Typically, when you read an analyst report, or a news article on a company, or when someone asks you to take a look at a stock with promising prospects, the decision to buy is usually easier, as you are buying on the prospect of potential gains. After your purchase, if the stock subsequently appreciates, or slumps, or stays around the same level for some time, you may wonder what to do with your existing stocks.
Through my work as a remisier, I have received extremely frequent (and rather standard) questions from my clients (or sometimes readers), whether they should buy more, hold or sell their existing stocks. Some of the situations which they are worried are
a) If they buy more, the stock may drop after their purchase;
b) If they hold (i.e. not buying or selling), the stock may appreciate or drop further;
c) If they sell, the stock appreciates after their sale.
Selling has always been a less discussed topic than buying. This may be because selling is considered “giving up” on the stock and its potential future returns. Oftentimes, it may also seem to be a recognition that one has made a mistake to invest in the stock. However, I believe that knowing when to sell is paramount to obtain an overall respectable portfolio return.
When do you sell?
According to Philip Fisher, the best time to sell a stock is “almost never”. The key word is “almost”. This means that under certain circumstances, it is justifiable to sell. What are these “certain circumstances”? In my opinion, these are the usual situations which I will tell my clients to consider selling.
1. Basis of entry is invalidated
This can manifest in four main ways.
Firstly, if my reason for buying a stock is event driven, such as to punt on its upcoming results (likelihood of a good set of results), or a potential bullish chart breakout, once the event materializes, I will sell the stock. Even if the event does not materialize in a favourable way (e.g. the results turn out to be below analysts’ expectations or the chart breaks down), I will still sell since the basis of entry is invalidated.
Secondly, the company’s fundamentals may have deteriorated to such an extent which you would not have bought it in the first place if you have known that the fundamentals would have changed. For example, assume that I initially bought stock A with its excellent growth prospects and seemingly honest management. However, after some time, there was an abrupt change in management and the new management proved to be incompetent which seriously undermines investor confidence. Alternatively, stock A may issue a profit warning which would have invalidated my view of its excellent growth prospects. If the above occurs, the company’s fundamentals have changed and it warrants a sell.
Thirdly, I may have bought stock A due in part to my preference (or familiarity) in the industry and stock A’s pivotal position in the industry. However, if I sense that the industry may encounter a prolonged multi-year slump, which even the best company in the industry is unlikely to escape unscathed, I will sell it.
Fourthly, as a whole, there may be a change in the underlying fundamentals for the equity market, such as a global recession. If this happens, almost all companies will be affected and it may be wise to sell (at least) some stocks. (This is based on the assumption that we are able to identify the recession and sell the stocks at the early part of the recession.)
2. Valuations overshot fundamentals
Another situation which may warrant a “sell” is that valuations have overshot fundamentals. Take stock B as an example. You may have bought it at 10x FY16F Price to Earnings Ratio (“PE”). Due to your astute judgment, the price surged. After the surge, stock B trades at 30x FY16F PE vis-à-vis its peers which are trading at 15x FY10F PE. Stock B trades at 2.0x Price to Earnings Growth Ratio (“PEG”) against the industry mean of 1.0x PEG. Thus, according to these valuation metrics, stock B seems to be richly valued against its peers. Furthermore, at 30x FY16F PE and 2.0 PEG, this may imply that stock B is “priced to perfection” and it may take just a small hiccup such as a minor earnings’ miss to disappoint the market. This is another factor to consider whether to take the decision to sell.
3. Better usage of funds
Table 1 shows the existing portfolio of investments owned by an investor. These stocks have appreciated but they still have about 20% potential upside each.
Table 1: Stocks in existing portfolio
Table 2 shows the stocks which the investor intends to buy. Besides the estimated potential return, I have made an assumption that the investments in both Tables 1 and 2 have the same risk and all other factors being the same (or almost the same) for “apple to apple” comparison.
Table 2: Stocks which the investor intends to buy
Having compared both Tables 1 and 2, ceteris paribus, stocks E and F offer a better return to risk ratio. If the investor is unable, or not willing to put in fresh funds to buy these stocks, it may be wise to liquidate both stocks C and D so as to invest in stocks E & F.
4. Portfolio re-balancing
Most retail investors make their investment decisions by viewing their stocks individually and not on an overall portfolio basis. Let’s assume investor A has S$1,000,000 and invests equally (i.e. 20%) in the following five stocks as depicted in Table 3. He reviews his portfolio one year later and to his pleasant surprise, his portfolio has appreciated 34% in a year. He realizes that the outperformance mainly comes from Stock D which has tripled over the year. Due to the sharp appreciation in stock D’s share price, stock D now occupies 45% of the entire portfolio (instead of the previous 20%). As a result, investor A’s portfolio return is significantly exposed to the gyrations of stock D’s share price. Assuming fundamentals for all five stocks remain status quo, it may be worthwhile to consider divesting part of stock D to reduce the significant exposure and reallocate the portfolio accordingly.
Table 3: Portfolio*
*Excludes dividend income in the above computation
Conclusion – Selling is important too!
I have listed some of the factors above which should justify a “sell”, or at least warrant some thought on the investment decisions. Readers are advised to allocate as much time and effort on their “sell” choice as their “buy” choice. Remember – Selling is important too!
Please refer to the disclaimer HERE