If a man knows not to which port he sails, no wind is favourable – old Roman saying
A new week, and another new all-time high for the markets. As the market keeps razing past records, a lot of views are still out on the next target for the indices and which stocks to buy next. The wind is so much in favour of the markets, but is it favourable to you, ie — are you clear on your investment objectives and is the recent market performance taking you in that direction?
If you are not clear on the objectives for your investments, any kind of market returns may not be favourable for you. Success in markets is not just about buying the right stock, but in harvesting the gains at a reasonably appropriate time to attain your investment objectives.
A lot of research across various platforms goes into when and why to buy stocks, but so little on why and when to sell stocks. Many factors can be attributed to this phenomenon — the incentives for many participants in the ecosystem lie in a never-ending bull market, optimism is a far better trait to have over pessimism, bull markets are much longer than bear markets, and miraculous effects of compounding are realised only by holding stocks for the long term if not ever, etc.
A near impossible art
This makes the task of selling a stock much more difficult than buying. Even the best of experts don’t have a clear mantra. For example, Investing legend Peter Lynch laments that wrong selling decisions have been some of his worst mistakes as there are stocks such as Home Depot and Toys “R” Us that he sold early and they went on to become multi-baggers. But here it would be worth noting that not selling can also be a problem sometimes — decades after Peter Lynch regretted selling Toys “R” Us, the company filed for bankruptcy!
Warren Buffett, in 2009, sold a significant chunk of Berkshire Hathaway’s stake in Moody’s to part-finance his purchase of railroad company Burlington Northern Santa Fe (BNSF). This is a purchase that he is quite happy about as it finds positive reference in his annual newsletters. But, interestingly, since the time he sold that stake, Moody’s has given total returns including dividends of 21x, while listed railroad companies that are good comparable to BNSF have given total returns in the 5 to 10x range.
Jeremy Grantham , famous for perfectly predicting many of the bubbles in the last few decades — Japanese stock bubble of the 1980s, dotcom bubble of 1999-00 and housing bubble of 2005-07 — typically tended to sell stocks a couple of years before they peaked and so always had to endure a few testing years before his views/decisions were validated.
So this tells a lot on how and why even the best-in-class in the investing world find it difficult to get the selling stocks perfectly right. This more or less means it is a near impossible art.
But then, at the same time, there are cases such as Bill Miller of Legg Masson: a 2008 article on him in the Wall Street Journal notes how he, ‘Spent two decades building his reputation as the era’s greatest fund manager. Then over the past year, he destroyed it.’
After his Legg Mason Value Trust fund beat the S&P 500 every year from 1991 to 2005, a phenomenal track record, its 2008 drawdowns resulted in it landing amongst the worst performing funds over a 10-year period. The lesson to him and investors in his funds — they didn’t know when to harvest their gains and go a bit slow. If gains are not harvested at appropriate times, the chances are, unrealised gains can become realised losses.
Without exception, every investor would have had the experience of not taking some chips off the table for stocks that are trading way below peak. While broader markets may be trending up, what is happening underneath can be different — sector churn/rotation, stocks falling out of favour, change in fundamentals, etc. A recent analysis by bl.portfolio found that while markets are at all-time highs, around 55 per cent of BSE All-cap index stocks are 20 per cent below their peaks and 20 per cent are more than 50 per cent below their peaks.
In most of the cases of stocks that have underperformed, it may have been difficult to sell when the going is good. The reason being, there is always a bull narrative for a stock/index trading at all-time high levels/expensive valuation and it requires discipline to assess whether it is a good time to sell or not. Given these opposing factors, how does one decide when to sell, especially during times like now?
Can markets crash/correct from here? May be, may be not, and no one knows for sure. So the best way to approach this is from two angles — You and the Markets.
It’s all about You first…
A core part in making the selling decision is all about you — your investment goals, your time horizon and your investment strategy. It’s not about where the stocks/indices are headed, it’s about where and how you want to be headed. This needs to form the fulcrum of your investing journey.
One factor on when to sell a stock must revolve around what is the easiest and simplest way to achieve your financial goals. A reason why equity investing is recommended is that, stocks/index have a good track record of delivering superior returns over the long term over other asset classes. However, do note that many times during a long holding period, significant returns were realised within a short frame of time.
So if you are lucky enough to have been an investor wherein you invested just before a phase of significant returns, then if reaching a non-negotiable financial goal can be achieved with less risk from here, then selling stocks to achieve this goal may be ok.
For example, let’s say you have made a 15-year investment plan for your child’s higher education with an objective to realise 12 per cent CAGR returns over this period, to pay for it. Say, your portfolio of stocks or mutual fund investments has returned 25 per cent in the last four years; from here, a CAGR of 7.5 per cent is sufficient to reach your investment objective of 12 per cent CAGR over a 15-year period. This is mostly achievable via much less risky investments than equities.
So, it would be wise to assess your current portfolio value and the intended objective and work out in excel on a periodical basis as to what is the CAGR required to achieve it. Then it’s a simple choice — what is the path of least stress and sure shot way to achieve it. From pure equity fund, can shifting to a multi-asset or hybrid fund or safe debt investments help you achieve your goal?
