Don't Sell Such Stocks at Market Highs 

In one of my earlier YouTube videos I explained how an investors should evaluate high growth stocks trading at extremely steep earnings multiple.

Evaluating Dixon Technologies showed us what even the slightest slow down in growth could do to valuations.

200x P/E means that if you were to hypothetically buy 100% of the company's shares, it would take 200 years for you to earn back your initial investment through the company's ongoing profits.

But Dixon is not the only stock that has soaked in excess liquidity floating around in Indian stock markets in recent months.

And it is not the only stock showing any signs of bubble.

Liquidity inflow, not just from foreign institutional investors (FIIs) but also domestic investors by way of systematic investment plans (SIPs) has been consistent.

And unlike the rest of the world, Indian central bank (RBI) is not to be blamed for the excesses.

Just a decade back, the loose monetary and credit policies of 2006, created a bubble in Chinese stock market.

At the time, Chinese regulatory authorities imposed policies that sought to reduce the risk of a stock market crash. For example, the People's Bank of China raised the renminbi deposit reserve rate 10 times from the beginning of 2007. But the rising deposit reserve rate did not decrease excessive liquidity in the stock market.

A large volume of hot money continued to flow into the Shanghai A-share stock market, driving the stock price continuously up.

At the end of 2007, global financial turbulence caused major international stock markets to fall sharply. From November 2007 to January 2009, the Shanghai A-share stock price fell 69.2%. This set an international milestone as the largest-ever share price decline in history.

In comparison, India's stock market is today largely reliant on domestic inflows.

But will such liquidity stay resilient in the wake of a global tremor? Well, that remains to be seen.

Now, taking some profits off the table to prepare for a market correction is never a bad idea.

Rather, at Equitymaster, we always recommend readers to ensure they have funds to buy more stocks when valuations correct. That is precisely why I have been recommending subscribers to sell partial exposures in stocks that have met target prices.

But the question remains - What should you not sell?

To answer this, I always go back to one of my favourite memos of Howard Marks, Selling Out....

In the memo he wrote...

• When you find an investment with the potential to compound over a long period, one of the hardest things is to be patient and maintain your position as long as doing so is warranted based on the prospective return and risk.
  
  Investors can easily be moved to sell by news, emotion, the fact that they've made a lot of money to date, or the excitement of a new, seemingly more promising idea.
  
  When you look at the chart for something that's gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell.
  
  Marks gives the example of investors regretting not having bought Amazon when it listed at US $5 in 1998, ...
  
  But then he asks.
  How many would have continued to hold when the stock hit $85 in 1999 - up 17x in less than two years?
  Who among those who held on would have been able to avoid panicking in 2001, as the price fell 93%, to $6?
  And who wouldn't have sold by late 2015 when it hit $600 - up 100x from the 2001 low? Yet anyone who sold at $600 captured only the first 18% of the overall rise from that low.
  
  In short, a good deal of selling takes place because people like the fact that their assets show gains, and they're afraid the profits will go away.

Selling out of a position is much harder to do well than buying into it. People hate losses a lot more than they enjoy equivalent gains but reserve a special loathing for crystallising a certain loss.

Most people invest a lot of time and effort trying to avoid unpleasant feelings like regret and embarrassment. What could cause an investor more self-recrimination than watching a big gain evaporate?

If you sell an appreciated asset, that puts the gain "in the books," and it can never be reversed. Thus, some people consider selling winners extremely desirable - they love realized gains.

You might wonder...are the fund managers and institutional investors better at selling?

Unlike retail traders, the pros typically do not cling on to losers. Yet they do not make selling decisions the way they make buying ones i.e by choosing the asset adding the least to their risk-adjusted return and offloading it.

Instead, they just select positions where relative performance had been very bad or very good and exit those. As a result, they too often throw away two-thirds of the excess returns their skilful buying had won them.

Fund managers also face constraints that prevent them from selling perfectly. At times they may be compelled to sell...as the capital could be needed for another purchase, or to return to investors.

Moreover, if the stock to be sold is relatively illiquid, the fund manager may need to plan to weeks ahead to offload the stock in order to find buyers at low volumes. So it is not that professional fund managers have the selling decisions very easy.

On that note...here is a simple checklist that I run through to decide when not to sell and select stock not to sell...

There can be only three reasons for not selling a stock even at market highs:

• Want to own the stock like you own the business
  
  If you own a stake in a private sector company with enormous wealth compounding potential, strong balance sheet and great management, you should never want to sell it fearing near term correction. Great compounders are extremely hard to find, so it's usually a mistake to let them go.
  
  Also, I think it's much more straightforward to predict the long-term outcome for a company than short-term price movements. So, it doesn't make sense to trade off a decision in an area of high conviction for one about which you're limited to low conviction.
• Current valuations of the stock cannot undo the discounted buy price and the long holding tenure
  
  Not matter what the valuations today are, if you have bought the stock when it traded at deep discount and held on to it for years, you have already hedged your risks.
  
  Therefore, current valuations should not be the only reason to do away with such stocks.
• The stock is a high cash flow investment
  
  Businesses that are financially sound and regularly pay off their healthy cash flows to shareholders by way of dividends and buybacks may be great investments to hold on to. Notwithstanding the chance of temporary correction, the dividend receipts from such stocks, may over time, more than compensate for the long holding tenure. Case in point are stocks like Asian Paints and HCL Tech.

Meanwhile, if you wish to know the list of stocks you should consider selling for fundamental reasons, check out the Equitymaster Screener.

Hope you like this video. Thanks for watching.