This is the most difficult question
faced by most investors. It is a “moment of truth” - the point
of judgement on an earlier decision to purchase.
In instances where
there has been a favourable outcome, investors are faced with several
questions such as: How much profit is enough? Is the share price
sustainable? Could the profits be put to better use elsewhere?
When faced with potential losses, most
investors find it difficult to face up to mistakes. There is a raft
of behavioural studies which contend that investors feel the pain of
loss more than they do the joy of profit. For this reason, many
investors, myself included, are prone to hang on with the thought
(faint hope) that things will improve.
In a series of posts, I will
investigate various aspects of the decision to sell.
First, I will address the reasons
for selling: they're not always about profits and losses.
Second, I will advance a
conceptual model which illustrates a thinking process which I have
developed with experience.
Third, I will explore some
approaches to selling. Although many sellers profess to employ
sophisticated metrics and models, the sad thing is that most people
(investment professionals included) are motivated by fear and a
mindset hamstrung by a short-term perspective – hardly a sound
basis for managing one's hard-earned money.
Part 1 - Reasons to Sell
Not all selling is motivated by the
need to address losses or gains.
Sell when you need the money
Sometimes you need to open the till in
order to use your stash for another purpose e.g. large purchase,
unanticipated expenditures which you don't want to finance by debt, a
significant gift of cash etc.
These are usually the easiest decisions
as the pain/joy of a change from the original purchase price is muted
somewhat by the transformation of the concept of loss/gain into
something more tangible. Besides, it's always nice to reward
yourself or improve the lives of others.
I usually take sales of this nature as
an opportunity to weed out non-performers.
Sell if the Company Violates Your
Ethical Standards
Many people avoid companies whose businesses centre around the
practice of war or contribute to the bad health of their customers.
However, it's a bit more complicated than that.
If for example, you discover that management or board members have
been convicted of ethical or criminal breaches, it makes sense to
exit the company as characters of this nature seldom change their
spots. Remember, it generally takes egregious examples of behaviour,
supported by an overwhelming body of evidence, for miscreants to be
disciplined by regulatory bodies or convicted in the courts. You can
trace the path of slime left by such individuals by Googling the
names of company apparatchiks.
You may discover that the company has engaged in self-serving
behaviour to the detriment of share holders e.g. outrageous
compensation levels, sweetheart deals on stock options, nepotism
(hiring relatives as opposed to opening up the recruiting process).
In other instances, companies may brazenly ignore regulatory
standards or carry on their businesses with disregard to the
interests of local/regional communities.
Sell to Rebalance Your Portfolio
Many experts suggest that it is prudent
to rebalance one's portfolio at least annually. If, for example, the
performance of one or more asset classes departs from your allocation
model, say by 5%, it makes sense to rebalance your holdings by
buying/selling positions. The process of rebalancing provides an
incentive to sell positions which, otherwise, you might have
consigned to “benign neglect” in the hope that losses could be
recovered or profits would roll on forever.
Sell in Consideration of Tax
Planning
It is possible that you may have placed
income earning stocks in non-registered accounts with the result that
you are paying higher taxes than necessary. It is usually advisable
to place dividend earners and the like in sheltered accounts such as
RRSPs and TFSAs. I generally try to do this, but I do not hesitate
to place income producing equities in non-registered accounts,
especially if they have a high potential for capital gains.
I have had the experience of holding on
to stocks to the point where their only useful function is to be sold
to declare a capital loss for income tax purposes. I usually make an
effort to sell off these beasts when I have significant capital gains
to declare. Remember that losses can be carried forward.
Sell Because of a Change in
Fundamentals
You may be led to reassess your position in a company for a variety
of reasons:
change in management e.g. new management may have a different
approach to risk, a different hormonal constitution or have no
background in the company's sector
unforeseen events e.g. catastrophic events such as war, earth quakes
change in the operating environment e.g. change in interest rates,
political change (regulatory, trust, government philosophy vis a vis
private companies)
competition e.g. new products, more efficient companies etc.
