When it comes to selling stocks and shares, why you are selling is unimportant. All that matters is how you sell. Grasp that simple truth and an investor’s life becomes much easier. Sure, there is a ‘why’ somewhere in the mix. Whatever humans do, they claim a reason for it, which is where ‘why’ comes in. But it’s an unreliable input, full of uncertainty and faulty analysis.
Meanwhile, how to sell is clear-cut and reliable. Get that right and an investor will achieve a major aim: to maximise profits on winning situations. Simultaneously – and with a bit of mental fortitude – he or she will minimise losses on duff investments, which is almost as important.
But let’s start conventionally enough by examining why an investor might sell. Understanding the phoney reasoning at work makes it easier to accept that ‘how to sell’ really is much more important than ‘why’.
There are just three reasons for selling a quoted security in an investment portfolio. One – you loused up on your original assessment so what you thought was a thoroughbred looks more like a donkey and won’t achieve the returns you expected. Two – something bad happened that just could not be foreseen, so the prospect of good returns have gone ‘phut’. Three – you find an irresistible proposition and you have to free up capital to make the investment.
Notice there is nothing here about selling because the price has gone up a lot, or even if the price has fallen a lot; nothing about selling because you need to rebalance your portfolio, or selling because there is a ‘y’ in the month, or any of the spurious reasons splurged out to justify selling an investment.
Look around the web and you’ll see quite a few. The ‘best’ (ie, the worst) ones we found were: “Most financial planners suggest dropping a stock if it falls 10 per cent.” Not those with half a brain. “Any sale that results in a gain is a good sale.” Oh really. “Rebalance your portfolio every year by selling the winners and buying more of the stocks that did not do well.” Not quite so asinine as the other two; it flies in the face of rational advice, but might work for those who think that mean reversion is more powerful than momentum.
Perhaps it’s easy to spot the silly advice because there is so little advice of any kind about why, when and how to sell investments. Even the great investment gurus have little to offer. Indeed, the greatest of them – Warren Buffett – is no help at all as he says his optimum holding period is “forever”. Clearly that did not apply to the holding in Tesco (TSCO) that Mr Buffett had put into his investment conglomerate Berkshire Hathaway (NYSE: BRK.B). Late last year Mr Buffett acknowledged that he made a “terrible mistake” to build up a 5 per cent stake in the supermarkets operator. That prompted him to sell some – possibly all – of Berkshire’s holding, but Mr Buffett did not expand on his reasons behind the disposal.
Clearly, however, he had forgotten the advice of his own guru, Benjamin Graham, at whose firm the Sage of Omaha learnt his trade. “Never buy immediately after a substantial rise, or sell after a substantial drop,” suggested Graham, who – rare among investment stars – had a fair bit to say about selling. He used a formula to dictate sales of his “workouts” and we have checked its effectiveness. We applied it to similar 21st-century situations, namely Simon Thompson’s Bargain Shares Portfolio, whose methodology is based on Graham’s own ‘bargain issues’ investment criteria (see box, on page 30).
The investment guru with most to say on why to sell – and another strong influence on Mr Buffett –was Philip Fisher, a San Francisco-based investment adviser who plied his trade from 1928 to 1999. In his best-known book, Common Stocks and Uncommon Profits, Fisher – he died in 2004 – devotes a chapter, ‘When to sell’, to the subject.
Indeed, it is from Fisher that we derived our three reasons to sell mentioned earlier; not because we want to ape a money master, but because they are the only rational reasons why a quoted investment should be sold. Every other acceptable reason – sometimes with a bit of stretching or squeezing – somehow falls within their parameters. Let’s look at them in more detail.
■ The investment goof
In his rather laborious prose, Fisher explains that it is okay to sell “when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favourable than originally believed”.
So, imagine I had bought Tesco shares because the company looked like becoming the next Walmart (NYSE: WMT), but I couldn’t be bothered to check that it was ploughing too much capital into its new stores for too little return. Luckily, I twigged that things were going wrong in a big way when the company closed its operations in China in mid 2013. That prompted me to crunch the numbers properly and I exited before the flak really started to fly.
That sounds straightforward, but doing it is another matter. First, something has to happen to make an investor rigorously rework his calculations (assuming he did them in the first place). Second – and more important – as Fisher rightly says, “the proper handling of this type of situation is largely a matter of emotional self control”.
