Most investment adviser tell investors what and when to buy a stock; seldom do they talk about selling.
Selling a stock at the right time is key to making money in equity. The buy-and-hold investment philosophy does not hold good all the time. However, selling stocks because the benchmarks are trading at record highs is not a sound investment approach either.
The movement of the Sensex and the Nifty50 may not have any direct impact on specific sectors or stocks.
Here are four easy-to-understand reasons that tell you when to sell a stock.
Have a target, sell when you hit it
There will some stocks in your portfolio, which have made big gains. These are not stocks that have risen 10-20 per cent in a month, but the ones with 50 per cent gains in six months or 100 per cent-plus rise in a year. Having a price target is a great trick of successful investors.
Try and find out the reasons behind these bulky gains. If the rise in the stock has been driven by fundamental factors: was it becomes of improvement in the balance sheet, good sales or profit growth, large margin expansion or value unlocking of a subsidiary, assess whether those gains have been already priced in or not.
If you think the reason for the stock price movement has been fully priced in, it may be wise to book profit, at least partially. Mr Market re-rates stocks at the drop of a hat, and if you have made money i.e. got a handsome profit in a short time, it will not hurt you to sell some of those holdings. Re-invest in another potential opportunity.
Unfavourable changes in business
Most informed investors add new stocks to the portfolio, based on sound investment rationale. However, these expectations can turn out to be wrong. When a business turns out to be an under-performer given the expectations, the stock will suffer. One or two quarterly earnings miss isn’t a major issue. Alarm bells should ring in different forms. A perfectly good company may be suddenly accumulating massive debt, bumping up interest outgo. Cash flow situation of a company may deteriorate, in which case if the problem lingers on for some time, it’s best to exit.
Certain ‘hot’ stocks may shoot up on positive hopes, but a close inspection will show how such lofty expectations are difficult to be achieved on the ground i.e. reflect in earnings. Sustained strict regulatory action against a set of companies can also drastically change the dynamics of a business.
Other factors like losing growth momentum, erosion of pricing power or losing market share to competitors are bad signals. Of course, you will have to avoid reacting to short-term noise. Also, assess the fundamentals of a company executing a merger. Often, M&As are a good time to sell a stock and enter at lower levels.
Valuations turn very expensive
In a stock market like India’s, companies promising growth always get better valuations. You can measure valuation by using various ratios such as price to earnings, price to cash flow, enterprise value by operating profit, or price to book value (for financial companies). When a company or business is valued higher than its peers, there must be a fundamentally strong reason for that premium. However, even a premium has its limitations.
For instance, if a retail stock is valued at 2-3 times its peers, that is a fit case to sell, unless you have absolute conviction that the retailer will continue to post massive growth, beating the industry average and also eclipse competitors. Do not justify the stock price by using long-term projections. In the dot-com era of late 1990s and early 2000s, the dot-com bubble saw companies with questionable fundamentals getting sky-high valuations.
It must also be said that finding value stocks, especially if a company is a high-quality business, with definite economic moats and solid track-record of creating shareholder wealth, is extremely tough. That job should be left to investment professionals or advisers with research background. Such great companies will always have a premium, but if the premium gets pricey, it may be a good time to sell.
Your adviser tells you to sell
If you are not a do-it-yourself investor, you probably take professional help to invest in stocks. Like doctors and engineers, financial advisers are trained professionals. If your adviser had asked you to a buy a stock and is now telling you to book profit, listen to him/her. A professional adviser normally takes a fee for advice, so they are accountable for their recommendations. If you have made money on the particular recommendation, you should take his/her advice and book profit when suggested. If you are not convinced, ask them to give the reasons behind that call, study those reasons carefully, and take a logical step. Always take advice from somebody, who will suffer the consequence of his advice.
By Anil Rego