Knowing When To Sell

I have been asked to blog about the above, therefore I shall devote this entire posting to the perennial question asked by almost all investors and speculators: “When Do I Sell ?”

For value investors, the answer is of course radically different as compared to a speculator/punter. Value investors research into the business of the companies they invst in and their role is to be a business analyst. Speculators, on the other hand, observe purely price movements and the psychology of the market and try to make money by “outsmarting” the pack. The modus operandi of the value investor and the speculator are different, thus each has different cues which will tell him when to sell. For the speculator, it seems simple enough; sell when your gain or loss has hit a certain % above or below your cost (respectively). This may be 10%, 20% or even 50% depending on one’s personal preference. Taking profit and cutting loss have almost the same rules for punters because they are usually short-term by nature; and some even engage in risky contra trading which makes this cut loss or take profit rule all the more crucial.

That is all I will be commenting in terms of selling for speculators. On value investing, an article on The Motley Fool sums up pretty well the reasons when value investors should sell. The article states: “Value investors sell for four basic reasons. The first case is where the investor comes to the conclusion that the initial intrinsic value estimate is flawed. Value investing requires intellectual honesty, and errors must be acknowledged early. The second reason to sell is when another, even better value comes along that requires some capital to be freed up. The third case is when the business fundamentals upon which the initial purchase decision have deteriorated to the point where there is no margin of safety in the current price. The final reason to sell is when the stock price has moved up to a point to where the business is being fully valued and no longer offers a margin of safety.” I will now explain each point in turn and give my own views on them, and see if they are applicable to any investments which I had sold recently.

1) Flawed Intrinsic Value Estimate – This reason would imply that the value investor had made incorrect or flawed assumptions regarding the business which he studied, to the extent that those errors now have a material impact on the intrinsic value estimate. It could also be the case where certain factors were overlooked while doing a detailed study of the company in question, and these omitted factors seriously compromised the margin of safety for investing in the company. One example I can think of is Trek 2000 International which I sold some time back. I had incorrectly presumed that the company had a wide economic moat with its many patents for its Thumb Drive, but technology which can rival or replace this would easily erode their competitive edge. Thus, as a result, I purchased without the requisite margin of safety.

2) Better Value Comes Along – This reason to sell obviously correlates to a situation where a value investor sees one of their companies being severely over-valued, while at the same time one which is significantly under-valued comes along. Suffice to say that the right thing to do would be to sell the over-valued company and purchase the under-valued one as it would provide margin of safety and also guarantee a good expected rate of return (which the over-valued company now does not provide). However, in reality, such situations rarely if ever arise and one’s timing, luck and circumstance must be impeccable in order to take advantage of such an opportunity (because as a whole, over-valuation usually occurs on a broad market level and is seldom confined to certain companies only. The converse is true for under-valuation in a bear market).

3) Deterioration of Fundamentals – This reason to sell is fairly common and will surely be encountered at least once (I think) in a value investor’s lifetime. We can use history to show how once strong companies succumbed to competitive forces and lost their competitive edge, causing revenues, margins and hence profits to fall. A good example is Creative Technology, which was recently excluded from the revamped STI (as well as the mid-cap stock index). During its heyday in the dot.com boom, Creative traded at a high of S$65 per share and was garnering the lion’s share of revenues for its world-beating Sound Blaster Pro. Now, the company has made 4 consecutive quarters of losses and its products (the Zen player) cannot compete effectively against Apple’s iPod and Microsoft’s Zune. For a value investor, this deterioration should best be detected early, otherwise the investor would suffer a large fall in the value of his/her holdings. This is why I advocate keeping close watch on a company’s plans, strategies, margins, earnings and industry to monitor for possible sighs of decline.

4) Fully Valued Business – I do not fully agree with this given reason to sell. How does one know when a business is “fully valued” ? I guess the best answer to that would be to say that the business has no prospect of growing at a rate higher than the inflation rate. This means that the business may be stagnant or stagnating, and the products or services offered by the company may be close to a decline (due to obsolescence). So maybe we should modify the reason to make it read “sell if you feel the business cannot grow faster than the current inflation rate”. Unless you are a value investor who goes for dividend yield (i.e. your investment turns into a “cash cow”, dropping from a “star”; according to BCG’s matrix) , it is advisable to sell and look for another potential company with a good margin of safety.

Keeping these 4 reasons in mind, a value investor should continually monitor the companies he owns to see if any of them are in “danger”. This would fit Benjamin Graham’s idea of an active investor; one who knows his investments well and puts in time and effort to maximize his investment returns.