Rules for selling stocks

Most investment gurus tend to find selling much harder than buying. As Sanjoy Bhattacharya, the founding CIO of HDFC Mutual Fund, says in Chapter 1 of my book, Gurus of Chaos, "Selling is well and truly the dark continent of investing." So, I thought I would take a stab at how I, as a broker, identify high-conviction sells.

Let me begin by highlighting two weak 'selling rules'. The first is around cyclical stocks and the economic cycle. Common wisdom says that if the economic cycle is turning up, you should buy stocks from cyclical sectors such as banking, auto and industrials (and vice versa). There is some logic in this: the correlation of stock prices in cyclical sectors with GDP growth is around 45-50 per cent. The problem, however, is that champion cyclical stocks such as HDFC Bank and Maruti demonstrate much lower levels of cyclicality (around 25-30 per cent). Hence, to buy or sell the top-quality cyclical names on the back of the macro cycle might not make that much sense.

The second weak rule that often gets used is to sell a company's shares after it has surprised negatively in its results (and vice versa). Leaving aside the obvious issue that the stock will react very quickly to the results and hence the incremental upside left could be modest at best, there is another problem with this rule - most companies tend to have good and bad results in an alternating fashion as corporate profitability is usually a mean-reverting series. Hence, an investor who responds to results could find himself buying and then selling the same name in six-month cycles, which are unlikely to make him a successful investor. That being said, there is some logic in selling a company's shares if results are repeatedly below expectations.

Let's now turn to the more effective selling rules. Firstly, it makes sense to sell a stock when you can see that the competitive moat around that company is eroding. For example, for more than a decade after Maruti entered the Indian market, Hindustan Motors, the manufacturer of the now obsolete Ambassador car, was a Sensex company. Even after the opening up of the Indian economy in 1991, investors did not figure out that this company's moat was going to be eroded by economic liberalisation. I reckon investors face a similar risk in Indian banking, housing finance and NBFC stocks, given that the RBI is now whacking out new banking licences by the dozen.

Secondly, it makes sense to sell, I believe, when a company's capital allocation is deteriorating. ROCE, as a measure of the effectiveness of a company's capital allocation, is the most accurate predictor of stock prices. Great companies start sliding when they can no longer figure out how to invest their next dollar of free cashflow at a higher ROCE than their current ROCE. Bharti Airtel and Tata Steel are the best examples of the titans who have suffered on this front. Asian Paints, on the other hand, has been a champion of the capital-allocation game over the past 30 years.

Finally, the most effective selling rule, I believe, is centred on accounting quality. When a company starts cooking its books, it is time for minority shareholders to head for the door. Every year in the month of December, my colleagues and I crunch through the last six years of annual reports of the BSE 500 companies. What we find every year is that the bottom 40-50 per cent of Indian companies (i.e., companies with weak accounting) do not provide any shareholder returns over the medium-long run. At one level this isn't surprising. However, what is interesting is that large, well-researched companies also tend to have glaring accounting issues which the stock maket sometimes takes years to unearth. So much for the efficient market hypothesis.

Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of Gurus of Chaos: Modern India's Money Masters.

This column appeared in the November 2015 Issue of Wealth Insight.