Investors – being human – lack this self control. In particular, they hate to admit their failings, and selling for a loss is the ultimate manifestation of their stupidity. Much better to hang on and sell when the price recovers sufficiently to turn a small profit. Fisher labels this response “one of the most dangerous in which we can indulge ourselves in the entire investment process”.
And this prompts perhaps the best-known quotation in favour of taking losses on the chin in the entire investment cannon. Fisher writes: “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”
It sounds good, it seems logical, it seems appropriate (why shouldn’t investors be punished for their stupidity?) – so no one challenges it. Yet even a moment’s thought ought to do so. After all, on average share prices rise. That, too, is not an immutable law, but it has applied pretty well to the UK and US these past 100 years and more. That being so, even the price of dog stocks will rise. So it seems unlikely that holding on to lossmaking situations is the biggest single cause of investment losses. Rational thought points to the notion that, by keeping lossmaking investments, an investor will eventually turn his book losses into profits, even if the opportunity cost of failing to switch into something more profitable is considerable.
So the ‘investment goof’ reason to sell looks better in theory than in practice. Superficially it sounds good, but for it to work requires a level of prescience that investors simply don’t have. Besides, it’s probably unnecessary since, more likely than not, the price of lossmaking stocks will recover.
■ Couldn’t see that coming
As we’ll see, there is a gap between theory and practice in all the rational reasons behind selling a security. Take Fisher’s second reason for selling. Being a man not to do things by halves, Fisher listed 15 factors that needed careful examination before deciding whether or not to buy a security. These ranged from the commonsensical – “does the company have worthwhile profit margins?” – to the obscure – “does the company have management of unquestionable integrity?”; how on earth can an outsider assess the latter?
Still, Fisher says the stock should be sold if the company “no longer qualifies in regard to the 15 points”. He does not say whether failure on just one point would justify a disposal, yet it does not really matter. Generically, he is saying that the outlook for a company can change for the worse and, when it is clear this is happening, the stock should be sold.
For instance, let’s imagine we are back in early 2013 and I buy shares in Ladbrokes (LAD) because the bookmaker has a great presence in the UK’s high street and, belatedly, looks as if it is sorting out its digital side, improving both its online offering and –crucially – its platform for betting via mobile phones. In other words, it’s a viable recovery situation. Six months later, however, it becomes clear that – actually – the company’s bosses are making an unholy mess of rolling out the digital platform so, fearing for the company’s competitive position, I sell the stock.
That sounds straightforward but, once again, we are assuming a level of prescience that investors cannot reasonably have. We are ‘jobbing backwards’, so – yes – it’s easy to say that Ladbrokes’ shares should have been sold in late 2013, but that’s of no help because investors only ever act in the present. What about the recovery stocks that might be in an investor’s portfolio today?
For example, do I sell shares in supermarkets operator Wm Morrison (MRW) because the imminent departure of its chief executive, Dalton Philips, confirms that the group is locked into decline or hold on because his successor will build upon tentative signs that the deterioration is slowing? More controversially, how do I interpret the remuneration-guidelines-busting rewards being offered to the new chairman and deputy chairman of insurance claims processor Quindell (QPP)? Maybe they are a sign that the company is, indeed, a basket case – why else would these businessmen insist on so much? Alternatively, perhaps it’s bullish that Quindell can attract such heavyweights, implying there is a business there to be saved.
True, we can make an assessment – that’s what investors have to do – but we cannot know that our reasoning will apply. So why sell even if it looks as though the outlook is changing for the worse?
■ The better option
Thirdly – and equally rationally – Fisher said that just occasionally an investor stumbles on a brilliant opportunity but does not have the ready funds for an investment. In that case, he should sell security A in order to buy B.
Clearly it can happen; with hindsight, it does happen; but in real time this proposition suffers the same shortcoming as the first two reasons to sell –how confident can I be that B will perform better than A? The assessment will also depend on my investment horizon – probably the longer the better – and on my attitude to ‘risk’ (ie, the bounciness of security prices).
If I can tolerate big dips in the price, then a high-risk situation may well bring better long-term returns than a low-risk one. But then I have to understand that I have changed the nature of my investment. If I switch out of shares in GlaxoSmithKline (GSK) for a stake in Aim-traded GW Pharmaceuticals (GWP) then I need to grasp the implication of swapping the solidity, dullness and dividends of Glaxo for the potential (and the absence of profits and dividends) of the cannabis-based drugs developer. Let’s put this another way – if I sell holdings because I want to rebalance my portfolio, that’s fine. But it’s only sensible if I do it knowingly.