For these reasons, I am somewhat leery about investing in most high
tech companies as the playing field can change very quickly. Herr
Buffet seeks to avoid these circumstances by focusing on the quality
of management and the effectiveness of “competitive moats” -
barriers to entry by potential competitors. This will be addressed
later on in Part 2.
Sell if There is a Merger
Through experience, I have learned to
sell my position in a company once a take-over has been announced –
this as opposed to taking shares in the purchaser company. Why?
It's best to take the premium
(which can range from 20 to 40 percent) as a profit and lock in your
gains;
Many mergers are not successful.
There may be difficulties caused by conflicting cultures and/or
management styles, a shift in loyalty of the customer base and the
like. All too often, I have lost money by not taking my money off
the table. In other instances, it has taken years for share
prices to recover after an initial decline (an opportunity cost as
time is worth money).
On the other hand, I will generally
retain my holdings in companies which have a proven track record of
incorporating acquired companies successfully into their businesses.
Examples include: Rocky Mountain Equipment, and World Fuel Services
(recently sold for other reasons).
Sell in the Advent of a Change in
the Action
Many investors rely on charting to determine exit points. They look
at a wide variety of quantitative indicators in efforts to determine
a change in investor sentiment. Others combine quantitative
indicators with pattern recognition. Much has been written on this
topic. Many are the studies which have “proved” various methods
with the use of retrospective data.
I believe that some simple charting metrics are useful IF combined
with with other information. It takes diligent work and experience
to get a “sense” of the price action. Nowhere is this portrayed
better than in Reminiscences of a Stock Operator, an account
of the career of Jesse Livermore, one of America's most successful
speculators. I used this approach to good advantage on a few
occasions when I engaged in short-term speculation in “hot”
sectors. (For example, I wrote about my speculation in rare earth
minerals in an earlier edition of The Financial Passage Maker.)
As a visually oriented person, I find that charts are useful
indicators of investor sentiment but I also consider company
fundamentals and strategic positioning e.g. market cycles. It is
more an art than a science.
Your Target Price is Achieved
There are several ways to fix a target
price.
One famous investor sold winning
positions once they appreciated by 50%. By the same token, he sold
losing positions if losses exceeded 20%. He was very successful with
this technique as it was simple and provided clear direction. (I am
still trying to find the reference as I came across it during the fog
of the early morning.)
Another way is use a valuation
technique and fix a target price for a stock. Unfortunately, there
are so many variables in play that efforts of this nature are very
fallible. Despite this, legions of analysts are forced by the
investment community to engage in the ritual of “financial
divination”. Instead of augury, cleromancy, augury and the like,
modern day practitioners practice a litany of black arts promulgated
in modern business schools. All of them purport to add measure of
believability through the use of quantitative methods and models,
many of which have rather breath-taking assumptions and/or
simplifications of “reality”. Further, some of them are naive in
the sense that they rely on an uncritical acceptance of financial
statements (which can be manipulated to meet the needs of
management). For these reasons, I never attempt to set a target
price based on financial models.
My decisions about selling consider the
following:
strategic conditions: place of the
sector in the economic cycle, vulnerability of the company in
relation to the competition, interest rate increases, etc.
company fundamentals: management
effectiveness, profitability, debt, etc.
“price action” as per Jesse
Livermore – a function of charting and a “spidey sense” of
where the sector is headed (this is especially the case with the few
short-term ventures I undertake on occasion)
the “dividend factor” - I am
more prepared to tolerate price fluctuations if moderated by
dividend income (I look at the price history of the company under
various economic conditions and its ability to maintain its
dividends).
Selling is an art. Everyone has a
different viewpoint. Were this not to be the case, we would not have
a market. The key is to develop an approach which is congruent with
your tolerance for risk and your outlook on life.
I will write more about the art of
selling in the future. It is much harder than buying and is key to
the well-being of one's investment portfolios. As Herr Buffet
contends, the first three rules of investing are not to lose money.
