Knowing When To Sell A Stock
Knowing when to sell a stock continues to be one of the biggest worries for investors. Investors need to offset competing forces of greed and fear, balance position sizes with investment objectives and constantly worry about selling a stock that is (perhaps) about to soar.
Everyone loves making money, and, as the saying goes, you can never go broke taking a profit. That said, how many of us have sold a stock and then watched it soar in value when we no longer owned it? Tesla Inc. is my shouldn't-have-sold-it regret. I sold the stock I owned years ago. Had I kept it, I probably could have bought one of their cars with the profits.
Selling is always difficult, but we're here to help.
For this article, we are first going to discuss some “invalid” reasons to sell. These are often-cited reasons to let a stock go, but we do not think they should be.
Let's look at a few:
Because It Is UP
Frankly, we think this is possibly the absolute single worst reason to sell a stock. A rising stock means other investors like the company. It is confirmation that things are going well. A rising stock attracts even more investor interest. A higher stock lowers the cost of capital for a company. These are all good things. Selling just because a stock is up makes absolutely no sense to us. So, before you consider selling for this reason, think about the buyers of the stock. Investors buying at ever-rising prices are not buying with the expectation of losing money. They like what they see and expect the stock to rise more. Are these buyers delusional, buying a stock after, say, an 80% gain? Nope. In fact, they are probably pretty smart. Sure, they can be wrong, just like you can be when you buy or sell a stock. But, like a train rolling down a hill, once a company has fundamentally strong momentum, it can be hard to stop. Yes, you can make a nice profit selling a stock that has gone up. But, you will never get rich doing this. To get truly wealthy, you need those once-a-decade stocks that go up 1,000, 3,000, or 10,000 per cent. Think Apple Inc. Nvidia, Tesla and Alphabet. Not every stock that goes up will keep going up, of course. But we know one thing: You can never make 1,000% on a stock if you sell it after a 100% gain.
New Competition
Some investors panic when a new competitor to one of their investments emerges. "Oh, no," they cry. "Margins are going to decline. What if there is a price war?"
But we take a different view. Competition is part of the game. If new entrants want in on an industry, it confirms there is growth potential and profits to be made. Frankly, we are more concerned when competition does not emerge. This might mean a stagnating or, worse, declining industry.
If your company has been around for more than a few years, it has clearly faced competitive threats before and will do so again. A new competitor is not a reason to throw in the towel on a good investment.
The CEO Sold Some Shares
We don't think an investor should completely ignore insider selling. A consistent stream of selling by insiders might well mean there are some problems at the company. But insider trades need to be taken into context. A CEO who owns $400 million in shares should be able to sell $20 million or so every now and then. After all, why can't they enjoy some of their company's success?
We also tend to ignore a lot of insider trading if a stock has sharply risen. If a stock has doubled in a year, a CEO could still sell a lot of shares and ultimately still have more dollar exposure at risk than they did last year. Furthermore, insider selling during the first few months of a calendar year is very often associated with tax filings/payments and is not something to get all worked up about.
As long as insiders remain committed with a high dollar value of shares, we tend to let some insider selling go without too much overall worry, and it should not be a reason to sell.
Stock Declines After Strong Earnings
We see this all the time. A company reports strong earnings or even ups its guidance and their stock declines. As Kenan Thompson of Saturday Night Live would say, "What's up with that?" But we do not think it's a valid reason to sell.
First, there are always some investors who will view an earnings release as not good enough. There are also some investors who typically sell on the news. And there are those who decide that the earnings were good but can't possibly get better, so they sell.
For us, none of these are valid reasons. Focus on the fundamentals. If earnings are growing or accelerating, the stock price should follow. It may not be today, but stock prices will—most of the time—follow the fundamentals.
Stocks that have risen a lot will sometimes fall on earnings releases simply because of profit-taking. But we are more likely to view a strong earnings report as a reason to buy more, not sell.
Broker Downgrades
Sorry, analysts, but your downgrades are not a reason to sell. There are some good stock analysts with good calls sometimes, but they are, on average, stock price followers. The majority of downgrades occur after a stock has already declined.
Multiple broker downgrades can often be a good contrarian indicator for stock buyers. Many investors still blindly sell a stock when it receives a downgrade. We think this is only a good way to lock in weak returns.
Look at the longer-term picture. Look at the reason for the downgrade. Often, the reason is simply valuation, which means investors like the stock—a lot. Selling a stock that is popular with investors is not often a solid strategy (hint: there are valid reasons why it is popular).
With our Bloomberg terminal, we note that every single one of the top 20 stocks of the past five years has had broker downgrades at one point. These downgrades prompted many investors to sell and miss out on some big gains.
Bad Economic Numbers
When you buy a stock, remember that you are buying shares in an actual company. You are buying into that individual company's prospects. You are not buying an inflation index, interest rate futures, unemployment data, gross domestic product, consumer sentiment, oil inventory levels or any other data point.
