Reblog: When to sell a stock

Most investment writing revolves around telling investors what to buy. But selling a stock at the right time is equally important. Many investors base their sell decisions on stock price moves. They book profits if a stock doubles or trebles.

But this can rob your portfolio of potentially big wealth creators in the long run. Instead, it is better to base your sell decision on fundamental changes in the business itself. Here are four sell triggers that work well in India.

Investment case goes awry

When you add any new stock to your portfolio, you do so based on an investment rationale — why you think the business will deliver better-than-market profit growth or command a higher valuation.

Your expectation is usually based on prospects for the sector, market share gains for the company or margin improvement. But any or all of these expectations can turn out to be wrong. If they are, profit growth will undershoot your expectations, challenging your raison d’etre for buying that stock. When this happens, admit to it quickly and sell the stock.

Investors have been buying sugar producers lately, hoping for an upturn in sugar cycle after five consecutive years of excess production and low prices. Sugar output in the 2016-17 season is expected to dip by 4.3 percent to 220 lakh tonnes, reducing inventory and helping prices. But if the production estimate is revised sharply higher in the next two months, earnings expectations will need to be tempered. Sugar stocks may then need to be sold instead of bought.

However, realising that your investment rationale isn’t working is seldom this easy. Signs of a sector losing growth momentum, a business losing pricing power or a company ceding market share to competitors, is usually available only from performance trends over many quarters. Usually, a steady slide in sales growth, consistent shrinkage in operating profit margin and dipping return on equity — all while the economy is in good shape, are indicators that you need to sell.

Numbers under a cloud

Let’s admit it, only a handful of business groups and companies in India can lay claim to a spotless governance record. Therefore, selling a stock at the first sign of any governance issue is easy enough to advise, but difficult to practise. Investors may therefore have to make distinctions between different types of governance risks before deciding to exit.

Board-level skirmishes, family feuds, regulatory action against top managers, run-ins with tax authorities and related party deals are not great news for shareholders.

But these governance infractions are so commonplace in the Indian context that stock markets brush them off pretty quickly, as long as earnings prospects remain bright. Tata Steel and Tata Elxsi have actually gained 5 per cent since the Tata-Mistry feud broke out. The Maruti Suzuki stock is up 350 percent from the time it decided to route its Gujarat expansion through an unlisted associate.

But one kind of governance issue that you shouldn’t take lightly is any development that casts doubt on a company’s reported numbers. Once that happens and the company is unable to provide a satisfactory explanation, valuations can collapse in the blink of an eye, never to recover.

Take the case of Treehouse Education, the pre-school chain which was a stock market darling until 2015. A warning note from a proxy advisory firm on the high receivables in its balance sheet set off a chain of events, which led to deteriorating results and severe punishment for the stock. Investors who sold the stock in 2015, when the warning flag was raised, could have avoided a 95 per cent erosion in their holding till date. Ricoh India, Onmobile Global and Helios & Matheson are other instances of stocks felled by allegations of accounting fraud.

Business takes a wrong turn

“Don’t fix it if it ain’t broke” is a piece of good advice that Indian promoters often ignore. Often, you find a company you bought for healthy growth and shareholder returns, taking a wrong turn into a capital-guzzling business that the promoter fancies, and thereafter it’s a downhill journey. While it may be tempting to hold on to such stocks and see how the move plays out, the experience with some of the large business groups (the Tatas, United Breweries, Jaiprakash Associates) suggests that it is best to sell the stock as soon as such an announcement is made.

Whenever you find a company allocating capital to big-ticket acquisitions, new sectors that are red-hot, capacity expansion during boom times, or diversification into ‘hobby’ businesses such as sports or airlines, it’s a red flag. When such moves are accompanied by heavy borrowings, that is even more reason to exit quickly.

Valuations too pricey

Some seasoned investors argue that if you’ve managed to buy a good business at a reasonable price, you should just hang on to it, no matter what the valuation. But most stock market bubbles take shape when an inherently good business idea gets over-hyped to a point where investors are willing to pay any price for it. Just as most stock market wealth is created when a company in an ordinary business gets re-rated, the biggest losses are made when bubbles pop, causing PE multiples of a perfectly good firm to suddenly collapse.

Between 1999 and 2002, frontline software firms such as Infosys and Wipro which traded at triple-digit PEs subjected investors to considerable wealth destruction after the dotcom bubble burst. Realty and infrastructure firms, the worst wealth destroyers of the last decade, traded at PEs of 60-70 times in end 2007.

So how can you distinguish between the market simply re-rating a stock, and hyping it up into bubble territory? Well, valuation multiples that are way above the historical PE band (five years) for the company can be one warning sign.

But more importantly, when you hear that the PE doesn’t matter and a brand new valuation metric (replacement value / PEG / land bank) is used to justify valuations for a sector, it is time to take your money and run.