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
With the recent market turmoil and increased volatility, investors may be tempted to rush to push the sell button.
However, a sell decision should be based on a disciplined investment approach. And selling a stock in panic, impulsively following the crowd – when the market declines or when market psychology changes – is not part of a disciplined approach.
Here are some common-sense rules and a check list of when to sell.
First, the most obvious reason to sell is when the company's stock price has reached its estimated intrinsic value or, alternatively, when the company's intrinsic value has fallen to its market value. In other words, one needs to have an idea of what the stock's intrinsic value is and whether it has changed to best know when to sell.
The most basic rule, for example, could be that one buys when price to normalized (average historic) earnings is 10x and sells when the ratio reaches 20x. But this ratio can change, either because price has changed or because earnings changed.
Second, what normally gets people in trouble when investing is greed. An investor has to guard against becoming too greedy. When a stock has risen sharply over a short time period, covering most of its upside, an investor should sell and move to another stock with higher upside.
Third, it's often time to sell when the balance sheet is deteriorating. This could be the case when the industry has structural overcapacity and many of a company's assets may never be used. This happened with Nortel in the early 2000s when the company built up an excess capacity of fibre optics and demand never picked up. Along with large amounts of debt, this caused Nortel's eventual demise.
Or it could be time to sell when goodwill has evaporated after a company overpays for a target company and the price of underlined assets has fallen sharply. This was the case a few years ago when oil companies started to write off goodwill aggressively owing to the abrupt collapse in oil prices.
Fourth, consider selling when the stock has risen so much that it represents a very high proportion of an investor's portfolio. Investors should have position limits and not allow a particular stock to exceed a predetermined price point, ideally 15 per cent.
In this case, the investor should sell into strength to go back to the desired position limit. While excessive diversification is not good for a portfolio, too little diversification may be hazardous, too. If an investor allows a given stock to reach, say, 60 per cent of one's portfolio, as was the case with Nortel back in the early 2000s, then the investor exposes themself to a high degree of risk.
Fifth, it could be a signal to sell when management does not deliver on a major promise or when it lies. Many times CEOs tell investors what they want to hear and make promises, like politicians. But they are not politicians. So if they said they would write off a division, but instead expanded it, this represents a major deviation from what was promised. One has to wonder what else they have lied about.
It could also be time to sell when customer relations and a company's reputation are deteriorating, such as was the case with Volkswagen AG and Loblaw Cos. Ltd., for example.
Sixth, it could be a sell sign when a merger takes place. This is unavoidable. Being a minority shareholder is not a good idea and so the investor needs to sell to the bidder.
Seventh, it makes sense to sell when one can improve price to value substantially. For example, you might decide to sell when an opportunity has come about to replace a business selling at 90 per cent of its intrinsic value with an equally attractive company selling at 50 per cent of its intrinsic value.
Think of it this way: 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 halfway toward its intrinsic value. Selling CP and buying CNR will improve price to value significantly for the investor.
Eighth, think about selling when the company's business model has changed. That is, when the company is no longer the company an investor bought into in the first place.
This scenario unfolded in the early 2000s when a good number of North American furniture companies – which investors were convinced were manufacturers of quality product – decided to close their plants in North America and outsource production to China. This decision changed those companies' business model from being manufacturers to distributors – and distributors have very low margins. This would be a good reason to sell.
While nothing is guaranteed, having a disciplined sell approach will go a long way toward 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 check list – ask any airline pilot.