Saturday, 17 March 2012

When to Sell Stock: Decision Making Based on Value Investing Approach


I have always felt that decision on when to sell a stock is much harder to make then making a decision about when to buy. Once you have already bought an investment, you are prone to cling on to your decision due to number of psychological biases such as endowment bias where you tend to overvalue your possessions most of times and confirmation bias where you look for confirming evidences to support your initial hypothesis. 

Even though when to sell stock is as critical and complex question as that of when to buy stock, there is relatively very little information available in literature of value investing on detailed methodology or framework regarding the selling decision. one school of thought suggest a "buy and hold forever"strategy. However, the underlying assumption for this approach is that one has followed the central premise of value investing thoroughly and has made investment in an enterprise that is able to increase its intrinsic value consistently over a long period of time.Though it sounds simple and elegant, putting this into practice consistently in all investment decision is very difficult except for some exceptional and legendary investors. Hence, I feel one needs to develop a clear understanding on how one should go about making a decision to sell. The approach/framework shall be as much rational  as one would expect in a decision to buy an investment. 


I can conceive three situation in which you shall exit an investment.

1) When price no longer offer enough margin of safety: The most important aspect of value investing framework is margin of safety i.e. discount compared to intrinsic value. Hence any decision to buy or sell shall revolve around this central tenet. Any security/stock that does not offer enough margin of safety for an investor with respect to intrinsic value of an enterprise is not worth holding. Now this situation may arise due to following reason


Re-rating of Stock : This situation happens when market takes cognisance of the fact that underlying value of a business is substantially higher than the price offered by the market. There may be very many triggers such as consistent earning growth, sell off of a division at substantially higher price than market expectation, stake sale/takeover of a company or in extreme cases liquidation etc for re-rating of a security. These catalysts will help market discover the intrinsic value of an enterprise and market prices will move towards bridging the gap between price and intrinsic value. In order to arrive at the conclusion that market has bridged the gap between price and value, investor must reassess the intrinsic value of an enterprise  at the time of making a selling decision (Don't use intrinsic value that one might have approximated at the time of buying decision). 

However, I will warrant a caution here that intrinsic value of an enterprise is very dynamic in nature and keeps on changing. It is perfectly plausible that if one has invested in a great enterprise, intrinsic value of that enterprise keeps growing and you might sell it out much early in the process by adopting this approach. 

Intrinsic Value of an Enterprise Decline: This situation is reverse of the re-rating. In this case the intrinsic value of an enterprise decline so that the gap between the intrinsic value and marker price narrows. Decline in the intrinsic value may be due to change in management or its policies or due to more structural changes in the economics of business or due to faulty capital allocation policy (overpaying for  M&A  or tardily managed diversification). In any case, one must ascertain that such decline in intrinsic value is not due to temporary/short term factors and is the result of fundamental changes that are long term in nature. 




More Lucrative Opportunity: As warren buffet says, if an investor applies value investing principles diligently and only looks for mispriced opportunities where probability of loss of capital is close to zero, one will find a handful of opportunities in one's lifetime. He emphasises that one must opt for an opportunity when odds of winning are overwhelmingly in one's favour. 

However there are certain situations when one particular bargain is so compelling and risk rewards are far superior than that of existing investments and one has fully deployed one's capital in his existing portfolio (i.e. he is fully invested). In such cases, one may want to sell some portion of existing holdings to deploy it in an opportunity which offers much higher margin of safety and hence much higher potential for return. However even in this case, which stock in one's portfolio should first go out? Instead working on gut-feel and making subjective judgement, one can take a far more systematic approach as to determine relative attractiveness of each stock within one's portfolio and chose to sell a security that is least attractive. Please read my post on applying capital allocation framework


 In my limited experience, such opportunities will not be very many if initial selection of stocks has been done carefully by applying value investing principles diligently (except in extreme cases like crash of 2008 where plenty of such opportunities were available). Hence most of the times adding position in existing stocks may turn out to be most rational approach.



3) When One Has Made an Mistake: It sounds very logical and simple that as soon as one realizes that he/she has made an error of judgement in assessing intrinsic value of a business and there is no margin of safety available, one must sell the investment.However, it is very difficult emotionally to accept that one has made an mistake and act decisively to rectify the same. I have faced this emotional trauma many a times and incurred severe losses (loss of capital as well as opportunity cost). There are number of behavioural aspects that may act as impediment to taking a decisive action (as Mr. Robert Heinlein put it, man is not a "rational" animal but a "rationalizing animal").  However, one must resist clinging onto such mistakes as opportunity cost of inaction will be very very high.

This approach about when to sell stock is based on my limited understanding  and grasp of the value investing philosophy, little bit of experience in investing and from reading of the work of some great value investors . It will be very useful to receive comments/suggestions from fellow investors regarding missing links or inconsistency in the approach  

P.S.: This post is a more elaborate and structured presentation on one of my comments on this topic in earlier post.

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