A Good Time To Sell The Low-Quality Stocks That Slithered Into Your Portfolio

In 2009, the S&P 500 went up. In 2010, the S&P 500 went up. In 2011, the S&P 500 went up. In 2012, the S&P 500 went up. In 2013, the S&P 500 went up. So far in 2014, the S&P 500 has gone up. I have no idea what will happen the rest of this year, next year, or the year after that, other than to say this: It would be highly unusual for this string of consecutive up years to continue, and the consequence is this: A bunch of bull market years in a row can make it easy for some trash and junk—truly low-quality holdings—to work their way into your portfolio.

With the stock market up around 30% in 2013, and gains continuing into 2014, it can be easy for something to work its way into your portfolio that you would never want to own if something that comes within hailing distance of a Great Depression scenario were to show up again. A lot of times, people have the tendency to be reactive and see certain stocks fall 30%, 40%, 50%, or more before they realize, “What the heck was I doing with Pandora and Barnes & Noble in my portfolio anyway?” That’s probably something you would have wanted to discard ahead of time, before the losses arrived.

That’s my point of this post: Is there anything you own right now that would make you cringe if 2008 and 2009 happened all over again? If the answer is “yes”, and you’re otherwise diversified, and could deal with playing the probabilities of something that terrible happening again, then okay—keep doing what you’re doing.

On the other hand, if there is important money that you’re relying on—of the “I need dividend income from this stock for the next 20+ years otherwise my standard of living will be impacted” variety, then it could be worth stopping to take a moment to see if you own stocks that can meet that objective.

Now is the safest time to do so—if some low-quality companies found their way into your portfolio, you can get rid of them now before absorbing your losses and realizing what low-quality means at the worst possible time. It’s a way to correct an error before having to pay the consequences (the only downside would be if we are in the middle of a very extended upward trajectory, of the 1982-2000 type, in which case you would be missing outsized gains).

Buying Coca-Cola at $40, Procter & Gamble at $80, Wal-Mart at $75, IBM at $185, BP at $50, Visa at $215, or Exxon at $95 would put you in the position of doing very well over the coming ten to fifteen years, as you would likely experience total returns that mirror the growth rate of those companies (in the case of Visa, the P/E might come down a bit, but there’s a very strong argument to make that the continued 15% growth of the firm would more than offset some P/E compression). Those are high-quality companies you could buy today where you’d do all right.

My favorite question to ask to pre-emptively determine whether you could handle a stock market crash is this: Would you add, or at least hold, this company upon learning of a 50% drop in price? If the answer is no, there could be something lacking concerning your understanding of the business.

When I pose that question to myself, the companies I would be most likely to purchase upon learning of a 50% drop, based upon my understanding of the business and my confidence in their ability to ride out a very long economic downturn, would be: Coca-Cola, Colgate-Palmolive, Disney, Nestle, Exxon, Johnson & Johnson, and Procter & Gamble. Buy-and-hold only works if you decide before a crash that you are buying ownership stakes in companies that you would actually hold throughout a very deep recession.

The other thing that can help you keep perspective is this: Once you hold a high-quality company for a few years in a non-recession scenario, certain price protections start to get baked in. I’ll use Procter & Gamble as an example, because I’ve recently been discussing its future with you.

From 2008 through 2009, the price of Procter & Gamble fell from a high of $73.80 to a low of $54.90 during the early months of 2009. Those are the scare tactic numbers you hear that often get repeated from someone trying to illustrate the maximum moment of paper wealth to its immediate decline.

But imagine if you had owned Procter & Gamble for a few years before the recession—say, you bought the stock at the most expensive point in 2005, at $59.70 per share. From that moment in 2005 until early in 2009 before P&G made its first payment that year, you would have collected $4.88. So, for holding P&G three years through the worst financial crisis of the generation, and having bought the stock at the worst possible time in 2005, you saw your $59.70 investment turn into $54.90+$4.88=$59.78. Counting dividends, buying P&G stock at any time in 2005 would have put you in positive territory (barely) at even the lowest price point of the 2009 recession.

Now is the safest time to reflect upon your holdings and make sure that everything in your portfolio is there deliberately, as the consequences of shedding an inferior holding are relatively minimal right now, from an opportunity cost perspective. The whole point of buy-and-hold investing is making sure that you buy things that, given your goals, time horizon, and comfort zone, you will actually hold throughout the low points of the market cycle. You don’t want to be like everyone else that waits until Fall 2008 or Early Winter 2009 to perform quality checks on your portfolio; the wise thing is to make sure you are satisfied with the quality of your holdings during times like these when the other stock market participants are willing to pay a good price for your junk.