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Growth Investing -- When to Sell

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- Following on from last week's article on Stop Losses, and prompted by a message on the growth shares message board, I would like to look at the subject of when to sell, in particular, when to sell 'winning shares'.

When to sell a 'winning share' is one of the most frequently asked questions here at the Fool, and it is also one of the hardest to answer. Buying shares is easy; selling is much more difficult! There have been a number of 'mechanical' selling strategies that have been suggested, and I will have a quick look at some of them.

Setting a 'stop profit' limit
This is similar to using stop losses, in that when you buy a share you set a percentage price increase with which you will be happy, and once the share price hits this level you sell. So, for example, if you buy a share at 200p and feel you would be happy to make a 25% return, as soon as the share hits 250p you sell.

This strategy is used by a number of my 'not so Foolish' friends who like to speculate on penny shares. One person I know will only ever buy shares that are priced at below 50p, and sets a stop profit limit of 100%: once the share price has doubled, 'I am out of there' he tells me.

Recently I had a long chat about his portfolio, and he listed of a list of about 10 companies that he had bought in the last year (some he had bought more than once in the year) and all of which he had sold at a 100% profit. Based on the shares that he had sold, and the reinvestment of the money, he claimed that he was sitting on a profit of well over 500% for the year. Naturally I was amazed (and somewhat jealous). I asked him how much he invested in each individual share. He said that he never thought about the amount of money he was investing, he simply always bought 5000 shares. By my calculation this meant that the maximum he ever invested was £500, and he said the average was probably about £300 at a time! I asked him how much he was paying to his 'traditional' broker for this service, and he said it was £25 a time, buying and selling. When pressed he had to confess that his profits were notional, as he did not take into account the dealing cost, or the bid-offer spread, but even so he was still sitting on a profit of many hundreds of percent.

I then asked him what he did with his losing shares. "Oh -- I hang on to them until they double" was his reply. How many shares did he have in his portfolio, I asked. "About 25," was the reply. On pressing him it became clear that he was buying penny shares simply on the basis that they were penny shares, never selling his losers, and always selling his winners. He even had 'penny shares' that had gone bust (Ionica and The Car Group). I calculated very quickly that he had invested about £8000 and had made a profit of about £3000, but the shares that he was still holding were worth much less than he had invested in total. He was not sitting on a profit after all, he was losing money hand over fist, but he would not accept this, saying that he was confident the shares he held would eventually double from his purchase price, and that he would make a substantial profit. He was not worried at all about my Foolish protestations!

Selling half when the share doubles
This strategy involves buying a share, and if it doubles in price you then sell half of your holding, so releasing the money you originally invested. The remaining shares that you then hold are 'risk free'.

This strategy quite frightens me when I hear people suggest it. It is simply bunk! If you invest £1000 in a company and the share price doubles to £2000, you then sell £1000-worth; you still have an investment of £1000 in the company. You still have £1000 at risk. The "£1000" is still real money; if you lose it you will still lose £1000. It makes no sense to me for anyone to say, "It doesn't matter as it is the profit -- I have got back my original investment." The profit is still real money and should be treated as such. The fact is that relative strength is a strong indicator of future increasing performance, so to sell out of a winning share simply on the grounds that it has already gone up is daft.

Selling is one of the most difficult decisions that the investor ever has to make. You will agonise over whether to sell today. If the share price falls tomorrow, should we sell? If the share price reaches a new peak at the end of next week, should we sell?

These questions are all impossible to answer. In my Foolish view, there are only three reasons ever to sell a share.

Reason One: You need the money for something -- to buy a new house, a new car, a carpet, to pay for your daughter's wedding (not for 20 more years in my case, I hope). In all of these cases, I believe that you should try to find the money from somewhere else first. Use up the funds sitting in your current account earning no interest, or the funds in an obsolete building society account earning a miserly 3%. Only then should you consider selling your shares. Reason Two: When something has changed --when the reason that you bought the shares in the first place no longer exists. For some ideas of things to look out for see below. Reason Three: When you can find a better home for your money.
As David and Tom Gardner, the founders of The Motley Fool, state in their book The Motley Fool Investment Guide: "This is a profoundly simple thing, but too many investors fixate on kicking out individual stocks based on particularly good or bad recent performance, as if these events have suddenly enabled them to foretell the future."

We don't think long-term investors should be setting target prices for their stocks, or should be trying to time the market's movements. We think the money you dedicate to the stock market is money that you should be intending to keep in the market for a long time -- five years at least, and we hope much longer. We also think that in the most Foolish of investment strategies, you should not be buying a stock with the intention of selling it soon at a better price, but rather because you intend to participate in the success of a business as an owner of a portion of that company.

When you find a better home for your money, when you have discovered that exciting new share that will grow and grow, that is the time to look at your portfolio and shed the shares that look the most fully valued and so have the least room to increase.

The Foolish selling strategy says that you should keep your money invested in the stock market, and we would encourage you to concentrate on managing your portfolio of shares as a portfolio, and not as bunch of individual stocks.

