You may be familiar with the old sharemarket saying that “you only make a profit when you sell.” This saying has a great deal of truth to it—which far too many investors ignore by spending too much time developing buying strategies while neglecting the other important aspect of investing: selling.
There are danger signs that can provide an investor with warning that a company’s fortunes might be about to deteriorate, however. It is important to devise a buy/sell strategy that can recognize these signs and act accordingly.
Standard selling strategies
A good case can be made for selling in a bull market, where everyone is buying and the market enjoys a great deal of exuberance, because share prices very often do not reflect the intrinsic value of their future cash flows. Of course, selling in a bull market has its risks: share prices could be headed for higher levels. Investors, understandably, can feel reluctant to recommend selling.
But the risk of selling too soon is really just the risk that a investor set artificially low target selling prices to begin with. Investors, then, must ensure that they use sound fundamental and technical sharemarket principles in order to achieve the best return on sold investments.
That doesn’t mean, though, the exact top of a market can be pinpointed. Even the most experienced investors could not consistently foresee the pinnacle of a stock’s price: it is only realistic to acknowledge that a company’s share price will likely rise after a seller’s shares have been sold. Though this is a frustrating aspect of a investor’s job, regret over selling too soon is better than regret over holding on too long. Once a price falls, the decision to sell will look like a great one.
Still, this risk can prevent investors from making the proper decision to sell. By asking if your would be willing to purchase the shares at the current market price, however, an easy answer to the question of selling vs. holding emerges: if you wouldn’t buy them at their current price, then it is almost certainly time to sell.
Determining when to sell
Similar criteria can be used to determine when to sell as is used to determine when to buy. For example, a investor may decide to buy shares based on the security having a price/earning ratio of 10, increased profits by an average of 20% over the past five years, and dividend yields of 4% at the time of sale.
A few years later, the shares might be selling on a P/E of 25, profit growth is only around 4% per year, and the dividend yield has fallen to 2.5%. The investor should see that not only has the rationale for buying disappeared, but that there is also a clear sign to change their decision to sell. The profit, then, can be reinvested in shares which fit their client’s buying criteria.
The decision to sell does not need to be an emotional one. Using fundamental analysis, investors can decide objectively what course to take and adopt a few simple rules to utilize over and over in determining whether to buy, sell, or hold on to a security.
When buy and hold might succeed
There is an alternative to this method: the “buy and hold” strategy, which can work if applied to companies where it is likely to succeed. In other companies, the buy and hold approach can lead to average returns at best or, at worst, financial ruin.
Most companies listed on the sharemarket can be sorted into one of the five following categories:
- Established “blue-chip” industrials
- Established smaller industrials
- Established mining and oil companies
- Start-up industrials
- Oil and mining explorers
Fundamental analysis can be applied to the first three groups of companies with ease, but not so the last two. A buy and hold strategy, then, is more likely to succeed with established companies, who can be better analyzed. Of course, some start-ups go on to become huge, multi-national corporations (Microsoft, for example). With these rare stocks, a buy and hold strategy could prove to be incredibly profitable.
In short, if an investor can identify that a company is in the early stages of an explosive growth pattern and then adopt a buy and hold decision strategy, a great deal of profit can be made. But such companies are hard to come by, since the majority of start-up companies remain comparatively small or, worse, go out of business and take their shareholders’ money with them.
It is also important to remember that in their early stages, start-ups are often priced on potential earnings and over-enthusiastic projections made by sharemarket speculators. This occurred during the “dot.com” boom, where telecommunications companies in 1998 and 1999 were overvalued because profit projections were based on the seemingly imminent emergence of a global market for a company’s services/products. This market, however, failed to materialize, and share prices fell accordingly.
Another important tidbit: mining and oil exploration companies are intrinsically speculative; thus, investors are typically wise to take profits when they come rather than adopt a buy and hold strategy.
Time to sell: eight warning signs
The following eight events are signals that it could be time to sell, despite any preconceived hopes at the time of sale.
Management Changes
When major changes in a company’s management team occur, it is essential to reevaluate its prospect for growth. The founder of a company, for instance, may be innovative and entrepreneurial, while their successors are less creative, more risk-averse, and more focused on keeping up the company’s status quo. This “safe” approach obviously has its advantages, but the explosive growth the company may have had in the past could be over, replaced with a more conservative—and less lucrative—path.
Company mergers or take-overs
Even with thriving companies, takeovers do not always work out as well as hoped. Occasionally, major problems with the acquired group can emerge after the takeover. Also, the benefits of a corporate takeover might take longer than expected to materialize. Investors should ask whether the company paid too much to acquire these assets: after all, it’s not just investors who can get carried away in a bull market. Companies, too, can buy overpriced securities.
No more dividends
If a company stops paying dividends, take heed: bad news is almost sure to follow. Ceasing to disperse dividends usually shows that the board of directors is extremely concerned about the company’s financial position, meaning that shareholders should be too. Companies may then try to issue a statement to soothe the mind of investors, claiming that the decision is temporary and prudent; but it remains a clear sign that the shares should be considered high risk.
Disappointing Profits
While slight underperforming doesn’t necessarily mean that investors have cause to panic, when profits are much lower than expected that spells danger. Today, many major companies will give “profit warnings” if they believe that investors and investors have become over-enthusiastic about future profit potential. These can cut 10% or more from a company’s share price in a matter of hours when the market is volatile.
Enter: a new competitor OR government-level policy change
The advantage of free markets is that new companies can enter any industry at any time, keeping companies on their toes and encouraging innovation. If a price war begins, new competition can erode the profits of pre-existing companies, however. Changes in government policy can increase the likelihood of this occurring: take, for example, Australia, who has recently deregulated the telecommunications and electricity supply industries. A number of new companies have entered the playing field in both industries, causing profits for preexisting companies to erode.
Top executives dump their shares
Company management owning stocks in their company is an encouraging sign, showing that executives are willing to back their own performance with their own money. If, then, senior executives start selling large numbers of these shares without a personal reason given, it is probably time to reassess the potential of these shares. Investors can keep abreast of these “inside” sales by reading the financial press.
Single company dominance in your portfolio
A single successful company might come to dominate a share portfolio after a period of a few years. If this company continues to perform at a high standard, this is not a bad thing, but if anything changes, the entire portfolio could lose big. If one company dominates a portfolio, a single “profit warning” could wipe out the entire portfolio—very quickly.
The company becomes the “flavor of the month”—pushing share prices to unsustainable levels
By measuring a company’s market capitalization, investors can determine whether a company’s shares are over-priced. Market capitalization—a share price multiplied by the number of shares issued against other well-known companies (such as BHP Billiton, News Corporation, or the National Australia Bank (NAB))—can be used for this purpose. Suppose that a company’s shares rose to the point where it had a market capitalization of 40% of the NAB. Ask the question: is this company really worth 40% of the National Australia Bank? If the answer is no, it could be wise to sell and take some profits.
Conclusion
The above factors are best considered as indicators, not definite signals to sell. If two or more occur simultaneously, however, more weight should be added to each indicator, making the signal to sell stronger. When developing a buy/sell strategy, it is wise to consider the above warning signs in conjunction with your own personal buy/sell indicators.
Using a well-researched and developed buy/sell strategy in day to day trading can provide a two-fold benefit: first, operating in accordance with a buy/sell strategy can remove the opportunity to rely on emotions rather than facts while trading; and second, it can ensure that your approach to portfolio management—and achieving success in the market—is consistent.