Many investors openly admit they struggle with selling their stocks, be they winners or losers. Everyone has heard adages like "ride your winners, sell your losers" but most still struggle to come to a decision. Most of us have an uneasy feeling about hitting the "sell" button. Lots of questions race through our mind like "Am I selling to too early and missing the next run up?" and "Wait, why should I take a loss, will it not rebound"?
This article presents the various inputs collected from investment books like "One up on wall-street" by Peter Lynch (of the Fidelity Magellan fame) as well as some experienced investors in Seeking Alpha like Norman Tweed and David Crosetti. Please bear the following points in mind before jumping onto the article:
- The article is about investing and not trading, as the number of trading strategies equals the number of traders out there.
- Now, every category mentioned below is going to have some exception and one such exception is actually mentioned in the "Growth stocks" category. Going by the outliers instead of the general norm will not be profitable for the majority of the crowd.
- This article talks strictly about selling and almost assumes the investor has already picked good to great stocks but is confused about selling them. However, some of the generic rules can be used to cut losses on existing bad purchases as well.
So, let's take a look at some of the most popular sell signals.
Category based sell rules:
a. Growth stocks: In our view, this is the trickiest of the lot. Apple (AAPL) is the best example in this category. Investors who bought Apple in the late 1990s or early 2000s would have been tempted to sell their shares at double or triple price but hindsight tells us they would have missed out a potential 50 to 100 bagger. Investors owning value-growth stocks look at the PEG ratio. Typically, a strong sell signal on the growth stocks is when the PEG reaches 1. The glaring exceptions here are companies like Coca-Cola (KO) in the 1960s and Microsoft (MSFT) in the 1990s, when their PEG was greater than 1 but still the stocks did very well for the investors. For all its recent run up in price, Apple's PEG is less than 0.60. That's the type of stock you should own if you believe in growth at reasonable price.
b. Dividend stocks/Long term investors: The most common and proven successful sell signal for the dividend stocks is when the company cuts it dividend repeatedly or stops increasing its dividend. Most retirees look for an increasing stream of income from their dividend stocks and when the dividends aren't raised or even worse, slashed, it's not a good sign.
c. Cyclical stocks: Examples of cyclical stocks are Freeport-McMoRan Copper and Gold (FCX) and Arcelor Mittal (MT) which flourish or flounder depending on the general economic condition. Peter Lynch advises to sell cyclical stocks when inventories are piling up in the balance sheet, as it's a bad sign the company doesn't have any control over the supply-demand. Companies cannot control the demand beyond a point but sure can control the supply. This topic was touched upon in a recent article about the Potash Corporation of Saskatchewan (POT).
d. Turnarounds: Turnarounds are stocks that were once a high-flyer or an above average performer but went down the dumps. History shows a lot of auto companies fall in this category. The best time to sell a turn around is after the turnaround. Ha, how simple? In other words, sell when the PE compression is off. Let's say Research in Motion (RIMM) comes up with some magical product and starts to turn around, the PE will grow. The sell sign is when the PE reaches the market average or goes beyond that.
Other ideas:
3:1 Rule: William O'Neil, author of "The Successful Investor" suggests setting up a strict rule (irrespective of the stock's category) that involves using stop losses at a predetermined rate of say 5%, while letting the winners run up to at least 15%. Going by this rule, you can technically afford to have 3 losers for every single winner and the odds are stacked heavily in your favor to eke out a meaningful gain from a moderate sized portfolio. We've been following this rule in 2 or 3 of our family's portfolio and it has been quite successful so far.
Portfolio Rebalancing: Out of all the points mentioned in the article, this one is the least universal. Some investors rebalance their portfolio when one particular sector/company becomes overweight. So, if a stock runs up a lot, it would affect the portfolio distribution. Investors do sell in such cases and redeploy their money to keep the numbers even.
Capital-Free Ride: Let's say you invest $1000 in a stock and the value of the holding goes to $2000 in X years, including capital gains and dividends reinvested. This strategy involves selling enough shares to take out your initial $1000 investment but leave the remaining $1000 on the table. This lets you deploy the money elsewhere and diversify if you believe in it, while making sure you still gain from the stock which doubled your money in the first place.
Taking Losses: A lot of people sell their losers right at the end of the year to claim losses on tax returns. The prudent thing to do when a stock you like tanks is to check if the losses are because of the company's woes or any external problems. People who were active in the market in 2011 would remember how Greece totally ruled the direction of the U.S. market. Unless the company's fundamentals are deteriorating and better alternatives are available in the same sector, it's better to stick with your picks.
Conclusion: We hope at least one of these rules is helpful for each individual investor out there. Pick and choose the ones you believe in and stick with it. There are also other mechanisms like charting, which traders use heavily. You may also choose to use a combination of these strategies, like yours truly does. Irrespective of the strategy used, always remember that no one gets hurt taking profits.
