Tuesday, August 25, 2009

When should you 'hold' and When should you 'fold' a stock?

There are four things you can do with a company's stock:-

1. Avoid it 2. Buy it 3. Hold it 4. Fold (or, sell) it.

In several blog posts, I have indicated the types of companies that an investor should avoid, and why. A quick recap may not be out of place here. Companies with

* questionable management
* negative cash flows from operations
* high debt and frequent share issues
* 'me-too' products with no competitive advantage
* low trading volumes
* high 'beta' (i.e. stock rises and falls more than the index)
* low growth in sectors that have seen better days, are the ones to pass on.

A series of articles have also been written about market cycles, sector selection, top-down and bottom-up methods for picking individual stocks, 'margin of safety' and 'circle of competence'. 'What to buy' should be supplemented with technical analysis to decide 'when to buy'.

Hopefully, readers have started absorbing some of the guidelines and are now sitting on (or in the process of building) a portfolio of well-chosen, fundamentally strong stocks, from sectors or industries that they can understand. That is only half the job done.

Buying a stock doesn't make any one any money. Holding it for a reasonable length of time, and then selling it at a profit completes the cycle.

How long should one hold a stock? Warren Buffett is ready to hold it forever. You may not have that long a time frame. But long term isn't one year. To get proper returns from a stock, you should hold it for at least 3 to 5 years. Like good wine, a stock should be given time to mature.

That doesn't mean you put it in a locker and forget about it. Industry and company developments should be regularly followed. (If you are unable, or unwilling, to track your portfolio - refrain from buying stocks. Invest in index funds/ETFs or balanced funds.) Irrational price movements - either up or down - should be used as opportunities to book partial profits or add to your portfolio.

When should you sell? That's the million dollar question. If you can learn the art of selling, you will be on the path to riches. Before we get to that, one must learn when NOT to sell. Do not sell a stock if

* the price has gone up from 41 to 48 in 15 days
* the quarterly results have been below expectations
* a temporary calamity has stalled production
* a big order has fallen through

There are only three reasons why a stock should be sold. By 'sold', I mean sold off completely from the portfolio.

1. You realise you've made a mistake in selecting the stock. Could be due to making incorrect assumptions, or, not researching the stock adequately.
2. The fundamentals of the company takes a turn for the worse. A failure of imported technology, fraud by top management, new and more nimble competitors changing the rules of the game, a big acquisition turning sour, could be some of the causes.
3. There is a sudden emergency or unforeseen requirement of money, for a medical condition or a job loss or a daughter getting admission in a foreign university or investment in an apartment.

I also use the 'sleeplessness indicator' - though it may not be universally reliable! If I'm unable to go to sleep at night because a stock investment isn't turning out the way it was supposed to, I sell it the next day.

(Readers may please share why they have sold stocks, if any mistakes were made and what lessons were learned.)


ekamber said...

dear Subhankar ji

Thanks for the post

As usual the hall mark of you is evident

I appreciate the fact about the classification of the shares into four categories in such a manner that no one can forget the same

Regarding when to sell, is a debatable one but an individual shall do so as per his own requirements, commitments and conviction as also the results that were expected - as it is sometimes no one shall be married to any share - off course which again is also a debatable issue

But the one aspect I could not agree with is sleeplessness indicator

with regards

SG Money Mind said...

I have decided to keep away from companies which have to rely on heavy working capital requirements, year in and year out.

The reason is at times they may end up using debt financing for managing their cash flows.

e.g. Indian Hotels, ACC.

KKR said...

there is no point of cross verification of selection of stock. then it leads to fundamentally wrong. We should do analysis and fix the target & fold the stock irrespective of other priority. it is applicable in other side also. this will give disciplined profit.

Unknown said...

From my very limited experience of nearly 5 years, I can say that in spite of a few mistakes and blunders...

1) I have by and large sold when I realize I have made a mistake in stock selection.

2) Sleeplessness is a great influencing factor. Yes! I could have skipped a few multi-baggers, but we do not have to jump without a parachute to feel the thrill!

3) Stable businesses and many cyclicals with good management offer chances to sell and buy. But, even if you skip the selling or buying, good cos will still yield good returns.

But, I skip Sugar stocks as I do not understand the cycle and they also tend to be high beta, which requires me to be alert and be nimble for trading the cycle.

