The decision to hold on to a stock is not so different to the decision to buy it at the current price. After all, you would only hold on to a stock if you thought it would earn you an acceptable return over time. So, it's almost as important to have a basic rationale for keeping a stock as it is for buying it in the first place.
There is a lot of talk about buying stocks and holding them over the long term, but what of selling? When should you sell? When your stock has gained 25%? When it has fallen 25%?
While a company's stock price will obviously influence your decision on whether or not to sell a stock, don't let it dominate your thinking to the exclusion of all else. The secret to knowing when to sell a long-term holding lies in doing your homework, even before you buy the stock in the first place. If you conduct your analysis thoroughly and follow the company closely, the decision to sell becomes a lot easier.
Selling a stock because it has done well
There is logic in cashing in some of your gain if a stock has moved to a level at which you believe it is overvalued. Having said that, don't make decisions about long-term holdings on past performance alone. Get back to fundamentals: How healthy are those earnings? What are the growth forecasts? How likely is the company to achieve those forecasts?
If a company's share price has had such a good run that its price-to-earnings ratio, or PE, has been driven to an unsustainable level it may be time to lighten your holding while you're ahead. You're not selling out of the company altogether - merely accepting that the current valuation is attractive and will deliver you a higher return than you may have otherwise expected.
So what PE level would be considered "unsustainable"? It's hard to say, but it depends on the company's earnings growth, as well as all those other factors that can affect valuations. Also remember to use other yardsticks, such as comparing a company's PE to that of its competitors. If one stock is trading at a much higher PE than the rest of the sector without apparent justification, it's usually a good time to head for the exit with at least part of your holding.
Selling a stock because it has done badly
Selling stocks that have fallen in value often means that you buy high and sell low - no way to make a profit. However, just as it's unwise to sell stocks solely because they have fallen in value, it's even more common for investors to get it wrong in the other direction altogether.
If a stock in your portfolio has done badly, it could be either that the market is wrong or you were about the company. Don’t languish in the assumption that holding on to stocks that have fallen in value is wise because “everything goes up eventually”. The overall stock market rises over time, not all stocks do.
If you've held a poor performer for a long period, you'll need to be absolutely confident that your analysis isn't off-beam or that you haven't missed an important change. If, however, you have held a stock for just six or 12 months and the market has turned sharply against it, revisit your original analysis. Have the earnings come through? Do they continue to come through? Did you miss something in your analysis? And even if you conclude that the market is definitely wrong, what will be the triggers for the market to recognize the stock’s value. And can you afford to wait?
Stock prices, remember, venture far away from reality in both directions and if you paid a fair price for the company and the earnings are coming through, or are likely to, there's every chance its performance will pick up.
Some possible "sell signals"
1) A lack of direction or significant changes in senior management;
2) Don’t ignore management incompetence or unethical behaviour, specially in a mid or small cap company;
3) Earnings per share growth slowing with no new earnings streams - such as new products or services - in the pipeline;
4) A stock reaching a cyclical high - for example, there being "too many cranes in the sky" for building stocks;
5) A gearing ratio creeping higher as a company tries to fund uncertain growth in earnings per share with debt;
6) A company or a significant segment of it being susceptible to a major change in government regulation, tax legislation, social demographics or the economic cycle;
7) Any other factors investors can identify, such as significantly increased competition that clouds the medium to long-term outlook.
Selling a stock because you found something better
Remember that when you evaluate new opportunities, you are doing them against what you already own. So the new opportunity can’t have similar upside to your stable of investments, it needs to have considerably more upside to replace the “trust” in what you already know. Keep your hurdle rate high for new investments. Unless you find something that is very compelling, don't sell an existing position to buy it.
Selling one stock to buy another can potentially cost you in two ways. First, the opportunity cost. If you get it wrong, you may not only make a poor return on the stock you just bought, you may also miss out on gains from the stock you just sold. Second, the "cost" cost. It's expensive to buy and sell shares all the time and the higher your portfolio "turnover" - the more often you buy and sell - the more it will cost you.
