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When to sell a stock

Selling your stocks at an appropriate time is important for your investment success. Here we present 4 situations in which you should sell

When to sell a stock

Do you know that Nick Train, the founder of Lindsell Train and the UK's star fund manager, has created enormous wealth simply by 'not' selling? He is a rare buy-and-hold investor who has rather successfully avoided the bad investment behaviour of over-trading. Like Warren Buffett, he believes that investors are generally too ready to sell out of investments. They are mistakenly confident that doing something, as opposed to nothing, will make a positive difference.

Buying the right stocks and selling them at an appropriate time is important for stock-investing success, but it is even more important to not sell stocks prematurely. Value Research Stock Advisor not just helps you pick winning stocks, but we also keep a track of them so we can promptly tell you when it is time to exit them.

But when should an investor sell his holdings? He should do so in four cases. First, when he's achieved the financial goal he was investing for, for example, retirement or paying for his kids' university education. Second, the stock's fundamentals have changed - debt has exploded, sales have gone into a terminal decline or the CEO has been arrested for defrauding shareholders. Third, the valuation or the price the stock is commanding has gone up beyond a rational explanation. Fourth, his original thesis was wrong in a substantial sense.

Let's look at these reasons in a bit more detail.

1. Approaching financial goal
Wealth creation is not an end in itself; it is usually a means to an end. This could mean a trip to the Grand Canyon, paying for home refurbishment or your parents' medical expenses in their old age.

The best reason to sell your investments is that you've met the financial goal you had been investing for in the first place. It is the ultimate definition of investing success and perhaps nothing is more gratifying than reaping the rewards of your investment efforts to fulfil what you want. Therefore, if your financial goal is approaching and your investments have grown sufficiently to meet it, by all means go ahead and sell your stocks. But make sure you don't leave your money invested until the last minute. The market is inherently unpredictable and you may find yourself hit hard by a sudden crash. It is best to start pulling out of the market at least one year in advance and keep doing so gradually over the subsequent months as your goal nears.

Lastly, selling to meet your financial needs doesn't mean you consume your investments for impulse spending on the latest cell phone or any fancy gadget.

2. Fundamental shifts
Companies are rather fond of citing statistics such as these: India has only 13 cars per 1,000 people compared to the USA's 440 and this implies huge future growth. Enter Uber and Ola, which are rapidly rendering car ownership redundant and casting serious doubt on the forecast.

And this does not end with cars. The rise of the internet and mobile banking means that those missing bank branches in rural India may never get built. The rise of restaurant delivery apps may mean that those local Dominoes and Pizza Hut outlets never materialise. The unleashing of locked-up accommodation capacity through Airbnb has serious implications for hotel chains. Google's ever-growing reach into our lives threatens a host of industries - travel agencies, IT and even automobiles. One of today's largest sectors, oil and gas, is reeling from the impact of the shale revolution.

The point is a lot can change after you have invested in a stock, casting doubts on your investment rationale. It could be a factor internal to the company - a deteriorating moat, a new management taking the company in a direction you don't like, or a boardroom tussle. Or it could be an external factor causing an industry-wide impact.

These are all plausible reasons to be worried about the prospects of your stock. But be sure to validate them before you press the sell button.

At Value Research Stock Advisor, we keep a track of our recommendations and revisit our thesis should a fundamental shift take place. Usually, the signs of trouble will start showing up in the numbers, which you should investigate further. Among others, here are some of the things you should watch out for:

  • Falling market share
  • Deteriorating sales and margins
  • Dwindling operating cash flows
  • Lower dividend payments
  • Rising debt levels
  • Notable equity dilution
  • Suspicious related-party transactions

3. Price turns irrational
One of the fundamental rules of investing is to buy a great business at a reasonable price. Hence, valuation plays a very important role in making money even in the long term. Similarly, valuation plays an important role in deciding when to sell a stock.

During the course of the investment, the valuation of your investment may go up and down and staying the course is important to making money in the long term. However, there comes a time when the valuation goes beyond reason and that is the time when one should start considering selling the stock or reducing one's stake.

"Price is what you pay. Value is what you get," said Warren Buffett. It is important to ascertain the maximum price one is willing to pay for a company. This should be evaluated periodically. One should ascertain the value, given the quality of the business, its management and the growth one can expect. After factoring in all these, if you feel that the valuation is not justified, move out of the stock. For example, if a company with a great business and competitive strength is expected to deliver growth of 20-25 per cent over the next five-10 years, then a price-to-earnings multiple of more than 100 times is not justified. Therefore, it's time to sell.

4. Faulty thesis
Everyone makes mistakes, especially in a complex process such as stock analysis. Irving Fisher, one of America's most respected economists, said that stocks had reached what seems like a permanently high plateau, shortly before the 1929 crash and the depression that followed.

Companies do their best to portray a positive picture without necessarily making false statements. If you realise that you were wrong about a meaningful part of your investment thesis, you should admit your error, shake off the dust and sell the stock immediately.

Investors often continue to hold onto their losers in the hope of recovering their money, or worse still, invest more money to 'average out' their cost of holding. That's a big mistake. There's no point throwing good money after bad. Besides, the more you delay your exit, the higher the opportunity cost of sticking to a loser instead of moving your money to a good company.

At Value Research Stock Advisor, we closely keep a track of these factors to decide when to sell a stock. We constantly evaluate our recommendations on the basis of the fundamental shifts, valuation and revisiting the original thesis and testing it. But as an investor, you need to evaluate your financial goals and take action as you are nearing them.