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Knowing when to sell! - Views on News from Equitymaster
 
 
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  • Mar 22, 2007

    Knowing when to sell!

    Warren Buffett, the value investor par excellence was once asked about his holding period and he replied by saying that 'My holding period is forever'. While this statement endorses long term investing, which even we are proponents of, it also side steps one of the biggest quandaries in the investing world. And this quandary is choosing a right time to come out of an equity investment. Although there may be a debate among the investment fraternity on how to correctly identify a cheap stock (to look at low P/E or low P/BV or P/Cash Flow), there is a widespread consensus among the same set of investors on the fact that there is indeed no predictable and foolproof way to decide that the time has indeed come to sell one's holding in a stock. Imagine how many investors would be ruing selling a blue chip like Infosys or coming out of HDFC a little too early. Or worse still, imagine someone riding the entire growth in market value of a particular stock and then watching helplessly the decline in the same stock just because he could not arrive at a proper selling price. Cases like these abound and often one is left wondering, is there a way one could minimize the heartburn caused by such inabilities on the part of investors.

    We believe that though there is no foolproof way to decide whether the time has come to exit a stock, there are indeed certain guidelines, which if properly adhered to can definitely allow the investors to profit from their investments in a rational market.

    Valuation: We are of the opinion that a stock becomes a sell candidate the moment its price reaches its intrinsic value. Intrinsic value could be defined as the total cash that can be taken out of a business during its entire lifetime. Now, here comes another problem. How can one arrive at an intrinsic value of the company? Businesses that are easy to understand and have predictable growth rates lend themselves to simple analysis of intrinsic value while others do not. So how should investors arrive at an intrinsic value of a company, which has complex businesses or simply have too many variables involved. This is where the concept of a circle of competence comes in. Invest only in those businesses where you think you have an edge in terms of arriving at a correct value of the company. The moment the share price reaches that value, exit the stock. Hence, keeping a close eye on valuation levels can help investors take 'Sell' calls in the correct ballpark, if not at an exact price.

    Wrong assumptions: Since stock market investing involves making predictions about the future, there are certain sets of assumptions that are involved while investing in a company and which are critical for the target price to be met. If these assumptions do not pan out along expected lines then one should be honest enough to admit one's mistake and exit the stock. For eg. if one has purchased a stock in a company on the back of the assumption that margins might improve exponentially from current levels in the next couple of quarters and hence would translate into higher earnings. If this assumed scenario does not pan out in the next couple of quarters or if the margins fail to improve, then without waiting any further, one should quietly accept one's mistake and come out of the investment.

    Deteriorating fundamentals: This is another important reason for which an investor can mark his exit from a company. If a company is rapidly losing market share to its competitors or margins are eroding fast then more attractive opportunities should be looked into and the current investment needs to be exited from. Quite often, investors have certain sentiments attached with a stock, which makes them stick with the company despite its deteriorating fundamentals. This kind of a mistake should be avoided and exit has to be timed as quickly as possible. It should be also noted that if deteriorating fundamentals is an industry wide or an economy wide phenomenon, then your investment may not be that bad at all and hence such investments should be persisted with, for if the situation were to improve in the medium term, an investor would benefit from the upside.

    Other reasons like change in management, change in the business model of the company also exists but they are too obvious and hence, it would not be difficult for investors to miss those. Thus, having looked at some of the key reasons behind knowing when to exit a stock, we would like to advise investors here that these methods do not guarantee capturing complete upside from a stock but nonetheless will help in making informed decisions. Furthermore, the idea should be to earn a reasonable rate of return from your investments and not look for a 'multi bagger' in every investment you make. Since the cricket fever is in the air, we would like to draw an analogy from cricket and conclude by saying that, the idea should be to play each delivery trying to score singles and doubles and if some fours and sixes come along the way, well and good!

     

     

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