A lot gets written about what you should buy or avoid buying, including here at OfWealth. But I find there’s less emphasis on when you should sell the investments you already own. And much of what’s out there is poorly thought through, especially when it comes to what private investors should do. So let’s take a look at the good (and bad) reasons to sell your stocks.
Every company has an unseen future ahead of it. Some will thrive, some will take a dive.
Most successful investments in stocks and shares involve finding companies that go on to thrive in future. But just because a company is successful doesn’t mean its stock is necessarily a good bet. There’s also valuation to take into account.
A great company bought when its stock is hugely expensive is unlikely to be a good investment. It’s much better to find great companies with lower valuations – relative to earnings prospects or net assets – if you want the best results.
(Even stocks of companies in shrinking business sectors can be good investments if they’re bought cheaply enough. But in that case they need to be really cheap, and earning enough cash to pay very fat dividends.)
Let’s say there are two identical companies. Both grow their earnings-per-share (EPS) at 5% a year, and pay out the same total amount of cash dividends from their profits.
The first company has a dividend yield of 2%. But the second company’s stock is much cheaper. It’s price-to-earnings ratio (P/E) is half as much, which means the dividend yield is twice as high, at 4%.
If you owned both stocks, and the P/Es of neither changed, you’d make 7% a year from the first company and 9% a year from the second, cheaper one. Both have 5% a year price gains, driven by the growing EPS, but the cheaper one has a higher dividend yield.
Which would you rather own of these two identical companies with different market P/Es? It’s obvious that you should buy the cheaper company with the higher dividend yield.
But what if you buy the cheaper one and then its P/E rises over time, until it’s at the same level as the more expensive one? First of all there would be an extra boost to the investors’ profits.
If the P/E doubled over, say, five years that would add 100% to overall profits, or the equivalent of an extra 14.9% a year, with compounding (profits on profits). Suddenly the average profit has leapt to nearly 24% a year. (Actually it would be slightly less, as the dividend yield would fall over time as the P/E ratio rises.)
In this situation, when a stock has gone from cheap to expensive, our clever buyer – who got in cheaply – has to make their next decision. Whether to sell or hold on.
The P/E can’t keep rising forever, although it may overshoot for a time. But it’s safe to say that the mega profits of the earlier years are highly unlikely to continue.
Let’s say the P/E has tripled, from very cheap to pretty expensive. In other words, just like we’ve seen with most developed market stocks between 2009 and today.
In this case the dividend yield falls from 4% to 1.33%, and total expected future return – from that point on – is a modest 5.33% a year. And that’s assuming the P/E doesn’t fall again before the investor gets out.
That would be a great reason to sell. Something you bought has gone from cheap to fully valued, or downright expensive. There’s little juice left to squeeze from it.
On which note, the US stock market has carried on getting more and more bubbly recently. One of the more-than-usually reliable measures for assessing this is the Cyclically Adjusted P/E (or “CAPE”), also referred to as the Shiller P/E or P/E10.
At 29.3 the US CAPE is now officially above the peaks of 2007, just before the (latest) big bust that culminated in early 2009. In fact the US CAPE has only ever been exceeded twice before, during the market’s most notorious speculative bubbles. That was briefly in 1929, ahead of the Wall Street Crash, and between late 1997 and 2001, during the heady days of the dot com bubble.
Below, I’ve updated my own chart of where things stand today. (For a full explanation of CAPE and the chart see here.)
We’re now fast approaching the point where the monthly CAPE for US stocks has only been higher 3% of the time. Which is to say that US stocks are more expensive today than they’ve been for 97% of the months in their history. Clearly there are some major optimists at work in the markets.
Let’s get back to what investors should do after a good result. They shouldn’t worry about squeezing out the last few percentage points of gains. If they’ve had a great run with a stock that’s gone from cheap to expensive then they should take their profits.
This is especially true if markets in general are looking “toppy”. A big “correction” in the US – or even full blown crash – will most likely drag other stock markets down with it for a time. After all the US market makes up around a half of global stock market capitalisation (total value at current market prices). Other stock markets often dance to its tune, especially during brief but repeated times of market stress.
On the other hand a crash may never happen. And in any case, crashes are usually relatively short-lived affairs followed by big recoveries. Put another way, sky high average market multiples are not good reasons to dump everything you own today, especially if what you own is fundamentally cheap in the first place.
Overall, there are many good (and bad) reasons to sell your stocks. I’ve made up a checklist below that you can use to guide you when making decisions.
Good reasons to sell a stock are:
- You bought it cheaply and it’s made you a lot of money. But it’s no longer cheap, or it’s downright expensive, and future returns are likely to be modest at best and perhaps terrible. It’s time to sell and look for new bargains.
- You made modest gains, but things didn’t go exactly to plan in the underlying company. The stock is now fully priced, and there’s no obvious catalyst for future business improvement. There’s better stuff out there.
- You made a loss because circumstances fundamentally changed and the underlying business has hit hard times. With little prospect of a turnaround, it’s time to move on to pastures new.
- Although I don’t generally recommend it, you buy something that’s highly speculative, such as a hot technology stock or junior mining company. Instead of doubling, as experts have predicted, it halves. In these cases you should set a stop loss up front to protect your downside and prevent a major loss. (A stop loss is where you instruct your broker to automatically sell if the price falls by a certain amount. Say 20%.).
Bad reasons to sell a stock are:
- You bought a cheap stock and the price fell hard soon after buying. This is despite no problem with the underlying business, making it even cheaper. In fact this is usually a good time to buy more shares at an even lower price. The eventual rebound will reward you even more. (This kind of value investment is absolutely not a situation where you should set a stop loss to protect your short term downside.)
- You bought a cheap stock, it’s still cheap and has good prospects, but you’re worried that generally overpriced stock markets will crash and drag it down. Again, if that happens, you should usually buy more – unless something fundamental changes.
- You own the stock of a good quality company that’s going through temporary setbacks in its business. This has caused the price to fall as speculators dump it (or “sell it short”). This is another chance to buy more at a knockdown price, in anticipation of a turnaround and subsequent price jump.
Please let me know if you come up with some more reasons of your own (or if you disagree with mine). As always I’d like to hear from you.
Stay tuned OfWealthers,