Similarly, if you are bound by a time horizon, like a retirement due in 3-5 years or intend to settle major debts such ashome loans within a few years, then too, cashing in on the gains when markets are expensive is an ideal approach to follow.
The above factors apart, selling decisions also have to be based on what kind of person you are and your investment strategy. From any level, at any point in time, stocks can go up/down, melt up/crash. You need to be clear which will cause you more regret — whether selling early and missing the melt-up, or seeing your unrealised gains turning less profitable or even into losses? Answering this will make your decision-making simple and easy.
..and then the Markets
Once you address the core aspects on ‘when to sell’ that revolve around you, then you will have to address aspects relating to the markets. Like if you have surplus investments after attending to the above mentioned factors, you are early in your career and retirement is at least two decades away, if you need to sell stocks, which ones to sell, etc.
What type of a stock it is
One can be a value investor or a growth investor, but in either case a time comes when a stock looks very expensive, raising the question whether you should sell?
For such instances of dilemma, investing legend Peter Lynch recommends assessing why exactly you bought a stock. For example, if you bought a cyclical stock when the chips were down, then in such instances, if the company has turned around and the stock is doing well, then maybe it’s time to sell it.
However, if you bought a growth stock, then he recommends assessing which innings of the game the stock is in. If there is a 10-year or 20-year story and the stock is still in the early phase of the long growth story, then it may be too early to sell.
So it is important to understand clearly what kind of business and opportunity the stock represents. In doing these, investors need to be mindful and make clear distinctions here — it may get tempting to view even cyclical stocks as growth stocks in a long bull market.
Stocks in bubble territory
If you are a fundamental investor, valuations matter. But then the lesson from centuries of market cycles is that valuations, while they matter for long-term returns, don’t matter much in the short term.
Veteran investor John Hussman puts it thus: ‘Valuations are like potential energy, and it’s important to know when you’re sitting on a powder keg. But investor psychology, which we infer from market internals, is the main catalyst that suppresses or releases that potential energy’
So, you could identify a stock trading at an unsustainable price level, but it may continue to double or triple from there if investor psychology is favourable, before it crashes to or below its fundamental value.
When you exit such stocks, you must be ready to accept the opportunity loss from speculative frenzies. Alternatively, if you deem investor sentiment to be very positive as appears to be the case now, you could extend the boundaries by tolerating valuation levels a certain threshold above what you deem as irrational value. However, this comes with the risk that in case of any unexpected correction, you may have missed a better selling opportunity.
When in doubt on whether stocks are in bubble territory or not, refer to historical data across different valuation parameters. There is always a bull story, but when it comes to stocks, in most cases than not, numbers are more reliable than prose — as Warren Buffett once said, ‘bull markets can obscure mathematical laws, but not repeal them.’
Better opportunities
The real cost of any investment isn’t the actual amount but the opportunity cost – what you could have done with the money if you invested it elsewhere – Charlie Munger
Berkshire Hathaway does not churn its portfolio much, but amongst a few reasons why it does, is when it wants to part-fund what appears to be a better opportunity than what is being currently owned. So, if you have made any substantive profits in any stock and there is a case that much of the optimistic forecasts are priced in, locking in the gains to fund a more attractive bet may be worth considering. There may be times when, after making hefty gains, the risk-reward from fixed income and not just another stock could present a better opportunity.
However, the risk here must be to guard against falling into the trap of ‘selling your winners and buying your losers.’
There really must be a case that the other bet is fundamentally more attractive, and not any mere reason that it has underperformed, or you want to average some loss-making stocks.
Change in thesis
When the facts change, you need to change your view accordingly. Structural long-term bull stories for stocks can get substantially altered when disruptive innovations happen. The dotcom revolution disrupted many brick-and-mortar businesses, SaaS innovation disrupted the well-established business of ERP players such as Oracle and SAP. Streaming has significantly disrupted traditional media businesses.
Not just innovation, change in competitive dynamics (Jio and the Indian telecom sector), or how competition from China totally disrupted prospects for global companies across sectors, from renewable energy to metals, during the 2010-20 decade is another example. Suzlon, a stock that has been in the news for stellar returns in recent years, was a Sensex stock earlier. Despite its over 10 x returns from lows now, it is still down over 80 per cent from its 2007 peak! Global slowdown resulting in governments across the world reducing fiscal support for renewable energy and low-priced competition from China proved to be a double whammy between 2008 and 2015.
So, always be alert to what change to structural thesis can do. In deciding whether to sell or not, assess whether the stocks are priced for the structural disruption (less convincing case to sell), or not priced at all (a convincing case to sell). For example, AI is going to disrupt many sectors resulting in churn in leadership and new gainers. Assess how your stocks are priced for this. Within the IT sector, many companies appear to be priced to benefit from AI — as can be seen from premium valuation despite lacklustre performance from the likes of Infosys, HCLTech, Wipro, etc. What if the winner from AI is another player and not these companies?
For example, the winner from the EV revolution was Tesla, not a Ford or a Toyota. Always be alert for disruptions to the business model of established players. If not priced for disruption, then it could be a selling opportunity.