Fundamental Reasons To Sell A Stock

When does one SELL a stock?

Given the fact that the market has been falling non-stop for the past few days (6 days and counting), perhaps now is a good time to make a review on why an investor should sell a stock.

Time for that reality check.

In my opinion, to discounting everything as poor market sentiments is simply suicidal. It's best one face reality and ask ourselves if the business economics had seriously changed. Would the fundamentals of the business be impacted by such changes?

Anyway my opinion matters not. What's more important is your own reasoning to hold the stock.

Anyway, I do have a collection of articles written on why one should sell a stock.

One of the best logical reasoning to sell is we want to sell the stock before it turns into a loser and one of the best checklist of telltale signs that a stock could be a potential loser are mentioned in a Wallstraits article, Market Rules: Let Winners Run

• 1. Declining sales quarter-to-quarter and year-to-year
• 2. Rising debt levels
• 3. Declining profit margins
• 4. Rising inventory levels
• 5. Changes in regulatory or legal environment
• 6. Emerging competitors or technologies
• 7. Rising interest rates
• 8. An emerging overall bear market
• 9. Events that negatively impact future earnings
• 10. Mergers and acquisitions
• 11. Management changes
• 12. Institutional or insider selling
• 13. Dividend cut or elimination
• 14. Concerns over accounting procedures

(Some simple fast questions I would ask myself now. Let's see, a high inflationary environment, profit margins have a strong possibility to be impacted greatly and would this result in lower profits? Would this have ultimately result in a long period of declining profits? Changes in political environments? If inflationary pressure continues, would interest rates raise? An emerging overall bear market? (do a simple check-list, how are the major markets faring since the start of this year? ( A couple weeks ago, Dr.Brett did a simple posting A Worldwide Bear Market - do consider that most markets have fared worse since then - are they justifiable reasonings why most global markets are performing so alarmingly poor?) Any big fund selling? )

There's another wonderful article written by Ms.Teh Hooi Ling back in 2005 on Singapore Business Time.

• Published October 15, 2005
  
  When to sell a stock can be a tough call
  Find out why you own that stock and never wait to catch the top of a rising trend
  
  By TEH HOOI LING
  
  'WHAT's a good question,' a private equity investor said when I asked him when he would rebalance his portfolio. 'Sembawang Kimtrans has gone up so much it's now a big part of our portfolio. We still don't know what to do with it yet.'
  
  He runs a pretty focused portfolio, consisting of about 10 stocks. Let's say he started with $1 million three months ago which was equally invested in ten stocks. In other words, each stock had a 10 per cent weighting in his portfolio.
  
  Assume that the remaining nine stocks did not move. Logistics company Sembawang Kimtrans, which tripled its share price from June to the end of September, now constitutes about 25 per cent of his portfolio. To have 25 per cent of one's funds concentrated on one stock is quite a risky proposition.
  
  There has to come a time when he would have to cut back on his holdings of SembKimtrans. The question is when. But at least his problem is a happy one.
  
  Take another example of Inter-Roller Engineering. In November 2001, it was a loss-making company trading at as low as 7.3 cents a share. Today, those same shares are worth $1.14 apiece.
  
  If you had bought the stock at 7.3 cents in 2001, by August 2003, when it had risen to 45 cents for a whopping gain of more than 500 per cent, it would have been tempting to just take the profit and run.
  
  And if you had, you would have missed out on another 900 per cent return on your initial capital. But had you held on, and again assuming that Inter-Roller made up 10 per cent of your portfolio five years ago, it would now constitute 63 per cent of your stock-holding, if the others stayed put.
  
  Again there has to come a time for the sell decision. If not, any falter in the company could deal a severe blow to your portfolio.
  
  Thus the decision to sell a stock is just as important, if not more, than a buy decision.
  
  I've read through some literature on when to sell a stock and I've found those in the Morningstar Investing Classroom to make a lot of sense.
  
  According to the articles, the best way to know when to sell a stock is to know why you own it in the first place.
  
  For a disciplined investor, there are usually a few reasons for buying a stock.
  
  Fundamental question
  
  One is you like the fundamentals of the company. If this is the case, you should sell when the fundamentals change.
  
