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Market Buzz - Knowing When to SELL a Stock

There is an old adage in the investment industry that says it is easier to know when to buy a stock then it is when to sell a stock. From our experience this statement has genuine merit. The decision to sell is often a difficult one, particularly if the company has done well and the outlook remains positive. But as many investors can attest, holding a stock too long can not only erase your profit but can also result in an eventual net loss. Every stock is different and there is not precise tool for knowing when to sell. When we make the decision to hit the exit doors, on all or on a portion of a stock position, it is typically for one or more of the following four reasons.

1. Valuation Increase: We discussed the concept of valuation in an earlier chapter and have reiterated several times that value is the principle component in our investment methodology – we want to buy stocks at an attractive price. This same methodology is also applied to the sell side of the equation – we want to sell companies that have become overvalued. When we initially recommend a stock, we generally have a target valuation in mind that we would consider fair. We may recommend a company that is trading with share price of 8 times earnings and set a rough fair value target of 12 times earnings. If the share price appreciates beyond that target then it is time to consider selling at least a portion of the position.

2. Profit Realization: When we generate a significant return in a company it is often prudent to consider realizing some profit on the stock even if you think there is more room for price appreciation. Most stocks to not move up continuously in a straight line. If you are in a situation where you have doubled or tripled your initial investment then there is nothing wrong with taking some capital off the table, particularly if the valuation has become more expensive, growth has slowed, or the outlook has become less attractive or less certain.

3. Rebalancing the Portfolio: This reason is very similar to profit realization but with a different objective in mind. If in the previous example you double or triple your initial investment in an individual stock, that stock likely now accounts for a larger percentage of your portfolio. Your portfolio may then suffer from concentration risk by over-weighting to one company. By reducing your position in that one company (perhaps selling 1/3 or 1/2 of the position) you can both realize some profit on the investment and rebalance your portfolio while still maintaining good exposure to the company.

4. Deteriorating Fundamentals: In even the most stable economic environments the fundamentals or outlook for a company can change for the worse. Industries and economic backdrops change. Competition can heat up and margins can decline. Even a good company can make poor decisions and put themselves in a position of risk. When you purchase a company it should be because you like the fundamentals of the business. But if those fundamentals change that it may be necessary to reconsider your investment decision and sell the stock.

2014 KeyStone Financial Publishing Corp.