By Bina Brown in the Australian Financial Review 9 October 2015
While this article is historic, the message is still relevant:
It has been a gruesome couple of months for investors in Australian stocks.
At the start of August, the chatter was whether the benchmark S&P/ASX200 would hit 6000 points. It is now mid-October and the hard reality is an index that is hovering closer to 5000 – although this week long suffering investors were treated to some hefty gains.
The recent fall left many investors pondering why on earth they hadn't seen the rout coming and why they hadn't hit the sell buttons on their holdings.
Knowing what and when to buy are the questions that tend to dominate investors' minds. But knowing when to sell is just as important.
Yet the absence of an exit strategy is an all too common trait, with most investors unsure of when to part company with stocks in their portfolio. It is as if they prefer to think of share certificates as works of art, to be displayed on the wall for future generations to take care of.
Investors love to buy stocks. They are also good at holding onto shares in good and bad businesses for years. But when it comes to selling, powerful emotions including pride, fear or regret tend to raise their heads.
Pitcher Partners Investment Advisory's Sue Dahn says the decision to sell can be extremely challenging.
"Buying a stock engages our hopes and desires – we see something of perceived value which will pay us income and maintain or increase its value. Engaging these emotions makes us feel good, excited and happy," says Dahn.
"Selling a stock, by contrast, engages fear and guilt and regret and indecision – emotions we don't want to feel," she says.
Selling is doubly hard because two decisions have to be made – to sell and where to reinvest.
"It's at least two decisions instead of one," she says. "It's harder. The emotions are at best mixed. But good investing is a discipline – buying assets when prices are attractive and selling to make gains," says Dahn.
The market's rebound might make some investors wonder if now is the time to take profits – or crystallise losses – and run. It may or may not be, but the lesson of the past few months is that a sell strategy is needed.
And it is never too late to learn from past mistakes.
AMP Capital's head of investment strategy and chief economist Shane Oliver says the key to enhancing the value of a portfolio by buying when prices are low and selling when they are high is to put in place valuation indicators and use them.
"The key is to avoid buying at the point of maximum optimism or when everyone else is buying and valuations are highest and selling at the point of maximum pessimism when valuations are low," he says.
Just recalling why you bought shares in a company makes it easier when it comes to selling them, says Elio D'Amato, the chief executive of stock researcher and fund manager Lincoln.
"If you are investing in a stock for income then before you buy it you should decide when you will sell it. Some of the reasons may include if the company stops paying dividends, if there is a risk to future earnings or the company inflates its debt levels," says D'Amato.
"Set the rules early based on the rules behind the decision to buy it."
D'Amato says that if you are investing for the long term and you make a decision to buy based on the fundamentals, then a decision to sell should also be based around the fundamentals rather than the price.
The fundamentals may be stock specific, but they may be more general in nature.
Arguably the fundamentals were turning sour in the lead-up to the recent correction. There were uncertainties about the rate of economic growth in China and emerging economies; talk of a rate rise by the Federal Reserve, and ongoing malaise from weaker commodity prices and the end of the mining boom.
The other big indicator that the share market may have been getting top-heavy was the higher than average valuation at 16 times price earnings. Since hitting its high in April, the Australian market at one stage was down about 18 per cent, bringing the valuation back to the long-term average of 14 times price earnings, he says.
If the original investment strategy was to hold no more than 20 per cent of a portfolio in a single stock, and the value of that stock rose so it accounted for 80 per cent, it might be time to rebalance.
"It is all part of having a robust investment strategy such as how many stocks will I hold in my portfolio, what is my risk profile and what is my time horizon?" says D'Amato.
"Had the investor taken some profits they would then have had the option to diversify into other investments. With the current BHP share price hovering around $25, taking some profit and paying some tax a few months ago would have been quite okay," he says.
Easterby also argues that when markets change, portfolio composition needs to change, such as reducing the exposure to resources-based companies and increasing the allocation to health care stocks.
Examples might be moving from miners Rio Tinto and Fortescue into healthcare groups such as CSL or Sonic Healthcare.
Another common mistake made by many investors is having an "all or nothing approach" to selling, says Middletons Securities director Nick Loxton.
It's OK to only sell part of a holding, he says.
"If you have had a star performer in your portfolio you may be reluctant to sell because you're in a good thing. But if it is priced highly then taking a bit off the table seems logical," says Loxton.
"It is equally hard to sell when something is down but if it's not paying you a good income or it is not worthy of adding to, then why hang onto it," he says.
Portfolio manager Ben Griffiths says the motivation to sell a stock should often centre around fundamental risk management.
Has the value of the stock holding become too large in the portfolio? Are you wary of the broader market direction and looking to add/build a cash buffer to buy your favourite stocks cheaper?
Griffiths adds that it can pay to be nimble when it comes to selling, because stocks can tank so quickly.
"One lesson I was taught early in my career, and one that I try and rigidly adhere to where possible, is learn to be a slow buyer and fast seller. In nearly every instance this rule of thumb will look after you," he says.
Setting a sale price – naturally – is easier said than done.
Knowing when a stock has exceeded its intrinsic valuation, in other words knowing when its price to earnings ratio is out of sync and will no longer be tolerated by the market takes discipline, research and experience, says the managing director of small companies’ fund manager Eley Griffiths.
Selling shares of fast food deliverer Dominos Pizza at 25 times earnings may have felt right, but how is the investor looking when the price earnings ratio has expanded to 42 times earnings, Griffiths says.
"We have been a long-time investor in Domino's Pizza and only in very recent times have we decided to trim our exposure to what has been one of the market's most enduring growth stories. The decision to sell was influenced by a number of variables, including the stock's recent inclusion in the ASX100, its expanded PE and prudent portfolio risk management," he says.
Selling successfully also requires keeping a cool head.
Emotions, including guilt at making a bad decision on a stock which is now worth less than you paid, or regret, are neither reliable or very often true, says Pitcher Partners Investment Advisory's Dahn.
"Good investing is a discipline – buying assets when prices are attractive and selling to make gains. Some good investors buy with a sell target in mind and execute the sell when the target is reached, distancing emotion with discipline. For most good investors the target price is driven by fundamentals including earnings multiples, earnings per share growth forecasts, dividend capacity," she says.
Dahn says trying to pick the top or the bottom of a company's share price or the market overall is a mug's game. It is also why she rarely buys the entire quantity of a stock that as an investor she may wish to hold.
"Chipping away and keeping cash available for an even better price is the best strategy when prices are falling. Trimming positions and creating a cash reserve is the best strategy when prices are rising," says Dahn.
Eight tips for selling:
1. Reduce the size of individual stocks if they become more than 5 per cent of your portfolio.
2. Sell any stock if its market price is 25 per cent more than its intrinsic value.
3. If you can wait 12 months from date of purchase to take advantage of capital gains tax discounts, do so.
4. If you can sell in a tax-free environment (pension phase in your SMSF), that's great.
5. If you have bought a stock expecting price increases and this does not eventuate, re-assess whether it has a place in your portfolio.
6. If you have bought a stock for its income and the income does not eventuate, sell the stock.
7. Set a stop-loss for all stocks – say 15 or 20 per cent – and exit the stock if the point is reached. Exit dispassionately and clinically.
8. Know what you are going to do with the proceeds before you sell.