  According to Philip Fisher, author of the important book Common Stocks and Uncommon Profits, 'It is only occasionally that there is any reason for selling at all.'
  
  And the occasional reason is the deterioration of a company's underlying business. 'When companies deteriorate, they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did,' he says. ( so very important this issue! )
  
  Eastern Asia Tech is one example of how a company's fundamentals can change over time. The Taiwan-based company used to be a promising enterprise, being voted by Forbes Global magazine as one of the world's 200 best companies under US$1 billion for 2002 and 2003.
  
  In 2003, it was the largest original design manufacturer of DVD Home Theatre in a Box combo systems, with more than 20 per cent of global market share. It was also the largest original equipment manufacturer for speaker systems, with about 23 per cent market share. And it was gaining market share.
  
  But it was still clinging on to its vertically integrated business model of producing most of the parts it needed on its own. The manufacturing sector as a whole meanwhile was moving towards focusing on only one's core competence and outsourcing other operations.
  
  As it turned out, Eastern Asia Tech found it could not keep up with its competitors in terms of cost structure and has sunk deep into the red. It is now trying to restructure its business. Its share price has plunged by some 60 per cent in the past year.
  
  Whether Eastern Asia Tech can gain back its market share after its restructuring remains to be seen. But for the company's investors, it's probably a tad too late now to sell. As of yesterday, the share price is trading at some 60 per cent discount to net asset value.
  
  However, if a stock's fundamentals remain intact but the stock price is battered - due to, say, a major shareholder selling part of his stake - one may not want to panic unnecessarily.
  
  There could be other reasons not related to the business prospects that had prompted him to cut his stake. It could be that the major shareholder wanted to diversify his holdings, or that he needed to raise cash for something else.
  
  But always be willing to cut loss if you find flaws in your initial buy analysis.
  
  ( ah.. this is something I see too often and I think it is the biggest flaw amongst investors. Admit your mistakes! It's never a shame to admit that we made a flaw in your stock selection. It happens to everyone.
  
  We were wrong. Admit our mistakes. And CORRECT our mistakes!
  
  If you do not correct our mistakes... when will we be right?
  
  Even the great Warren Buffett do admit when he is wrong....
  
  So why can't we do so? )
  
  Another reason we might buy a stock is because we like the industry it is in. An industry could be just at the cusp of the next wave of growth. A rising tide lifts all boats. So a company in the right sector is likely to do well. Witness the oil and gas and marine-related sectors in the last couple of years.
  
  Industry cycles tend to last a few years. The growth came because there had been a neglect of that sector for a period. Few were investing in the sector and thus production capacity was limited. And when suddenly a surge of demand materialises, established companies can increases their prices and enjoy super normal growth.
  
  But slowly, more companies would join the industry, and established companies would invest to increase their output. This would continue until one day the supply would again exceed demand, and the industry would head south. (cycles... the earnings cycle...in a cyclical environment, the good times would not last forever and this is a very good point to remember!)
  
  So if you buy a stock because of the industry it is in, it is crucial to monitor such things as the inventory level of the industry and its current and future demand.
  
  And thirdly, we may buy a stock not because of its fundamentals but because we think that it is cheap and is trading at a significant discount to its net asset value.
  
  For example the likes of Orchard Parade, Hong Fok, and Bonvests were trading at more than 50 per cent discount to their net asset value.
  
  In these situations, you might want to decide to set a target for selling when the share price climbs to, say, 70 per cent or 80 per cent of asset value.
  
  Watch the P-E ratios
  
  Meanwhile, too much of a good thing can be bad. Examples would be stock prices which have run ahead of their fundamentals because investors are pricing in all the good news and more.
  
  Keeping an eye on a company's price-earnings ratio vis-a-vis the industry's and its earnings growth is one indicator to look out for.
  
  And finally, how much a stock will move is a function of, among other things, the market cycle as well as its business cycle. If prices are coming off a very severe bear market which had lasted two or three years, a 200 to 300 per cent gain is not out of reach.
  
  Similarly, if a company had so much bad news and was dumped indiscriminately, any signs of a turnaround could send its stock price back on a recovery trend, and if things continue to be on the mend a doubling or tripling of its price is achievable.
  
