The Investor’s Dilemma

Foreword from ShareInvestor

This article “The Investor’s Dilemma” by Teh Hooi Ling was first published in TheĀ Business TimesĀ on 01 Apr 2006 and is reproduced in this blog in its entirety.

To sell or not to sell? Here’s a checklist to go through before disposing of your stock


A LOT of investors have a happy problem on their hands now. But it’s also a problem that’s one of the most difficult to solve in the investment context. It’s when to sell your holdings.

A super-performer can grow to have an overwhelming influence on your portfolio. Let’s consider an example made up of 10 Singapore stocks.

On Dec 30, 2002, Mr Tan decided to invest $100,000 in these stocks – $10,000 in each. Based on his own research and recommendations from friends, he picked these companies: China Aviation Oil, Citiraya, City Developments, DBS Group, Goodpack, Inter-Roller Engineering, Labroy Marine, Singapore Airlines, Singapore Telecom and Tat Hong.

Just over three years later, Mr Tan’s $100,000 investment is worth about $440,000. Among his picks, airport logistics systems solution provider Inter-Roller has been the best performer. In the past three years or so, its share price has climbed 20-fold. The original $10,000 investment is now worth about $200,000. The counter’s performance has eclipsed that of most of Mr Tan’s other picks, though Labroy and Goodpack have chalked up respective gains of 550 per cent and 400 per cent.

So Inter-Roller now makes up a whopping 45 per cent of Mr Tan’s portfolio. Generally speaking, having almost half of your investment in a single stock is a risky proposition, and it’s not a situation that any financial planner would recommend to a client.

For most investors, however, this is not a likely scenario. Had you gone into Inter-Roller at the bonus-adjusted price of about 10 cents at end- 2002, it would have been very tempting to take profit when the stock hit 45 cents – for a gain 300 per cent – just eight months later in August 2003. And for those who caught the ride in early 2004 when the share price was about 40 cents, it would similarly have been hard to resist a 50 per cent gain in the following two and a half months.

The thing is, there have been many points at which an investor could have got off the ride and missed out on even greater gains. So, what is the checklist that one should go through before selling, a checklist that will minimise the chance you will want to bang your head against the wall after you’ve sold?

Valuation Vs Fundamentals

Number one on the checklist, I think, is to get it into your head that the percentage gain on your investment should not have any bearing on your sell decision. Sometimes we tend to get lazy and think: ‘Oh, an 80 per cent gain or 100 per cent gain in three months or a year is good enough for me.’

But reaching a ‘sell’ decision should involve more than just a simple percentage calculation. A substantial amount of work in the form of research and the processing of information is required.

The crux is to ascertain the valuation of the stock relative to its fundamentals. There are two key words in the preceding sentence: valuation and fundamentals.

First, let’s look at fundamentals. The best way to know when to sell a stock is to know why you own it in the first place. For a disciplined investor, there are usually a few reasons for buying a stock.

One is, you like the fundamentals of the company. If this is the case, you should sell when the fundamentals change.

According to Philip Fisher, author of the important book Common Stocks and Uncommon Profits: ‘It is only occasionally that there is any reason for selling at all.’ And the occasional reason is the deterioration of a company’s underlying business. ‘When companies deteriorate, they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did,’ Fisher says.

So as long as the company you have invested in still has a competitive edge in an expanding industry, you have no reason to sell. That is, provided the share price has not run ahead of the fundamentals.

Sometimes a fundamentally good company can be a bad stock because the market is so in love with it that it is willing to pay through the nose just to be a shareholder. In situations like this, a ‘sell’ is in order.

Next, how do you know whether the share price has run ahead of the fundamentals? The most commonly used valuation metric is the price-earnings multiple.

One can use PE multiples to compare industry peers or a stock’s own historical PE band. The PE should also be weighed against the growth of the company. And finally, the appropriate PE should also take into account where in the industry and economic cycle the market is at now.

Until two weeks ago, Inter-Roller had always traded below 15 times its historical earnings. If one incorporates a little forecasting, assuming 20-30 per cent earnings growth, the prospective PE would have been in the range of 8-12 times.

So, Inter-Roller’s earnings in the past three years have been keeping up with its share price appreciation. At the same time, the outlook of its business has been positive. Budget airlines are allowing hundreds of millions of new travellers to take to the air, and many more are travelling more frequently. So airports all over the world have to expand to accommodate this deluge of travellers.

Against this industry backdrop and considering Inter-Roller’s solid track record – but also noting that the company is relatively small and not on the radar of big foreign broking firms – the forecast PE of about 12 is about fair. And ‘fair’ is no reason to sell.

At fair valuation, many things can happen to cause a re-rating. One, a company could bag a new big contract. Two, there could be PE expansion amid the flush of liquidity in the market. Three, possibly linked to the point above, a very bullish report from an influential broker is issued. Four, the company becomes a takeover target.

In Inter-Roller’s case, scenario No 3 eventuated. Citigroup issued a report setting a target price of $2.47, versus the $1.50 market price then. That was the catalyst for the stock’s 25 per cent jump in the past two weeks.

At current levels, it is trading at 15 times its earnings this year, assuming it can expand its bottom line 30 per cent.

Price-Earnings Comparisons

Is it conceivable for Inter-Roller to trade to a PE of, say, more than 20 times, as enjoyed by the likes of Osim or Raffles Education? The market would argue that both Osim and Raffles Education have stronger brand names and their industries are presumably less cyclical. There are some truths in these observations, but that’s not to take anything away from Inter-Roller’s stamp of quality in its systems.

Overall, it is safe to say that at its current price, the chances of Inter-Roller repeating its phenomenal performance of the past three years are slim. However, one would be inclined to think it has still not quite reached an outright ‘sell’ stage yet.

Another reason we might buy a stock is because we like the industry it is in. An industry could be just at the cusp of the next wave of growth. A rising tide lifts all boats. So a company in the right sector is likely to do well. Witness shipping a few years ago and the oil and gas and marine-related sectors in the past couple of years.

Industry cycles tend to last several years. Growth comes because a sector has been neglected for a period. Few invest in it, and so production capacity is limited. And when suddenly a surge of demand materialises, established companies in that sector can increase their prices and enjoy supernormal growth.

But slowly, more companies will join the sector, and established companies will invest to increase their output. This will continue until supply again exceeds demand, and the industry will head south. That’s what the shipping industry is expected to do this year. So if you buy a stock because of the industry it is in, it is crucial to monitor such things as the inventory level of the industry and current and future demand.

We may also buy a stock not because of its fundamentals, but because we think it is cheap and trading at a significant discount to its net asset value. The likes of Orchard Parade, Hong Fok and Bonvests were trading at more than 50 per cent discount to their net asset value.

In their case, the catalyst for re-rating has been the asset or property reflation theme in Singapore. Similar to industry cycles, such reflation also takes several years to play itself out.

Finally, if one senses that conditions are right for a multi-year bull market – for example, an improving macro-economy, an expected increase in fund flows into the market, and still fair valuations – then the only thing to do is to sit back and enjoy the ride.