Tom Gardner looked at this in early 1999 in a Rule Breaker update in the USA, which I am going to blatantly plagiarise here. Tom suggests that we can begin to break down the world of investors into three distinct groups, and that you can determine your own type by considering how you would react to the following situation:

You purchase shares in what you believe is a great company after very careful consideration at 500p, and within a month it has dived to just 250p (which incidentally is the story of my investing life). What do you do?

Share Traders -- Those investors who primarily follow share prices bail out. In fact, they often exit a stock if it drops just a few pence -- let alone a drop of 50%. We would characterise these people as "traders." They usually have a short-term mentality focused above all on the movements of a stock price. After buying the share at a specific price, they begin thinking right away about at what share price they will sell that share (note they are looking at the share price, not the business). Exiting early has a flip side: such an investor might have identified Vodafone at the start of 1997 and bought at a split-adjusted 48p. The share price quickly increased (in just a month or so) to 58p -- what do traders do? They exit the share with a fantastic 20% profit in just two months -- not bad, eh? But surely these traders will now be looking at the share, currently priced at 307p, and wondering why they did not continue to hold and so make a profit of over 600% in just 3 years.

Company Lovers -- These primarily follow businesses and fall in love with the companies that they invest in. These people will not exit a share where the price has halved -- in fact, they will often "average down," buying more shares so that their average share price is reduced. They may see no fundamental reason why their company has dropped -- the business looks okay to them. In fact, they really love the business. So they buy more of it.

Foolish Investors -- These investors are much closer to company lovers than to share traders. Foolish investors have bought into a business, not a share price. But they are humble enough to recognise that their thinking may have been wrong (heaven forbid!) -- especially as the market has taken a contrary view and halved the share price! Fools are not strong-minded or hard-headed; they are open-minded and willing to alter their thinking. Fools will maintain a position in a share, not because they are in love with the company, but because they have not found any rational, real-world evidence to disprove the original reasons for buying the shares. However, the very fact that the market has trashed the stock makes a Fool cautious. They will continue to hold until either (a) they see fundamental and empirical (which simply means "observable") evidence that the business's prospects are actually declining or will decline, or (b) they find a better place to stick the money. In almost no such situation should a Fool add more shares to this loser. They will admit that they could have been very wrong their original thinking -- even if they have not found the evidence -- and they don't want to compound the mistake.

So to the question we hear shouted many times "shouldn't you be selling losing stocks?" The answer is yes, but only if you believe that you can find a better place for your money, or if something has changed for the worse. If you have a disastrous share that has lost over 50% of its value, the business has not changed, and the reason that you bought the shares in the first place still hold, AND you cannot find a better place for your money, then leave it there. Often big losers that are still dependable companies have a higher probability for short-term gain than those that have been continually racing ahead. But, of course, you should hold the shares only if you have not found that something fundamental has changed.

In many ways I am not a Warren Buffett fan. I think he is a great investor, and a great stock picker, but for Fools to try and emulate him is almost impossible; he has many attributes that we don't have, and we all need to develop an investment style that suits us. Having said that, he does come out with some very Foolish quotes that are nice to use now and again. On the subject of selling, Buffett, says that "the best time to sell is never". Eliminating selling entirely eliminates commissions and tax payments. If you buy shares in a company that you believe in, and which continues to perform as you expect, then why sell? Even more importantly, why sell simply because the share price has changed? Fools out there should think about the wisdom contained in such a philosophy and look to buy companies that they don't envision selling for a very long time, if ever.

Selling quickly isn't Foolish when you buy good companies. The goal is to hold forever, if possible. Even so, there can come a time when you need to sell or when you should at least consider selling. Here are some ideas of when you should consider logging on to your Internet broker and clicking on the dreaded sell button!

If a company is failing you, you should consider selling if the failure appears to be long-term or permanent in nature. When you realise that you have made a mistake (and that could take months of thinking -- don't rush to sell, just as you shouldn't rush to buy), admit the mistake and sell. Some signs that you should watch for include:

Are the reasons that you bought the shares no longer valid? Has the company failed to grow as expected? Is it beginning to consistently lose money rather than make it, or consistently making less money than before or less than hoped for? Are the reasons for this understandable and short-lived?
Is debt increasing rather than cash without any growth, or at a faster rate than the growth implies is sensible? Is the cash flow per share falling behind the earnings per share? Earnings that are not being turned into cash is a sign that something may be wrong.
Do the management seem to have lost direction? Has their strategy started to fail? Are they lagging behind the rest of the industry? Have they lost motivation and a clear idea of the direction they are going in? Has the chief executive or the finance director (or any other director for that matter) resigned for no obvious reason? Has a director been sacked?
Has the company changed its focus or business to something that you don't understand or admire?
Has the company issued a profit warning? Over the years it always suprises me how many profits warnings are followed only a few months later by another profits warning, and then by a third. If a company you are invested in makes an unexpected profits warning, and you are uncomfortable with their explanation, then think very hard (and quickly for once) about selling!

These are all subjective reasons to consider selling. There are many more scenarios and this barely touches the surface. If you know why you bought shares in a company then the decision can be less subjective; the trouble is so few investors seem to actually know why they bought a particular share except that they hoped the share price would go up. In the end, each Foolish investor must work out their own selling strategy, but remember the most important decisions about selling should always be taken when you buy the shares -- not afterwards.

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