In addition to his sound reasons for selling, Fisher discusses three “silly” – yet widespread – reasons for selling:
■ that a bear market is in the offing, so stocks should be sold;
■ that shares in a great company have become overrated, so should be sold;
■ that the price of an investment has risen an awful lot.
The first – the bear market scenario – is past its sell-by date. True, City analysts still devote much time and resources to guessing whether equity markets are due to fall. But nowadays that translates into theoretical advice to institutional investors to ‘lighten’ holdings rather than stock-specific recommendations to sell.
The third ‘silly’ reason is just that. To sell a holding simply because it has been hugely successful is, as Fisher himself wrote, “the most ridiculous of all”.
Arguably, however, the second reason – to sell because the shares have become overrated – has some logic to it. Fisher counters this with the observation: “how can anyone say with even modest precision just what is overpriced for an outstanding company with an unusually rapid growth rate?” Fair point, especially as hindsight shows us that selling shares in great companies even at high ratings often turns out to be a bad move in the long run. Even so, if I do my analysis as thoroughly as possible I am confident about my facts and my reasoning and conclude that shares in, say, microprocessor designer Arm (ARM) – arguably London’s best growth stock this century – are only worth £7 each compared with a market price knocking on £10 then I might be justified in selling.
Perhaps. But here we come to the nub of the argument. Neither the spurious nor even the rational arguments for selling really matter if we can’t rely on them. What’s important – as we said at the start – is not why you are selling but how you sell.
Remember that in securities investment there are just two aims: to maximise gains from the winners and to minimise losses from the failures; to cultivate the flowers and to cut the weeds, according to Peter Lynch, an outstanding US fund manager of the 1980s. True, this runs contrary to the conventional wisdom cited earlier that ‘any gain is a good gain’ or its closely-related cliché that ‘you never go broke taking a profit’, but these aphorisms border on the stupid anyway.
Granted, you won’t go broke taking your profit, but you won’t maximise your gains either. And that will be a crucial omission. If you are always satisfied with a 20 per cent gain – or even 50 per cent – you will never run a ‘10 bagger’ (a gain of 1,000 per cent). Yet that’s the underlying aim – to have, in a lifetime’s investment, just one or two star performers whose returns are so brilliant that they lift the performance of the whole portfolio. Indeed, it is arguable that the only feasible way to achieve above-average long-term returns is to have one or two stars among the supporting cast, and their performance can only go stellar if they are allowed to run.
Consider this little scenario: imagine a portfolio with a starting value of £200,000 is always divided into 10 equal holdings and is run for 10 years. It does okay but, because the winners are sold too soon, its annual growth rate is 8 per cent. That turns its value into £430,000 at the end of period.
Now imagine that, in the same portfolio, just one stock has just one brilliant year in which it is a 10 bagger. That would generate £200,000 profit for the fund and – all else being unchanged – would mean that the fund’s growth rate shoots up to 11.8 per cent. More important, it also means that the fund ends up with £609,000 of capital, £179,000 more than under the original scenario.
The extra would be well worth having and would only have been captured because its owner knew how to sell. He would not have bothered with reasons why he should sell; he would not have worried about the rating on the shares or about the fact that the price had risen a lot. He would simply have focused on a formulaic way of selling to run profits and maximise gains. That way is to use a ‘stop-loss’.
We discuss the practicalities of using stop losses to sell in the box ‘Boxing clever’, on page 29. Essentially they take the qualitative – and uncertain – element out of selling and replace it with a quantitative one. As a way of running profits they are unbeatable in practice. As a way to cut losses – ie, to sell lossmaking investments – they may be the least bad method, but their merits are less certain.
Sure, investors with the mental resolve to accept losses can use them to get a lossmaker off their books and out of their mind – as Jesse Livermore, one of the greatest traders of all time, said: “A loss never bothers me after I take it. I forget it overnight.” For others, the problem with selling a lossmaker – even using a quantitative method – means admitting they were wrong. Either they can learn to live with it or they can’t. But the bigger difficulty – as discussed earlier – is that in a stock market that spends more time going up than going down, on average it may be right to persist with lossmakers because, after a fashion, they will eventually come good.
If, ultimately, this just shows that in selling – as in all elements of investment – there remains uncertainty, then it’s hard to argue with that. But this is where we came in. It’s precisely because investors face uncertainty that ‘how to sell’ is better than ‘why sell’.
