As an investor, you come across plenty of information that value investing is nothing but buying a stock with a margin of safety at a deep discount to its value. However, what you are not being told is when is the right time to sell a share that you once found attractive and bought for its discounted price.
According to Warren Buffett, the successful proponent of value investing, in outstanding businesses with outstanding managements, his favorite holding period is forever! A person of Warren’s stature can influence the decisions of management or help the management in further investing the profits elsewhere, but as a small, retail investor, will you or I be able to do that? No, not at all. Hence situations might arise where you may have to exit from a stock. So when is the right time to sell a company’s share? Let us see the situations where you may have to sell your favorite share other than for your emergency needs. Of course, I would vouch for you to keep an emergency fund instead of selling your shares, but that is a different topic.
To invest successfully in stock markets, first, you need to view a share as fractional ownership in a business. You are in fact investing in a business and becoming a partner of a company by owning a few shares of that company. Therefore, the reasons for selling a stock are the same as the reasons for selling your own business or partnership. When do you sell your business or partnership? Here are the reasons that should prompt you to sell the ownership or partnership of your business.
Market Offers Exorbitant Price
We know the mantra for success in stock markets is to be greedy when others are fearful and fearful when others are greedy. Value investing is nothing but buying an asset at a steep discount to its real value and becoming greedy when others are fearfully selling. So, you buy when the market tanked down by a significant amount. When there is a bloodbath in the markets, you look for opportunities. Thus you take the exact opposite stance while selling. When there is euphoria in the markets and everywhere there is talk about stock markets and stock tips, you sell. You become fearful when others are greedy for your business.
Therefore, you sell your ownership when you feel it is fully valued or overvalued for the price Mr. Market is quoting. Won’t you be happy if the market offers you a price equivalent to the business’ profit of 40-50 years down the road? I would happily sell my business and move on to the next idea. Else, I would sell and remain a fence-sitter for the prices to come from dream levels to reality levels!
Your Calculation Goes Wrong
Before we buy a stock, we do a lot of research. We read a lot about the business, the company, the annual reports, balance sheets, and P&L accounts. From these available data, we make some assumptions projecting into the future. We actually make the future valuation of a company based on the current set of available information. The research has to be thorough. It should not be based on some stock tips from a so-called expert or a stock recommendation you found elsewhere. However, to err is human. If you find your assumption and calculation to be wrong, or have missed a piece of significant information impacting the business sometime down the line, or if you find the business to be not performing as you intended, it is better to offload the shares there itself than to carry the dirt along from there.
Bleak Future Prospects
The business prospects of a company might change over time. It could be gradual losing of sustainable competitive advantage (narrowing moat) of a product or a brand. Maybe advancement or betterment of technology or a new invention thwarts a business model (disruption). Sometimes government could change the laws pertaining to a business that could impact the profits. Perhaps a change in human habits may leave a company’s core product to be obsolete. All these could significantly affect the operations of a company and could render a bleak future. If you ever could foresee the fortunes of a company change, it is time for you to exit that company.
The Company Borrows Excessively
Excessive debt is always a cause for worry, especially long-term, secured debt. We have seen many debt-ridden companies going bust. During an economic downturn, profitability may turn sour. However, the interest on borrowed money is a fixed cost, whatever the profitability is. The company’s ability to service debt may get impaired. Thus it leads to defaults, damage in credit rating, and even the ability to further mobilize funds. Furthermore, if the company’s debt cannot be repaid as agreed upon in the lending contract, bankruptcy may eventuate. In case of bankruptcy, note that creditors have a higher claim on the assets of a company than the shareholders. Isn’t it safe to sell the stock when a company starts funding its needs through excessive borrowing?
Promoters Pledge a Significant Stake
This is more or less similar to what I said above. Promoters often pledge either partial stake or full stake of theirs with the lenders to borrow money. The borrowed money is either used to fund their personal purposes or to fund the operations of the company. Whatever the reason may be, if the share markets tank, the lenders will be forced to sell the pledged shares. Thus the lenders recover their money. However, the promoters’ stake goes down. Hence they lose the grip over the company. It’s a chain of events ultimately leading to a total collapse. Hence it would be wise to sell off your shares if you find the promoters pledging more than 50% of their stake.
Significant Decrease in Promoters’ Stake
Promoters have better insights into a company’s operations than passive investors. Hence they might resort to fudging the accounts to show the world that the business is doing well. We have earlier seen several instances like these. Hence if you find the promoters diluting their stake regularly despite bright numbers, it is better in our interests to assume that they are the first rats jumping out of the sinking ship. Instead of waiting for the ship to sink completely, it is better for us too to jump along with them.
A Shoddy Management Takes Over
Howsoever good a business or a company may be, if it falls into the hands of management of bad reputation, it is worrisome for us. Shoddy management has its own vested interests in takeovers. They care, small shareholders, a damn. Try to stick with managements that take along small shareholders with them as partners. It is better to sell out at the first instance if you hear management known for its bad reputation is taking over the company in which you own shares, rather than to wait for the ultimate thing to happen.
Too Much Diversification by the Company
After paying tax and expenses, profits generated by a company should be either distributed to the owners (shareholders) or should be employed to generate more profits and thereby compound money. Businesses are money-compounding machines! That’s why stocks are the best asset class. Managements retain profits if they find investible opportunities. However, not all times their motives are really good. Excess cash sometimes tempts promoters to foray into uncharted territories and diversify into unrelated areas. This in turn would lead to a lack of focus on core business, distracted by the different, unrelated operations. The whole company would start to suffer and eventually, diversification would become diworsification! Whenever your commonsense says the company is diversifying too much without appreciable change in the bottom line, it’s time for you to offload your shares.
Keeps on Subscribing to Capital
Not only excessive debt but also regular subscription of capital by issuance of equity on an ongoing basis too is a cause of worry. A business that grows rapidly but needs significant capital to engender growth and then earns little or no money is a gruesome business. If you find the company you own is thirsty for capital apart from any accumulated profit and increases the equity on a regular basis, you have probably landed yourself in such a business due to wrong judgments. It is high time to pacify yourself and rectify the mistake, even if you are at a marginal loss before it becomes a significant loss. Sell your position and move on.
A Better Opportunity Available Elsewhere
Bull market or bear market, sometimes opportunities come across unexpectedly. If you find a better opportunity in some other share compared to the current one you own and you do not have funds to buy into that idea, why not sell a share that has made a runup already and neared its full potential?
Conclusion:
Had you been a regular, avid reader of the business section of your newspaper, you should have come across all the aforesaid scenarios. I have said nothing new. No matter where the economy, the market, or the index is headed or whatever the technical analysis says, a value investor is least bothered as long as the business is doing well and earns a decent return; however, he is bothered if any of the aforementioned scenarios come into place in a stock he owns. We do not have control over any of the situations above. Ultimately, we have only one rule and that is to not lose money. Therefore, should these likelihoods arise, the way out is to sell your stake and move on.