May 17, 2015

When to Sell a Stock?

For making wealth in stock markets, knowing when to sell a stock is equally important as knowing when to buy a stock. The investor should not end up selling those stocks early, which go on to make millions for their shareholders. At the same time, the investor should not keep on holding a stock even when it shows the signs of deteriorating business situation. Therefore, deciding when to sell a stock becomes a trickier decision than buying it.

Until now, we have covered the steps to identify fundamentally good stocks for buying in the portfolio, in detail on www.drvijaymalik.com. An investor may read about these steps in the article:


The current article aims to help the investor in taking the sell decision about a stock.

I believe that an investor should invest in stocks with a long-term perspective. The targeted time horizon should not be in months or years but in decades. Legendary investor, Warren Buffett also advised the same to investors in his 2014 letter:

 “Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years. Those who seek short-term profits should look elsewhere.”
“For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant.”

Holding a stock for decades is essential; however, the investor needs to make sure that she is holding only good stocks for these decades. Therefore, monitoring the stocks in the portfolio and taking the sell decision at the appropriate time becomes essential. Otherwise, the investor would find her limited capital stuck in suboptimal businesses, which exposes her to opportunity cost. Opportunity cost means that instead of keeping money in poorly performing companies; she could have invested her money in stocks of good performing companies and earned higher returns.


When to sell a stock rules shares How to decide about selling stocks Selling Strategies


While interacting with many investors, I have come across many common approaches, which different investors follow to decide about selling a stock in their portfolio. Many of these approaches are based on the profit criteria.

  • Sell when a stock doubles or goes up X% from the buying price
  • Whenever a stock investment turns into profit, keep a trailing stop-loss so that an investor does not forgo the profits already accrued.
  • Whenever a stock investment turns into profits, then sell stocks equal to the initial investment. It will ensure that remaining stocks are at zero cost to the investor and she can hold them despite steep fall in stock prices in future.
These approaches lead the investor to think about booking profits the moment the stock price rises above her buying price. These approaches invariably lead to one outcome: the investor gets out of her profitable stock investments early and fails to capitalize on the true wealth building opportunities in stock markets. Therefore, the investor should avoid these approaches of taking ‘sell decision’ based on profit criteria.

We know that stock investments have the potential of increasing multiple of times in value, also known as Multibaggers. Many investors have seen their stocks turn five-ten-or even hundred-baggers. However, many other investors end up selling their stock investments early and miss out on the wealth creation. These investors do not want to miss the unrealized profits, however small such profits are. 

It highlights the need for the essential qualities of stock market investors: patience and emotional control.


An investor should always remember that for any stock to be a hundred-bagger, it would pass through stages of two-bagger, ten-bagger and fifty-bagger. If an investor is not able to control her emotions and hold on to stocks on this journey, she would always end up getting suboptimal returns in stock markets.

This brings us to the cardinal rule of investing in stock markets: Never sell your good stocks.

However, at the same time, the investor should avoid being stuck in laggards. Therefore, the investor should actively monitor her portfolio.


She should identify the signs of weakness in portfolio companies and update her views on the stocks accordingly. This would help her in decision about selling the stocks. 

When to Sell a Stock

 


I believe that the sell decision should never be based on the stock price, let it be the current market price of the stock or the buying price of the investor. The sell decision should always be dissociated from its price and seen in light of business characteristics of underlying companies. I believe that the following criteria are a good guide for taking the sell decision:

1) Deteriorating Operating Performance of the Company:

 

An investor should monitor the operating performance of the company at annual interval.


An investor should take note of signs of business weakness like: 

a) Declining sales revenue year on year: 

Investor should analyse the portfolio companies whose sales witness decline year on year. At least two consecutive years of declining sales is essential before the investor makes any conclusive decision about sales decline. The investor should not become worried looking at changing trends in the quarterly sales performance.

b) Declining profitability levels year on year: 

An investor should monitor both operating and net profit margins. She should become cautious if the profitability margins are decreasing year on year.

c) Declining operating efficiency parameters year on year: 

Declining fixed asset turnover ratio, declining inventory turnover ratio and increasing receivables days: it indicates that the management is not able to use assets of the company efficiently and that  profits are being stuck in working capital.

d) Continuously increasing debt/leverage year on year to fund business operations.

These are the signs of developing weaknesses in the business model of the company. If after analysis, the investor concludes that the business advantage of the company has deteriorated, then she should sell it without thinking about existing profit/loss made on the investment.

However, it is essential that investor should notice deteriorating trend of annual values in these parameters for at least two consecutive years before getting worried about them. It is advised that investor should not become worried by fluctuating quarterly performances

In any business, short-term variations in performance are bound to happen and if the investor does not ignore them, then she might end up selling some great investment at the most inopportune time. Such times of temporary suboptimal performance are the best times to increase investments in stocks.