  But there's no certainty of catching the top of a rising trend. Perhaps the consolation is, it is better to sell an undervalued stock at a profit than to buy an overvalued stock and suffer losses.
  
  To sell now or not to sell: Always be willing to cut loss if you find flaws in your initial buy analysis

Here are some reasons to sell a stock from some investing legends.

• The Graham Way
  
  Graham was an advocate selling a security when it reached its intrinsic value. He reasoned that a security had little or no profit potential past that point, and that one would be better of finding another undervalued situation.
  
  So, if he bought a stock for $15 a share and assigned an intrinsic value with a range of $30 to $40 a share, when the stock reached the $30 a share, he would sell it. And he then reinvest his proceeds in another undervalued situation.
  
  To safeguard his interest against time, in which he would loses out against annual compounding rate of return, Graham would always buy if and only if the stock is selling at a market price which is sufficiently below the stock's intrinsic value, his margin of safety.
  
  But what if the stock never rises to its intrinsic value? Yup, what if tak laku? Wait 2 years? 5 years? How long should one wait?
  
  Graham's solution was 2-3 years. He reasons that if the stock hadn't reach its intrinsic value then, it probably never would. So, it is better off to SELL and find a new situation.

• Warren's Way
  
  Well Buffett found that these remedies did not really solve the REALIZATION-OF-VALUE problem. He found that more often than other, he was left holding stocks that never rose to their projected intrinsic value. And even if it did, once he sold them, the IRS would slap him with capital gains.
  
  So Munger and Fisher advocated another solution to this problem. They argued that if the one bought an excellent business that was growing, and that the management functioned with the shareholders' financial gain as their primary concren, then the time to sell was NEVER - unless these circumstances changed or a better solution availed itself. They believed that superior results could be had by following this strategy, which allowed for the investor to fully benefit from the compounding effect of the business profitably employing its retained earnings.
  
  So, Warren had to stop buying any situation solely on the basis of price. He began to base his investment decisions on the economic nature of the business. The excellent business with a high rates of return on equity, identifiable consumer monopoly and shareholder-oriented management became his primary target.
  
  Price, still dictated whether the stock would be bought and what the annual compounding rate of return would be. But once the purchase was made, it could be held for many years as long as the economics of the business didn't change dramatically for the worse.
  
  One removes the weeds from the garden but not the shoots of greens that are flowering and bearing fruit.

• The Mr.Market's Way
  
  Many investors continually fall victim to the threat that the next bear market is around the corner. The common adage is to take the defensive position which would means that selling to turn your investment into cash.
  
  Well, Fisher thought that this was a stupid way to conduct your affairs.
  
  But when will the Bear Market ever occur on schedule?
  
  Yup, could anyone ever predict correctly what Mr.Market would do? Cause if you sell your great investment, that the bear market just around the corner may end up as being a bull market instead, and you, you just missed it! How?
  
  But you argue, wait, I'll just get back into stock market if the bear market doesn't materialize, and even if the bear market does materialize then I can buy back at a lower price.
  
  Now, first of all, if you sold your stock, you will get whacked for your broker commission, which means you will lose some value of your money. And for you to rebuy your stock back, then your stock has got to drop considerably in a price to make up for your broker commission.
  
  Then if the bear market doesn't materialize then you would want to get back into the market again, in which you would end coughing out more money for your investment.
  
  Fisher also argues that people he knew seldom gets back into their original investments even if the Mr.Bear market does show up. For people, who reacts to fear usually are left in a state of paralysis when the soothsayers' predictions does come true.
  
  Well, Bernard Baruch summed up his feelings on this subject by saying "Don't try to buy at the bottom and sell at the top. This cannot be done - except by liars."
  
  Buffett solution to all these bear/bull market twaddle? Just ignore them!
  
  His solution is, he buys into a business on the basis of the price. If the price is too high, then the investment won't offer a sufficient rate of return and he won't buy it - regardless of how good the business is. For him, the right price is always very important.
  
  Now Buffett is aware that great buys can show up even in a raging bull market, but he has found that in a bear market, lots of great companies are sold cheap. And this would offer him his greatest opportunities to find a really spectacular deal. As in 1987, when the market went crazy, Buffett was standing at the bottom of the abyss waiting for a business he was in love with to drop by.