately in revenue. This visibility gives investors time to react before permanent damage occurs.

Financial institutions work differently. They can hide problems through accounting choices until disasters suddenly appear. Warren says it's almost impossible to spot trouble brewing at banks and insurance companies because of their ability to manipulate reported numbers. This makes financial companies riskier to own.

His sale of Freddie Mac ($FMCC ( ▲ 4.35% ) ) illustrates this principle. When Buffett bought shares, Freddie Mac securitized single-family home mortgages and sold them to pension funds, a straightforward business he understood. The company's government-sponsored status and residential mortgage expertise created its competitive advantage.

Management then expanded into commercial mortgages seeking higher profits. Commercial real estate requires different underwriting skills, involves longer relationships, and carries more complexity than residential loans. This shift into unfamiliar territory changed Freddie Mac from a predictable business into a risky one, triggering Buffett's sale.

Some investments have predetermined exit points based on specific catalysts or valuation targets.

All arbitrage situations fall into this category because they involve buying and selling to profit from a known price difference that will close at a specific time, like when a merger completes at an announced price.

Warren has also invested in companies converting from corporate form to partnership form. These conversions create their own type of opportunity with clear exit points, though they're separate from traditional arbitrage trades.

Corporate Conversions

Buffett has profited from companies converting from corporate to partnership structures. His 1981 investment in Tenneco Offshore (a natural gas producer) shows how these conversions create valuation gaps.

Tenneco owned a large pool of natural gas and was paying out all proceeds from gas sales to shareholders. The company planned to convert to a partnership to avoid double taxation:

• As a corporation: Tenneco earned $1.21/share but paid $0.41 in corporate taxes, leaving only $0.80 for dividends.

• As a partnership: It could distribute the full $1.21 to investors.

With treasury bonds yielding 14%, investors valued dividend stocks by dividing the annual dividend by the bond rate. Tenneco's $0.80 dividend meant the stock traded at $5.71/share ($0.80 / 14%). After converting, the $1.21 distribution would justify a price of $8.64/share ($1.21 / 14%).

Partnerships must distribute their income because partners owe taxes on profits whether they receive the money or not. This forces partnerships to pay out earnings, making the higher distributions reliable.

The market initially ignored the conversion announcement, allowing Buffett to buy at $5.71. After Tenneco made the conversion, investors realized they'd receive $1.21 annually instead of $0.80, and the stock rose to $8. Buffett sold for a quick profit.

This type of investment works because the conversion creates a specific catalyst with a calculable price target, making the exit decision straightforward.