When to Sell a Stock

Anyone who has followed this blog at all knows that I advocate long-term holding of stocks.  There are many reasons to hold stocks for the long-term rather than darting in and out of the market.  These include: 

1) Holding for long periods of time put the odds in your favor since stocks have a natural tendency to rise and you don’t need to  be right about timing, just direction.

2) Holding will lower your tax bills and fees paid.  Over time, this will significantly increase returns.

3) If you sell a stock just because of a gain, you may well miss out on much bigger gains.  Stocks going up tend to have momentum, and if you sell simply because you’ve made 10% you may well miss out on a 100% gain.

4) It is much easier to spot stocks whose intrinsic value will rise than make predictions about how the market will respond in the near-term.  Because price eventually tends to follow intrinsic value, it is much easier to predict which stocks will do well over the long-term than predict those that will do well over the short-term.

A few months ago I purchased shares of BJ’s Restaurants International (BJRI).  I felt that they had a good concept, steady earnings growth, and had a lot of room to grow.  The pick turned out very well as they rose by over 50% in a short period of time. 

While I had a good gain, I certainly felt they had more room to grow and in several years they may well be much higher than they are today; nevertheless, I sold out at around $38 per share.  Why?  The statistics for the stock can be found here:  http://finance.yahoo.com/q?s=BJRI

The reason that I decided to sell was that because of the huge rise in price, the Price-to earnings ratio (PE) has climbed to nearly 60.  Even great stocks that have very rapid earnings growth do not normally command PE ratios of more than about 30.  This indicates that the stock price has far outpaced earnings growth.  There is therefore very little chance that the stock will continue much higher in the next year or two, and a good chance that the price will reverse as investors get impatient. 

The stock has a large short position, which is a good trait since short selling tends to prop up stock prices (each time the stock falls, short sellers will buy back shares, providing some cushion against rapid falls).  The PE ratio, however, is just too large.  Even if the stock were to hold its current price, most of the return for the next few years has already been realized.  I will certainly keep an eye on the stock, but for now there should be better investment choices elsewhere.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

When to Sell Stocks – How to Determine when it is Time to Unwind a Position

Typically the posts in this blog are focused on buying stocks and accumulating shares.  Due to the long-term strategies, most of the time we are talking about buying into a position and adding to it during price dips and other opportunities.  I do state that some shares should be sold when the price has risen to the extent that it becomes too risky to hold the full position, such as when those 1000 shares that were purchased for $20 have turned into 3000 shares at $50.  Little has been said though on when to sell entirely out of a stock.

Those who favor trading will say that buying and holding stocks is in fact risky.  They will point out that many stocks that were around 30 years ago are not around today, and certainly most of the stocks of the 1920′s are distant memories.  Obviously as the economy changes some technologies and products are no longer needed.  Business models get outdated, or companies get purchased by other companies.  But those who make this point do not understand buy and hold investing.

The point of the strategy offered here is not to hold companies forever and be indifferent to changes in the economy.  It is to buy comapnies that one would expect to grow over the next several years and therefore one would not need to sell.  It is also to base sell decisions on the fundamentals of the company and not on the current price being offered by the market.  Companies are bought when there are good prospects for the next several years (as was discussed before, while all current news is already priced into the price of the stock, the future earnings predictions are discounted based on the risk involved).  When things change and the future no longer looks bright, that is the time to exit and put funds to a more productive use.

To understand how to spot the exit point, let’s look at the stages in the life of a successful company.  These include the start-up phase, the rapid growth phase, the stable earnings phase, and the demise.

In the start-up phase the company has just issued shares and probably is losing money since start-up costs exceed revenue being generated.  The stock price tends to be very low, and the stock may even trade in the penny stock arena.  Some individuals like to invest at this stage due to the potential reward and the low cost of the shares (for $1000 one can sometimes buy hundreds of thousands of shares of a penny stock).  Most companies do not make it past this stage, however, and even if they have a good business idea they can still fail due to competition and mistakes by novice managers.  Even if they do make it big, it may be years before they are discovered.  Stocks in this stage are also subject to manipulation since so few dollars can buy so many shares and there are typically few shares outstanding.

