Much has been written about when to buy a stock. There is a well-defined process – look for possible undervalued stocks by focusing on low price-to-earnings (P/E) or price-to-book (P/B) stocks, examine the stocks to determine their intrinsic value and finally make the decision to buy only if the margin of safety is satisfied.
But a disciplined approach to investing implies not only to know when to buy, but also when to sell. Frequently, the sell decision is more difficult than the buy decision. Many emotions come into place in the sell decision as well – such as, 'What if I sell too early and kick myself for selling if the stock then rises in value?' or 'Why should I sell at a loss and face the pain of regret that I made a mistake?' That is why it is important for investors to have an analytical approach and a checklist that will also help them guard against the possible emotional backlash of having to make a sell decision. Here is a checklist on when to sell.
1. When management did not deliver on a major promise, or lied.Many times management tells investors what they want to hear and makes many promises. So if they said they would write off a division, but instead they expand it, this is a major deviation from what was promised and one has to wonder what else they lie for.
2. When the balance sheet is deteriorating.When accounts receivable and inventories start to pile up, deviating from historical or industry norms, it implies the balance sheet is deteriorating. The same is the case when hidden assets, such as customer relations and product portfolios, deflate due to the advent of a new technology or a change in consumer tastes. Or when goodwill exceeds 20 per cent of the company's assets and debt piles up in excess of what is typical for companies in the same risk class.
3. When the market price rises beyond intrinsic value.A disciplined approach dictates that an investor should sell when the stock price exceeds a stock's intrinsic value. This is the most straightforward reason to sell.
4. When the stock has risen so much that it represents a high proportion of an investor's portfolio.
An investor should never let a stock dominate one's portfolio like Nortel's stock did for many portfolios in the early 2000s. While over-diversification is detrimental to portfolio returns, an undiversified portfolio increases risk inordinately. That is why most value investors impose position limits on the stocks they own. An individual stock should not be allowed to exceed more than 10 per cent to 15 per cent of one's portfolio.
5. When the stock has risen sharply in a short time.
Greed can hurt investment returns. No one knows what the future will entail, and so if the stock price has risen significantly over a short time period, particularly if it has come close to the stock's intrinsic value, a disciplined investor should sell and look for other investment opportunities with higher upside.
6. When a merger takes place.
This is unavoidable. Being a minority shareholder is not a good idea, so the investor needs to sell to the bidder.
7. When you can improve your price-to-value substantially.
If, for example, an investor believes Canadian Pacific Rail's (CP) stock price has come close to its intrinsic value, but that of Canadian National Rail (CNR) is only half way towards its intrinsic value, selling CP and buying CNR will improve price-to-value significantly.
8. When the company's business model has changed.
That is, when the company is no longer the company an investor bought in the first place. This happens, for example, when a Canadian furniture company, which an investor bought as a manufacturer of good quality Canadian furniture, closes plants in Canada and outsources production to China. The company's business model has changed from being a manufacturer to distributor; distribution has low margins. This would be reason to sell.
While nothing is guaranteed, having a disciplined sell approach and a "when to sell" checklist will go a long way in helping an investor achieve his or her long-term goals. And remember, when the risk is high, it is always a good idea to have a checklist – ask airline pilots.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.