Sure, these data points can influence general stock prices, but a good company will remain a good company, even as thousands of economic data points pass by our screens every year.
Good companies adapt to conditions. Also, of course, conditions can quickly change. A bad economic data point today might mark an economic bottom and might just be a big turning point for the market. You don't know. Neither do we.
As well, economic forecasters are often just wrong. We have now been waiting for the dreaded recession for more than 20 months. Don't sell a company because of a single bad economic number.
So, now we have discussed some invalid reasons to sell, let's look at some valid reasons:
Portfolio Management Reasons
This is, by far, the easiest reason to sell. It works both for a winning position and a losing investment. Suppose you happen to own a five per cent position in a stock that has absolutely soared. Good for you! But now, you might have a stock that is 10 per cent of your entire portfolio, or more, depending on how your other securities have done while your winning position went to the moon.
Position sizes need to be based on personal needs and objectives, but we get nervous when a position rises to more than 10 per cent of a portfolio. At that point, investors may want to scale back a position to manage overall risks. We would not suggest an exit but reducing a 10 per cent position to seven per cent reduces risk and still provides significant exposure to the stock in question. However, portfolio management selling works for loser stocks as well. Suppose you bought a two per cent position in a dud. Now, years later, it might represent only 0.5 per cent of your portfolio after a precipitous decline. Now, it will barely have any impact on your portfolio. Typically, in this case, the decision is to exit or buy more, so it becomes more meaningful to the portfolio. In most of such cases, it is almost always better to exit (see more below).
Tax Loss Selling
Now, we don't think an investor should ever let taxes drive all investment decisions, but they certainly can be a factor. We very much like to "water the flowers and pull the weeds," meaning we like to trim the losers from our portfolio on a regular basis and invest more in the winners.
In a taxable account, an investor can carry back capital losses for three years or carry them forward forever. Sure, there is always the risk that a loser stock is going to soar, but it happens less than people think. Plus, with a tax pickup, a loser stock must rise even more to make up the tax benefits picked up by offsetting some capital gains elsewhere.
Consistent And Ongoing Executive Turnover
This reason for selling may not be as clear-cut as some of the others here, but it is just as valid. To help, pretend you are an executive at the company. Your goals are varied, but one of your goals as an executive is to make money. For most executives, the potential gains from stock ownership and options far exceed one's salary. If you do not believe in the company or its stock potential, you are going to leave and seek greener pastures elsewhere.
However, turnover is not always stock-related. Maybe the company has a toxic work environment or is run like a dictatorship. That's never fun (trust us, I once worked at a company, and we used 'Hitler' as the nickname for one of the executives!). When looking at some stocks as sell candidates, then look at how many C-suite executives have turned over in the past couple of years. If it is more than average, you might have found a good candidate to sell. This indicator is less helpful when a stock is doing well. After all, when a stock has soared, some executives will no doubt simply cash out and retire. But constant, consistent executive turnover is more often a negative sign and very rarely a positive sign.
Consistent And Ongoing Missed Execution
This is the old "promise a lot and never deliver" scenario. If you own shares in a company and find yourself, time and again, disappointed in its results, then chances are you are not the only one. Consistently missed execution over time results in a lower valuation multiple and a lower stock price. If you constantly find yourself screaming, "Argh! Not again!" when a company misses estimates, then you may have found a candidate for selling. Note that for this reason, we are focusing on fundamentals. Often, a company will report good numbers, and its stock will still drop, be it for profit-taking or other reasons. We care less about a short-term decline in the stock price as long as the fundamentals of the company are performing. If the company is beating numbers and growing, the long-term stock price should follow.
A Deterioration In The Balance Sheet
Debt can provide earnings leverage, for sure, but it also adds risks. If you hold any stock for a prolonged period of time, you are going to see a recession. If your company has added significant leverage to its balance sheet, it may struggle during that recession. Not only that, but its valuation multiple may decline as investors fear weakness or even insolvency if the debt is really high. So, debt levels need to be watched. Debt incurred in an acquisition can be different from debt incurred simply to finance ongoing operations.
If one is a long-term investor, and one should be, then the key is being comfortable with one's stock positions. We prefer companies that we know will get through the next recession, financial crisis, or market crash. Sure, their stock will fall in such a scenario, but at least the company will be around for the rebound. If a company has too much leverage, it may not be. A glaring recent example is the U.S. regional banking sector. Today, there are several fewer banks than there were at the start of the year, as these banks—some quite big—couldn't handle the shift in interest rates. We look for "sleep at night" stocks with clean balance sheets because we do not know what tomorrow will bring.
Peter Hodson, CFA, Head of research at 5iResearch Inc, an independent stock research company, research@5iresearch.ca, www.5iresearch.ca