With the end-of-financial-year reporting season upon us, it’s often good to have a game plan going for when each of the companies you own publishes their full-year financial results. In particular, research has shown that investors often struggle with deciding whether to sell an individual investment. This is often psychological, for example, because they don’t want to sell at a loss, or for fear the stock price will rise after the investment has been sold.
While we encourage long-term investing, there are several important reasons why it may be time to part ways with one or more of your investments. Here are five of the most important ones to keep in mind this reporting season.
1) Weakening fundamentals
Strong business fundamentals are crucial to successful long-term investing. While investor sentiment and emotion can fuel a share price rally in the short term, it is the quality of the underlying business (usually the growth in profits or earnings per share) that drives long-term market-beating returns.
Therefore, it's important to monitor the fundamentals and check on the health of the underlying business. Are they selling more products? Are they raising prices? Is it still the most popular brand or the best service in the industry?
A good way to do this is to develop a checklist that you can run through when the company reports its financial results. This also helps ensure an investment is being sold for the right reasons and not driven by consensus thinking (your opinion about the results might not be the same as the consensus, after all).
Some important criteria may be checking a company’s debt levels, profit margins, or revenue growth. Which metrics are most relevant will depend on the individual company, including its stage in the corporate life cycle. For example, revenue growth is likely to be more important for early stage businesses that are gaining scale, while market share, cash generation and returns to shareholders (dividends and share buybacks) may be more relevant to mature businesses.
Other factors that may be important include the competitive dynamics in the industry or management’s strategy. If a company’s management has changed tack and is more aggressively pursuing acquisitions, increasing debt or branching out into new product lines, it might be time to reassess your holding.
We recommend you develop a checklist before you look at company results to stay objective (just like it’s a good idea to research a company before looking at the share price!).
2) Investment thesis is broken
Investors typically have a thesis, or reason for choosing a particular company to include in their portfolio. This represents their view of how they expect the future to pan out (in favour of their investment, of course). For growth-oriented investors, this will likely centre around a company gaining market share within a particular sector, or an industry having strong secular growth trends (such as cloud computing or artificial intelligence). For value oriented investors, this will be a view on a particular company’s stock price being underappreciated by the market relative to its earnings potential. Broadly speaking, growth investors typically expect the world to change, while value investors are betting that it’s likely to stay more or less the same.
The world is an uncertain place though, and things do not always work out as planned (a great investor usually has a strike rate of 6 out of 10 successful investments). As Warren Buffett once said “the most important thing to do if you find yourself in a hole is stop digging.” When things aren’t going as planned, investors should be open to the possibility they could be wrong, and be willing to part with their investment when their thesis does not play out.
3) To buy something better
One of the most difficult but compelling reasons to sell an investment is when a better opportunity presents itself. Within their own framework (risk tolerance, time horizon etc), investors should aim to hold a portfolio of their very best ideas at any given time. Investing it can be argued, is a relative game after all, not an absolute one. If one investment is forecast to generate a return of 50% over the next 3 years and another is estimated to return 75%, then it makes rational sense to switch (all else being equal).
During reporting season, investors may spend their time reviewing not only their current investments but also potential investments on a watchlist. If a watchlist company performs beyond expectation (or there is a dramatic change in the share price of the two investments), it may be time to switch things up.
While selling a good investment to buy a great investment sounds perfectly logical in theory, there are a number of psychological barriers to doing this in practice. Investors can suffer from several psychological biases that can hamper their portfolio management, including being more attached to investments they already own rather than ones they are yet to own.
4) To maintain diversification
As we’ve outlined before, diversification is a key tool for managing risk (but can also be overdone). When a company performs well and its share price outperforms other stocks in a portfolio, that position size will grow in size.
For example, the US technology sector (and in particular the mega-cap stocks) has had an especially strong run for the year to date. Investors holding these companies have been rewarded with strong returns, and their position sizes have likely grown over the course of the year. This can be a great time to reduce risk, realise some profits, and possibly to make a new investment that you’ve been waiting for.
If it turns out that momentum was driving up the stock price, or the company runs into some challenges later on, an investor will be greatly relieved to have lightened that particular position.
Unfortunately for investors trying to maintain some diversification, though, it's often the winners that keep delivering for a portfolio, and selling them too early can turn out to cause great regret. Many famous investors regret their errors of “omission” (ones they missed out on) far more than errors of “commission” (ones they included but performed poorly). Famous Canadian investor Francois Rochon discusses such a predicament regularly in his annual client letters.
5) When a stock is overvalued
Changes in company valuation can be another key reason to reduce or sell a position–but is one of the most difficult. It's important for investors to recognise the difference between price and value, and to have a fundamental value in mind for each of the investments they own–by assessing the company’s long-term cash flow generation and by comparing it to similar businesses or the company’s historical valuation metrics. One of the truly tricky parts though is assessing how the business may have changed over time (has its market position improved or deteriorated, for example) and how this may have changed the fundamental or intrinsic value.
Don’t be afraid to sell
Deciding to sell an investment can be a difficult one. Investors are often criticised for being too short-term orientated and they may try to overcompensate by giving a company or management team too much leniency. It’s also challenging to part ways with a company that you’ve done extensive research in and has possibly made you a considerable amount of money.
It’s generally not advisable to sell a stock just because its price has increased or decreased, but there are many compelling reasons for pulling the trigger and letting a company go from your portfolio. While not an exhaustive list, weakening fundamentals, a broken investment thesis, superior returns elsewhere, adequate diversification, and extreme overvaluation are great places to start. As you navigate through this earnings season, keep these in mind.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.