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Selling – The Other Aspect To Good Portfolio Performance
Education | 31 March 2010
By: Ernest Lim
Articles (134) Profile

Selling has always been a less discussed topic than buying. This may be because selling is considered “giving up” on the stock and its potential future returns. Oftentimes, it may also seem to be a recognition that one has made a mistake to invest in the stock. However, I believe that knowing when to sell is paramount to obtain a good, respectable portfolio return.

When do you sell?

According to Philip Fisher, the best time to sell a stock is “almost never”. The key word is “almost”. This means that under certain circumstances, it is justifiable to sell. What are these “certain circumstances”?

Fundamentals have worsened

This can manifest in two ways. Firstly, the company’s fundamentals may have deteriorated to such an extent which you would not have bought it in the first place if you have known that the fundamentals would have changed. For example, assume that I initially bought stock A with its excellent growth prospects and seemingly honest management. However, after some time, there was a change in management and the new management proved to be crooked and incompetent which seriously undermines investor confidence. In my opinion, the company’s fundamentals have changed and it warrants a sell.

Secondly, I may have bought stock A due in part to the excellent industry (for example, technology industry) it is in. I have confidence in the founder and the senior management who have considerable experience in running this technology company. However, it suddenly announced a paradigm shift in business operations and paid a premium to venture into the property industry where it does not have the requisite experience. This signifies a change for the worse and one should consider re-evaluating his investment in stock A.

Valuations overshot fundamentals

Another situation which may warrant a “sell” is that valuations have overshot fundamentals. Take stock B as an example. You may have bought it at 10x FY10F Price to Earnings Ratio (PE). Due to your astute judgment, the price surged. After the surge, stock B trades at 40x FY10F PE vis-à-vis its peers which are trading at 15x FY10F PE. Stock B trades at 2.0x Price to Earnings Growth Ratio (PEG) against the industry mean of 1.0x PEG. Thus, according to these valuation metrics, stock B is richly valued against its peers which may have limited upside potential and high downside risk. This is another factor to consider whether to take the decision to sell.

Better usage of funds

Table 1 shows the existing portfolio of investments owned by an investor. These stocks have appreciated but they still have about 20% potential upside each.

Source: Ernest
Table 1: Stocks in existing portfolio (Source: Ernest)

Table 2 shows the stocks which the investor intends to buy. Besides the target return, I have made an assumption that the investments in both Tables 1 and 2 have the same risk and all other factors necessary to justify the call to switch investments.

Source: Ernest
Table 2: Stocks which the investor intends to buy(Source: Ernest)

Having compared both Tables 1 and 2, ceteris paribus, stocks E and F offer a better return to risk ratio. If the investor is unable to put in fresh funds to buy these stocks, it may be wise to liquidate both stocks C and D so as to invest in stocks E & F.

Portfolio allocation

Assume that person A has S$100,000 and invests equally (i.e. 20%) in the following five stocks as depicted in Table 3 on 30 Mar 09. Markets have since rallied and some stocks have soared. Due to the sharp appreciation in Osim’s share price, it now occupies 62% of the entire portfolio. Thus, A’s portfolio return is significantly exposed to the gyrations of Osim’s share price. In my opinion, even if I believe that Osim has another 50% potential upside, I would still have divested part of Osim to reduce the significant exposure and reallocate my portfolio accordingly.

* Assume we can buy fractional shares for ease of reference.
Table 3: Portfolio – Assume we can buy fractional shares for ease of reference. (Source: Ernest)

Boom and bust cycle

Boom and bust can refer to the economy, as well as, the specific industry. According to Lakshman Achuthan, managing director of the Economic Cycle Research Institute (ECRI), he believed that there are likely to be more boom and bust cycles. He pointed out that recoveries from post WWII recessions have become weaker on aspects concerning employment, growth and production. Secondly, there have been a surge in volatility in the economy, with a substantial decline starting in late 2008-early 2009 and a colossal surge since Mar 2009. BlackRock vice chairman, Bob Doll also shared the view that recessions are likely to be more frequent. The frequency may be up to twice in every decade as they revert to the mean. Typically, according to historical data, recessions happen about twice every decade, except for the two most recent decades. In times of recessions or bust, it is unlikely that stocks would appreciate as their earnings would be affected. Market sentiment on the stocks, as a general asset class would also be weak which would result in the underperformance of shares.

For those companies which operate in cyclical industries such as the rig building sector or the technology sector (e.g. hard disk drive), they are subject to the business cycle as shown in Table 4 below:

Source: Ernest
Table 4: Industry Life Cycle (Source: Ernest)

Thus, it is not ideal to hold stocks which operate in cyclical industries as they are exposed to the vagaries of the industry life cycle. Notwithstanding the companies’ sound fundamentals, it is difficult to register strong profits when the industries which they operate in are in the doldrums.

Conclusion – Selling is important too

I have listed some of the factors above which should justify a “sell” or at least warrant some thought on the investment decisions. Readers are advised to allocate as much time and effort on their “sell” choice as their “buy” choice. Remember – Selling is important too!

Ernest Lim is a CFA, CA and has worked at GIC Special Investment. He has a solid feel of the markets and financial world and is now a remisier.

Please click here for more information about this author.


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