When To Sell

Foreword from ShareInvestor

This article “When To Sell” by Teh Hooi Ling was first published in The Business Times on 19-20 Jan 2013 and is reproduced in this blog in its entirety.

In a bull phase, investors must decide how long to hold so as not to leave too much on the table, and yet not be exposed to a sudden reversal in the market

I WAS with different groups of friends this week. Coincidentally, the same topic cropped up: When to sell the shares you have bought.

Friend No 1 says: “I have a near perfect record when it comes to buying. I have the guts to go against the market and buy undervalued stocks. And when the market goes against me, I have the conviction to hold and even buy more.

“It is when the market moves in my direction, when my position starts to make money that I make mistakes.”

He tends to sell too early. For example, he bought into Thailand real estate developer Quality House not too long ago. In the last one month alone, the stock surged nearly 40 per cent. He sold his stake at about 2.60 baht recently, only to see the stock go up to 3.08 baht in the following two days.

He is toying with the idea of moving the positions he has built up to his wife’s accounts so that he doesn’t have to look at them anymore.

At a lunch a day later, Friend No 2 says: “Hooi Ling, you know what your next article should be? When to sell!”

I ask: “So when do you sell the stocks that you’ve bought?”

He says: “Never.”

Consequently, some of his positions have gone from a 40-bagger to just maybe a three or four-bagger.

Friend No 3 quips: “I’ll give you a quote. ‘Buying is a science, selling is an art.'”

Friend No 4 chips in, saying: “We put in a trade, but we don’t realise that the trade will end up changing us.”

“What do you mean?” I ask.

He shares his experience. He says that he sold Raffles Education after it had gone up by six times. But after that, that stock went up by another 30 times from where he sold it. But now, it is back to the level he sold the stock.

He explains. “If I had held Raffles Education from five cents all the way up to $4.40, that may have changed me. I may end up spending all my time trying to find the next Raffles Education.

“I may not be the macro person that I am today.”

Indeed, he may not have been as successful an investor as he is today. Stocks like Raffles Education are very few and far between. And who is to say that he would have the fortitude and the foresight to sell the stock at its peak. There is a chance that he would ride it all the way down as well.

Well, generally the problem with value investors is that they sell too early. In fact they may go in to buy too early as well.

GMO’s Jeremy Grantham, in one of his quarterly letters, notes that you can apparently survive betting against bull market irrationality if you meet three conditions. First, you must allow a generous Ben Graham-like “margin of safety” and wait for a real outlier before you make a big bet. Second, you must try to stay reasonably diversified. Third, you must never use leverage.

“In my personal opinion (and with the benefit of hindsight), although we in asset allocation felt exceptionally and painfully patient at the time, we did not in the past always hold our fire long enough or be patient enough,” he says. “It is the classic failing of value managers (and poker players for that matter) to get impatient and bet too hard too soon.”

In any case, it is safer to err on the side of buying too early and selling too early than buying too late, and selling too late.

Mr Grantham’s colleague Ben Inker puts it this way. The risk of an asset, he reminded investors, rises with its valuation. Stocks at fair value are less risky than stocks trading 30 per cent above fair value because the expensive stocks give you the risk of loss associated with falling back to fair value.

That “valuation” risk leads to losses that should not be expected to reverse themselves anytime soon.

Meanwhile, a cheap stock can certainly go down in price, but when it does, one can expect either high compound returns from there, which makes one’s money back steadily, or a reasonable sharp recovery when the conditions that drove prices down dissipate, which will make your money back quickly.

“The loss is therefore temporary, although it may seem unpleasant while it is occurring. When an expensive asset falls back to fair value, subsequent return should only be assumed to be normal, which means that the loss of wealth versus expectations is permanent.”

Some advice given by Investopedia on when to sell is:

  • The stock hits your target price;
  • Its fundamentals deteriorate;
  • A better opportunity comes along.

Opportunity cost is a benefit that could have been obtained by going with an alternative. Before owning a stock, always compare it with the potential gains that could be obtained by owning another stock. If that alternative is better, then it makes sense to sell the current position and buy the other, according to Investopedia. Accurately identifying opportunity cost is extremely difficult, but could include investing in a competitor if it has equally compelling growth prospects but trades at a lower valuation, such as a lower price to earnings multiple, it says.

For me, I’d say that valuation is key. When the stock price runs up to a level that it no longer justifies the risk of owning it, then it’s time to sell.

This topic is coming up because I guess we are kind of entering the bull phase of the market. Price increases have been sustained in the past few months, taking by surprise investors who have gotten used to the constant fear factor in the market.

As we have seen time and time again, during a bull market there is a tendency for prices to go way beyond fair value. How do you identify if we are in a bull market and how long do you hold so as not to leave too much on the table, and yet not expose yourself to the sudden reversal in the market?

I lamented to another friend not too long ago about how I always tended to sell too early. He says he has a system. He says: “Shares enter my sell list when the price-earnings ratios go up too high, or when fundamentals deteriorate.”

But he uses technical analysis to guide him on the actual sell. “Actual sell is triggered when the RSI (Relative Strength Index) drops below 60.”

RSI measures the momentum of the share price. The RSI computes momentum as the ratio of higher closes to lower closes: Stocks which have had more or stronger positive changes have a higher RSI than stocks which have had more or stronger negative changes.

Perhaps this is an added measure one can put in.

Share investing should be made into a process. Follow the process, and constantly refine it. That should keep one’s emotions in check, and over time, should allow one to come out on top.