Knowing When To Say Goodbye

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“Goodbye” is often the hardest word. You can get emotionally attached to an investment, just as you can with a person. And, as with a personal relationship, it’s difficult to bite the bullet with an investment and call it quits. Your heart tells you one thing, your head another.

However, as an investor, you need to listen to your head, and remain coldly rational about your holdings. Below is a primer on how to tell when the time is ripe for a break-up.

This dilemma stole some of my sleep this weekend as I fretted about what to do with two stocks in my portfolio. They are solid companies with reliable operating models and conservative debt levels. They are not expensively valued when looking at their respective price-to-earnings (P/E) ratios. Both are enjoying growing earnings but they are acting horribly.

The industry of these two companies is cycle, which means their fortunes ebb and wane with the demand evolution of end customers. Demand doesn’t go up in a straight line; it curves upward and then back down and repeats this wavy motion.

Think of something like housing. Home builders’ profits are tied to the demand cycle for homes. Demand for homes follows a strong economy and the level of interest rates. Sure, there are pockets of the world experiencing unique secular waves, that is, one-time events instigating growth independent of interest rates and job health, but for the most part, these stocks are cyclical.

Such stocks are heavily influenced by the trends reflected in this chart:

The stocks I’ve been fretting about are not involved in housing. But there are many other industries considered cyclical, such as industrial machinery, truckers, capital equipment, and defense companies.

While I personally believe these two companies have succeeded in diversifying their businesses to the point where they are not wholly dependent on the business cycle, two questions remained:

  • Were they in fact diversified enough to exit a downturn unscathed?
  • Would the market even care? That is, would the stocks sell off so much that I would be better selling them now and returning to buy later at much lower prices?

Weighing Fear and Greed

The decision on when to sell a stock can be difficult to answer. In fact, I find deciding when to sell a stock considerably harder than deciding when to buy.

As with most stock market decisions, the emotions of fear and greed take center stage. Yes, I know every pundit in the world will tell you that you need to remove emotion from the decision-making plan. Perhaps  your final decision will be analytical and clinical, but you will almost certainly find yourself awash in conflicting emotions before reaching that end.

If the stock you own is up significantly since its purchase price, greed raises its voice, “You’ve made 40% on this stock; it’s a great one. What if it goes up another 120% after you sell?”

If the stock is down significantly (or almost worse, down after being up earlier), fear starts poking your neck, “Who knows what the bottom is? What does the rest of the market know that I don’t?” A losing stock will suck up a lot of your energy.

These factors govern how I approach this gut-wrenching decision:

  • Is the stock reacting to company-specific news or is it selling off due to market turmoil? If it is market turmoil only, the answer is fairly simple. Try to hold on to the stock but if your time horizon is shorter on this basket of money, set a stop-loss limit price on the stock. Sell half if it hits that limit, sell one quarter if it closes below that limit again, and then the last quarter if it still closes below that limit.
  • If indeed the stock is reacting to some company-specific news, the decision just got harder. I typically try to give a stock a one-quarter grace period if it reports a disappointing earnings number. Maybe the company had a shipping issue or a one-quarter blip in demand from a big customer. It may behoove you to wait.

You may think merely waiting because a stock is cheap is the best decision. This rationale might be valid, but you do need to have a reasonably long time horizon if the stock is a cyclical one.

The problem is that stocks suffering from cuts in earnings estimates have a hard time rising.

The rate of change in estimates is often more important than the year-over-year change in those numbers. If estimates peg a company growing earnings 20% this year, the stock might sell at a P/E anywhere from 18-21. However, if that growth rate is lowered so that estimates now assume just 18% growth, the P/E may compress dramatically to 14-16. This value trap has ensnared me before, and I’m trying to learn from experience.

With over 25 years of experience in the stock market, I know that each stock and business cycle has unique aspects but recognize that fear and greed will often interfere with analytic acumen. It’s my job to find those discrepancies and capitalize on them.

I’m still weighing my decision over these two stocks, but if I do decide to sell, I won’t look back. I’ll move on to the next opportunity. After saying goodbye to a stock, that should be your approach, too.
Courtesy of Linda McDonough, Investing Daily (More from Investing Daily Here

The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of EconMatters.

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