2) Government starts interfering with Pricing Policy and Profitability: 

 

A business should be able to earn the maximum return on its assets, which it can while facing the competitive pressures. An investor should be wary of investing in companies where government decides the pricing of products or puts a cap on the profitability of the companies. However, if the investor finds that any company in her portfolio, which was earlier not exposed to such government regulation, has now come under such rules, then she should consider selling the stocks of this company. 

Gujarat State Petronet Limited and Indraprastha Gas Limited faced such a situation in 2012, when the regulator, Petroleum and Natural Gas Regulatory Board, restricted their profitability.


Most of the times regulated profitability environment leads to suboptimal returns for investors. Therefore, she should sell such stocks irrespective of her investment being in profit or loss.

3) Change in Business Dynamics whose impact does not sound temporary:

 

An investor should keep on updating herself about the developments affecting her portfolio stocks. In case she comes across any adverse development, which can affect her companies, then she should analyse whether the resultant impact would be temporary. If she concludes that the impact of such adverse development would be long lasting and the company would not be able to recover, then she should sell her investments in such company. Such sell decisions should not be based on current market price or existing profit/loss on her investment.

A small cap glass manufacturer Haldyn Glass Limited faced such a situation in Sept-Oct 2014, when Petroleumand Natural Gas Regulatory Board (PNGRB) decided to cut supply of natural gas to many companies in Gujarat including Haldyn Glass Limited. 

The lobby fighting against the gas cut, South Gujarat Small Gas Consumers Association, does not bear very high influence. It could not affect the decision of gas supply cut. It resulted in plant shutdowns by most of the affected players. Haldyn had to cut its production capacity by 20%.

4) Portfolio contains too many stocks and effective monitoring of these stocks has become difficult:

 

As mentioned above, it is essential that an investor monitor stocks in her portfolio for related development.


However, the monitoring exercise containing of ongoing monitoring, quarterly monitoring and annual monitoring might become time consuming, if an investor has too many stocks in her portfolio. Therefore, if an investor notices that it is becoming cumbersome for her to effectively monitor all the stocks in her portfolio, then she should identify and sell weak stocks from her portfolio. Such selling should be done without considering current price or unrealized profits/losses in the weak stocks.

This would ensure that the investor has a manageable portfolio of good stocks, which would have a higher probability of creating wealth over the long term.

5) A stock is a very small portion of the portfolio:

 

Many times, the investor invests in a company, whose stock price starts rising fast and soon enough, its price crosses the levels where investor does not feel comfortable putting additional money in it. 

Such instances lead to situations where the company has been performing very well and its stock price has multiplied many times. However, because of no additional investment, soon, the stock becomes a very small portion of the overall portfolio. In such situations, even huge returns in this stock would have only modest impact on overall portfolio. However, the presence of this stock in portfolio adds to the monitoring burden on the investor. 

I believe that in such scenarios, the investor should pray that the stock price of this company falls to attractive levels so that she can put additional investments in it to make it a reasonable portion of her portfolio. Otherwise, the investor should consider selling this stock, as the cost-benefit ratio of the efforts put to monitor a small investment might not justify the return that might accrue from it.

This concludes the current article in which we discussed the various factors, which should help the investor take ‘sell decision’ about her stocks. 

Selling decision is as important as buying good stocks. It is crucial as selling a good stock early would lead to the investor missing the wealth creation despite investing in good opportunities. Moreover, holding on to poor companies would lead to capital losses as well as the opportunity cost of not investing in other good companies. 

In the article, we learned that the sell decision should not be based on the gains or losses, which the investor has made from the stock. Sell decision should instead be based on the parameters like operating performance, changing regulatory & business environment and portfolio composition.

Factors affecting the sell decision are very abstract and subjective. It is very likely that the investor would find that the stock sold by her have risen in price after she sold them. However, the investor should note that short-term stock movements are not always related to stock fundamentals. It is pertinent to quote Warren Buffett here, from his 2014 letter to Berkshire Hathaway shareholders:

“For those investors who plan to sell within a year or two after their purchase, I can offer no assurances, whatever the entry price. Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your Berkshire shares. As Ben Graham said many decades ago: “In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.” Occasionally, the voting decisions of investors – amateurs and professionals alike – border on lunacy”

It is therefore suggested that the investor should ignore short-term price movements and keep on taking her investment decisions based on fundamentals.

This ends the current article about when to sell a stock. Going ahead, I would write about the portfolio composition, optimal number of stocks and diversification. 

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Your Turn:


I would like to know about the parameters you follow for selling stocks in your portfolio. The checklists or parameters you find important for investment decision making and any other inputs that you believe would improve help the author and the readers of the website. You may write your inputs in the comments below.