4) When I have a large cash requirement or I want to cash out the exuberance,
I first write a sell plan. I identify which stocks to sell, how much to sell etc., It's not necessary to stick only to the plan, but it gives a general idea. Sometimes, I sell more than planned if I find too much irrationality around the stock price.

5) Steep rise is sometimes a warning sign, but not at all times. There are stocks which double and treble even if one manages to get in only after it has jumped 3X from 52-week lows. I can think of Opto Circuits, which I did get in very, very late and still managed to have a multi-bagger. But, chasing a stock when you are unsure about the future earnings is a strict no-no (refer back to [2] again :-))

Anonymous said...

Hello Sir,
i like sugar as a sector but 2 year back i learned a lesson from sugar stock that wherever govt. is interfering, don't enter such sector

Madhu said...

Dear Subhankarji
Very few people are good in analysis and also have a flair for writing. You have proved this once again that you are good in both.

I agree with you wrt most of the reasons for selling a stock however some of them are debatable.
Debatable because it is highly dependent on risk taking capability of the person.

I would like to add some more reasons for selling the stock. I hope others find it intersting.

1. Company advertises its results (not products) on CNBC
2. Every other news paper writes continuously (again and again)about the company
3. Too many people recommend the stock

Subhankar said...

First of all, a big thank you to all of you for participating. Knowledge increases through discussion and debate - not through agreement. So I particularly appreciate the opposing (or differing) views.

@ekamber: Well said. Each individual's investing style should dictate when to hold and when to fold. (I lost a lot of money playing poker - from where the 'hold' and 'fold' terminology has been borrowed - and buying stocks because I held on too long. Learning to cut one's losses takes discipline and courage.)

I did mention that the 'sleeplessness indicator' was not reliable!

@SGMM: That's smart thinking. I've not been very successful with hotel or cement stocks either.

But recently I bet a small amount in Indian Hotels as a contrarian play and because the technicals are indicating a possible upward breakout.

@Mitran: As a general rule, fixing targets and selling on target achievement is great for locking in profits.

But rules need to be flexible in the stock market. One can miss a multibagger by selling too soon.

That is why, I recommend investing 90% in a core portfolio, which should comprise stocks that you need not ever sell. Part profit booking at market tops and reinvesting near market bottoms works well.

The balance 10% can be invested in more speculative plays, where strict targets and stop-losses should be employed. Even here, if your target is achieved in 3 months instead of 18 months, booking partial profits and retaining the balance may provide bigger returns.

@Eswar: Those are some great lessons learned in 5 years. Wish I was as smart as you. It took me all of 10 years to absorb those lessons.

One of the important lessons to learn - specially if you need money when the market isn't doing great - is to NOT sell your winners, but sell your losers.

Accepting a loss is painful. Postponing selling in the hope that you will 'recover your principal' is worse.

@Titu: I avoid the sugar sector as well because too many imponderables decide prices. In fact, I avoid all PSU companies because of too much government interference. Just look at the state of the oil marketing companies.

@Madhu: Other than business letters and project reports - hardly examples of good writing - I had never been able to write much. The blog got started because of a friend's suggestion - and the ideas suddenly started to flow. Can't explain it in any other way, than to thank the Lord for bestowing this 'gift' at a fairly advanced age. I'm glad you are enjoying the posts.

As mentioned in the note to Ekamber, every investor should develop a system that works, depending on his or her risk tolerance and mental makeup. What I've given are some guidelines - based on my experiences.

Your reasons for selling can be summed up as the "Front Cover effect". When a CEO gets featured on the front cover of a business magazine, he has usually 'paid' for such an 'honour'. Similar is the case with the interviews of CEOs on business TV channels. A share or debt issue is probably round the corner!

Anonymous said...

Thanks a lot subhankarji for a very useful and well written article.
Regarding buying a stock and forgetting about it I have been holding a stock since my grandfather days and it has paid rich dividends in the form of bonus shares and high dividends plus price appreciation. However this may work gor some companies but not for all companies.This company is 70 years old company and has seen many ups and down and weathered all storms.
With regards,

Subhankar said...

Appreciate your feedback, Sujoy.

If the hard work is done before buying a stock, then there should be no problems in holding on to it forever!