For most long-term investors, deciding when to buy shares is a more forgiving sport than selling them.
You instinctively buy shares in good businesses when the price offers an attractive margin of safety relative to its value. However, the art of selling shares can be much less predictable, and it’s no joke once you’ve sold only to watch the price continue going up.
The decision to sell – as with buying – should always be based on valuation, and there are no better times to pressure-test that valuation – by way of portfolio review – than after a notable share market rally or at the end of the financial year.
What your portfolio review should highlight is key trigger points to rebalance your portfolio through full or partial sell down. The decision to rebalance is always a by-product of risk, and share price activity may have moved some stocks into an under or overvalued territory that you potentially shouldn’t be comfortable with.
Let’s look at key reasons why you might consider selling a stock down.
Taking profit
Everything being equal, a stock with a good underlying business trading at a significant discount to full value makes for a good buy. But what you can often forget is that the opposite is equally true. A company’s share price cannot run ahead of its underlying performance forever. Sooner or later the share price will start to converge with the company’s value.
The closer the share price gets to a stock’s value, the greater the risk of holding the stock going forward. And the more the share price exceeds a company’s value, the greater the portfolio risk of being overexposed to any single stock, and in most cases this should trigger a sell down.
It’s equally important to remember that as a value investor, selling near the top isn’t the end goal. The main game is maintaining a portfolio of underpriced stocks offering the best possible opportunity to outperform, without taking large risks.
Whether you sell out of a stock completely depends on your outlook for the stock and any future upside to current valuations. One approach is to start taking profit when the stock moves from ‘very cheap’ to ‘mildly cheap’ (based on value). Sell more again when it trades around ‘fair value’ and sell out completely before it hits ‘overpriced’ or ‘extremely overpriced’ territory.
But if you need to realise cash from shares and no single stock in your portfolio looks particularly overweight, what should you sell?
In this situation, you should start by maintaining your exposure to cheap stocks and sell down the most over-valued stocks in your portfolio first.
Cutting losses
It’s impossible to invest in stocks and never incur a loss, but you should never want to follow a stock down. Remember, the decision to park a stock in the bottom drawer and ride it down indefinitely is as irrational as refusing to lock-in profits on a stock that’s become seriously overpriced just to avoid paying tax.
Sadly, there’s no market bell-ringer to help you separate the ‘screaming buys’ from the ‘screaming sells’. But most stocks that find themselves significantly underpriced have typically become that way for good reason.
This usually happens due to poor management, the business loses its competitive edge, return on equity and (ROE) falls along with cash flow or as witnessed recently by mining services companies and other sectors wired to commodity prices, share prices have tumbled along with the outlook for the sector.
Hanging onto these stocks only dilutes the quality of your portfolio and its long-term performance. So if holding the stock isn’t working out based on the value proposition going forward, then it’s time to access the loss and switch the funds into stocks offering superior investment opportunities.
When to buy
Smart investors buy shares in great quality stocks when the market is telling them otherwise – during big market corrections – when the baby is being thrown out with the bathwater. Investors who braved the chaos of the GFC, the tech-wreck and the 1987 crash, and bought shares in top quality businesses during these times have laughed all the way to the bank.
The problem is that these are such rare events and you can’t always wait for them to come along.
Put top quality stocks on your radar
Some investors will undertake fundamental research first then overlay technical strategies to time their entry and exit, and this is a valid strategy.
An alternative strategy is to focus on building a portfolio of stocks that are of significantly higher quality (and buying their share at the right price) than the quality of the stocks in the broader indexes that you’re seeking to beat.
With your watch list full of top quality stocks, your focus now shifts to paying a rational price.
Work out your margin of safety
That’s where a safety margin comes into play. A safety margin represents the difference between the value of a company and the share price, and when it comes to truly quality stocks, the bigger the discount, the bigger the bargain.
While there’s no idea safety margin, professional investors typically look for at least 10% for industrial businesses and 20% for resources.
Be flexible
Warren Buffett famously said he’d rather buy a wonderful company at a fair price than a fair company at a wonderful price. Focus on the wonderful companies first – the ones with bright prospects – and don’t be overly concerned if the share price is 5 or 10 per cent above what the value is today.
There aren’t a lot of top quality companies listed on the ASX, and even less trading at prices less than what their businesses are worth. So if you find a great business, and plan to remain an owner for five years or more, then paying an extra 5 or 10% is probably going to be worth it.
