Monday, January 17, 2011

When you should sell your stocks

We always hear people talk about selling a stock because it went up from $20 to $22, revenue missed expectations by 2%, the company has no plans to go into the tablet computer business, or something else that makes absolutely no sense to a value investor. But what exactly are the reasons for an investor to sell a stock? When should we sell?

If you buy, at a reasonable price, shares in a company that has excellent fundamentals, then the right time to sell should almost always be never. There can, however, be situations where an investment like that should be sold immediately, as well as situations where selling such an investment can be considered. In this article, I will be talking about the situations where a stock investment should be sold immediately.

When the economics of the business gets significantly impaired

It’s the economics of the business that will drive its growth, protect its profits from being competed away, and allow it to earn good returns on equity or shareholders’ money. When there is significant deterioration to the fundamentals, the company’s long-term profitability will be at risk, and shareholders should sell the stock immediately, regardless of whether or not the stock’s price is below what they originally paid for it.

When the company’s long-term profitability gets impaired, it might not be able to generate decent enough returns to justify holding its stock. The economics of the business might also continue to deteriorate, which might in turn cause the price of the stock to keep falling.

The combination of earning poor returns on equity and the risk that the stock will continue its downward spiral in both fundamentals and price makes it a bad idea to hold on to such a stock in the hopes of at least breaking even, especially when you can use the proceeds of the sale to invest in a business with good economics  and which has a much better chance of not only helping you recoup your losses from the previous investment, but might even put you very far ahead.  

Very obvious side note: You should also immediately sell a stock if you find out that the economics of the business behind the stock is significantly worse than what you originally thought it was.  

When management shows itself to be incompetent

Management is trusted with the responsibility of safeguarding shareholders’ money or capital, and intelligently allocating capital so that shareholders can enjoy good long-term returns (or at least as good as it can get after taking into account the economics of the business). No one is perfect, and mistakes will be made every now and then. But when too many mistakes are made, a lot of shareholder value can be destroyed.

Here a few things that an incompetent or greedy management team would do:

Make pricey acquisitions or put shareholders’ capital to work at poor returns.

Issue shares when the stock is undervalued.

Buyback shares when the company’s stock is overvalued.

Take on too much risk (taking on too much debt, getting involved with a lot of complex derivatives, and etc).

Pay themselves huge bonuses that don’t reflect business performance directly created from management’s own talent and efforts.  

If you believe that management isn’t doing a good job at safeguarding your money, is more interested in their welfare than your welfare, and make decisions that destroy shareholder value. And you believe that the mistakes aren’t just one-time things, but are mistakes that are likely to occur. Then you should sell the stock immediately. Even if each mistake doesn’t do much damage to shareholder value on its own, the mistakes will add over time, and you will wake up one day to find that the intrinsic value of the company has dropped significantly.

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.