Markets are simple but not easy. But most on the street think exactly opposite. And this leads to problems as investors make things complicated. This not only applies when we buy a stock and even when we exit that stock. People apply different kinds of strategies and different sorts of filters to buy a stock. Some succeed and some fail. Still buying or entering a stock is not a complex factor. As there are many research recommendations available and many other avenues to get a buy Recommendation. Even those (mostly new breed of investors) trying Do It Yourself (DIY) in equity, know what to buy. Those who hardly understand go for Systematic Investment Plans kind of approach. However, an important factor is, unless we exit the stock the profit or loss remains only in the books. In simple terms unless we exit a stock one cannot book profit or loss. While everyone has an idea when to buy a stock – not many are aware about when to sell a stock.
There are different strategies applied here by investors while they plan to sell a stock. Like, those who bought based on Technical analysis parameters or recommendations would sell a stock when the target provided is completed. There are others who would sell a stock when their expected percentage gain is achieved. Or there are few who would churn the portfolio based on the sector preference. There are other strategies as well like –when stock turns profitable try to keep a trailing stop loss and exit at profit. A few would also try to apply a strategy that takes out your initial investment and hence you may not make any losses further as the investment cost is now zero.
While such exit strategies are good one would not be able to maximise the profitability based on the same. We are not trying to time the markets – just trying to maximise profit by applying a few additional parameters.
We believe that it is important to hold a stock for long term but to book profit even it is important to sell a stock. To create wealth holding a good quality stock for decades is essential. However, the investor needs to make sure that she is holding only good stocks for these decades. Therefore, monitoring the stocks in the portfolio and taking the sell decision at the appropriate time becomes essential. Otherwise, the investor would find her limited capital stuck in suboptimal businesses, which exposes her to opportunity cost. Hence it is important to understand a right approach to sell a stock. We usually say never sell your winners but then in that efforts do not get stuck in laggards. Here we present a check list of few parameters to analyze and decide when to sell a stock.
Declining operating performance
One of the most important factors to analyse a company is to understand the business and its operational performance. By operational performance we mean sales growth, operating profits and ability to generate cash. Let’s try to understand such different parameters.
The first and the foremost parameter indicating the growth of any company is the sales figure. If the sales growth does not occur it indicates some issue with product acceptance. It may be an overall economic scenario or may be a sector-related issue. If this is a scenario in the overall economy it is not a matter to worry about. The simple reason being, that economic peaks, and troughs occur and business gets affected accordingly. However, if the reason is different than the economic or sector-related issues it needs to be watched closely.
Again some amount of volatility on a quarterly basis is fine or even a one-year decline in performance would be acceptable. An investor should analyse the portfolio companies whose sales witness a decline year on year for more than one year. At least two consecutive years of declining sales are essential before the investor makes any conclusive decision about sales decline. As stated earlier, the investor should not become worried about changing trends in quarterly sales performance. It is the first indication that there is some issue with product acceptance. A consistent and significant decline in sales growth should be the first checkpoint to analyse to understand when to sell a stock.
While we spoke about decline in sales growth, it is important to understand the growth in operating as well as net profit. The sales may stay stagnant or may increase marginally. However, if there is no growth in the operating profit and net profit (or margins are shrinking) it is like an alarm bell ringing. One must take a deeper look at the profitability.
We spoke about the operating margins. There are other parameters to understand the operating efficiency. One must look at other ratios like fixed asset turnover ratio, inventory ratios, and even the receivable days. Any continuous deterioration on the above parameters would mean there is a need to look at the performance carefully or maybe it is time to sell the stock.
On the operational front, one must also check the debt levels on the balance sheet a well. If the company is constantly increasing the debt on the book to fund the company operations – This shows weakness in the cash flow generation ability. In simple words increasing debt for funding business operations is a major negative and should be one of the reasons to exit or sell a stock.
We all know that the regulation for doing business is set by the Government. However, all businesses get liberty to do business on their terms. However, when the Government Starts interfering in the pricing and profitability it is better to exit the stock and the sector. We have many such examples in sectors like fertilisers, Oil & Gas, Sugar and in some other sectors like Liquor business. Not that all investment in such business sectors is a bad idea. But if the sales and profitability are completely affected by Government policies, a prudent strategy is to avoid such sectors or in some cases better sell the stock.
Change in Business Dynamics
We invest in business and if the business is doing well – the investment yields a good return. But if the business dynamics are changing for the long term – it is time to exit such stocks or business. Just to give an example, globally we had Kodak which was making a killing in the market with its business in old cameras and photo films. However, the digital world changed everything. Now we know the way Kodak is struggling.
In India as well – there was a Company named Moser Baer. It had a Compact Disc Manufacturing plant which is now obsolete technology. So if the business dynamics are changing owing to competition, government policies and other factors –better to exit the company and look for other opportunities.
Too Many Stocks in portfolio with few stocks having miniscule allocation
When we create a portfolio it is always good to diversify. However, over-diversification is also a bad strategy – especially when we have limited capital and still diversify. The issues one faces are – difficult to track the performance of all companies. I have seen people owning more than 70 Stocks with just Rs 10 lakh capital. This won’t lead the investor anywhere. Therefore, if an investor notices that it is becoming cumbersome for her to effectively monitor all the stocks in her portfolio, then the investor should identify and sell weak stocks from the portfolio. Remember, such selling should be done without considering current price or unrealized profits or losses in the weak stocks. This leads to another issue of having too many stocks in the portfolio with few stocks being a very small portion of your portfolio. Such small investments won’t make you wealthy. And investment should be wealth creation. In such a situation, even huge returns in this stock would have only a modest impact on the overall portfolio. However, the presence of this stock in the portfolio adds to the monitoring burden on the investor.
To sum up
To exit a stock or sell a stock, look at operational performance, increasing government interference, changing business dynamics for the longer term, and then smaller allocation as a part of the portfolio.