In the rapid-growth phase the company has  found a successful business model and earnings are growing rapidly.   It is during this phase that we wish to accumulate a position.  Often it is wise to wait for a few years of earnings growth before making a committment to make sure the company is likely to be successful over the long stretch.  Usually finding stocks in this phase is as simple as looking through charts and finding stocks whose price pattern is a steady upward slope.   Earnings growth rates of 50% or more are possible, but these growth rates are typically unsustainable (resulting in stocks whose price graphs look like bell shaped curves rather than the desired steadily increasing line).  Rates of 15-25% are the ideal. 

During the stable earnings phase the company has pretty much saturated the market and is now making a good profit, but earnings are no longer growing as rapidly as they used to.  Often companies at this stage start paying out a lot of their earnings as dividends, which helps to stabilize the price since investors know that they will at least get the yield even if the stocks price remains stagnant.   Stocks at this stage are often favored by large accounts that need stability, capital preservation, and current income.  Stocks in this stage also start to be priced more due to interest rates than due to future earnings (provided that earnings are considered stable enough to maintain the dividend).  They will therefore move up in price if interest rates decrease and vice-versa.  Tax policy will also affect price since higher taxes on dividends will make them less desirable.

The final stage is the demise.  At this stage, the company has fallen into poor management or the service or product that they produce is no longer desired.  In some cases, the company has been built by a visionary and that visionary passes away or retires.  At this point, the company starts to fall in price, often having small, weak rallys, until the price falls to a floor level and then stays there indefinitely until the company is bought out or goes out-of-business.

In our case, we are looking to buy when the company is in the rapid growth stage and hold it until it reaches the stable earnings phase.  At that point, it is time to sell the shares and find the next great thing (unless we have accumulated enough money to desire the company’s stock for current income and stability).  The typical sign that a stock has reached this phase is a share price that is no longer increasing over an extended period and earnings growth rates that are slowing.  Again, if a visionary manager is leaving (such as Sam Walton), it is probably also the time to leave as well.  One must be careful not to hold onto companies that have passed their primes out of sentimentality, as is always a risk with long-term investing.  Remember that a stock is just a stock, not a child or an old friend.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

The Dangers of Stop Loss Orders

Unbelievable day last Thursday.  The Wall Street Journal published an article on some of the wild  activity on the stock market (see link): 

http://online.wsj.com/article/SB10001424052748704292004575230634251738768.html

Some stocks dropped from normal prices of $50 or more per share down to near-zero or actually zero.   In other cases, some stocks surged.  Sotheby’s stock price actually rose from $34 to $100,000!  The quip of the day was from Diana Phillips, Sotheby’s spokeswoman, who said “Clearly, it has been undervalued!” in an email. 

While the exact causes are still under investigation, it was found that the automated rapid trading firms stepped to the sidelines when trading at the NYSE got clogged.  Trades that normally were executed in less than a second were taking a minute or more to execute, causing the firms to step aside since the market was not acting in a way conducive to their trading strategies.  When this happened, the liquidity dried up, such that there were sell orders but no buy orders, causing the wild price swings that were seen.

One issue that occurred was that stop market orders (see post “Types of orders” for a definition of a stop market order, http://smallivy.wordpress.com/2010/03/25/types-of-orders/) were executed because the price of various stocks fell below the limits that were set, causing investors to sell their shares at very low prices.  When the stocks returned to their previous prices, these investors were left on the sidelines with big losses.

This is an extreme case,  but in general I don’t recommend using stop-loss orders because various traders will move the prices of stocks around to try to hit these limits and cause the stock to move up or down.  If you buy quality stocks that you plan to hold for long periods of time, you’ll want to hold through the minor market fluctuations anyway.  If you have a big profit and are just using a stop order to avoid having to pull the trigger and risk missing out on future gains, you are likely to see the stock move down to your stop limit, sell your shares, and then continue on its merry way upwards.  Just sell the stock.   Remember the rule, “Don’t Get Cute”. 

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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