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This article appeared in the February 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Understanding when and why you would sell, rather than reacting only to price, is key. 

Photo of Nicholas Grove By Nicholas Grove and Morningstar analysts

Although a company's stock price will influence your decision on whether or not to sell, 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.

Everyone buys a stock having certain expectations: earnings and revenue growth, expansion plans, new store formats, cost-cutting efficiencies, and so on. If the things you expected have not materialised, it is a warning that you should consider selling. If they fail to materialise to the extent you anticipated, that is another warning.

However, while past performance will naturally enter your decision, the difference between holding and selling rests on your expectations of the future. Often it will not be one thing that makes you decide to sell but a series of smaller disappointments. Any number of individual things may finally break the camel's back.

The signals

Possible sell signals include: 

A lack of direction or significant changes in senior management.

  1. Earnings-per-share growth slowing with no new earnings streams, such as new products or services, in the pipeline.
  2. A stock reaching a cyclical high. For example, there being "too many cranes in the sky" (suggesting a peak in construction) for building stocks.
  3. A gearing ratio creeping higher as a company tries to fund uncertain growth in earnings per share with debt.
  4. 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.
  5. Any other factors investors can identify, such as significantly increased competition that clouds the medium to long-term outlook.

When to sell a speculative stock

Selling a speculative or trading stock (for example, an early-stage micro-cap exploration company that is yet to earn income) is an entirely different proposition to selling a core long-term investment.

The best way to trade specs is to set a price target, usually based on the occurrence of a specific event such as a takeover or major contract announcement. Once you have achieved that target, get out. Great short-term spec buys can soon turn into poorly performing long-term portfolio holdings for those who get too greedy.

Positive selling - getting out with a smile

Most of the situations mentioned, in a sense can be classed as "negative selling," because you are selling either in disappointment or in anticipation of worse to come.

Even though selling usually involves an element of "worse to come", it can also be a positive way of locking in gains.

For example, if a company's share price has had such a good run that its price-earnings ratio (PE) has been driven to an unsustainable level; it may be time to lighten your holding while ahead.

You are 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.

It is hard to say what PE level would be considered unsustainable, but it depends on the company's earnings growth as well as all those other factors that can affect valuations. Remember, a company on a PE of 50 will theoretically take 50 years to "pay back" the share price out of earnings, which sounds like a long time to wait.

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 is usually a good time to head for the exit with at least part of your holding. (Editor's note: See Michael Kemp's article in this issue for more on the challenges of relying on PE ratios).

Another time to "positive sell" with a smile is when a company that you expected to turn around has done so. Typically, buying a turnaround stock involves a significant element of risk. If every other investor agreed that the stock was worth buying, it would no longer be a bargain.

You will know when a true turnaround has recovered, because all the indicators will be pointing in the right direction and everyone around you will be talking about the miraculous recovery, and probably how they managed to get in on the ground floor.

Just as the crowds are clambering on board, you should be starting to think about getting out. Most of the return from such a stock has probably already arrived and, while momentum may carry the price upward in the short term, you can expect some eventual downward readjustment as the realisation strikes that the recovery is already factored into the share price.

The squirrel strategy

For much of this article, we have taken a rather extreme view of the world by assuming an investor either buys a stock or sells it. Of course, you can easily sell half your shareholding or gradually add to it, sometimes through a dividend reinvestment plan.

In scouring the various sources of sharemarket information - including Morningstar.com.au, incorporating the Your Money Weekly newsletter - you will come across all kinds of recommendations, from Hold to Reduce to Accumulate, and some others.

Hold means a stock is considered roughly fair value; neither a Buy nor a Sell. Reduce means you might take the opportunity to sell down part of your holding depending on your personal circumstances. Accumulate indicates a stock is modestly undervalued.

The squirrel strategy is one way to reduce your exposure either to the sharemarket generally or to more speculative stocks if the outlook is a little cloudy, or simply if they have had a great run.

The squirrel constantly takes at least half the profits out of the speculative market and reinvests into something of long-term value. If times are booming, that might be cash for safety.

Squirrels are able to put enough away for a rainy day, without forgetting to enjoy the sunshine while it lasts.

About the author

Nicholas Grove is a Morningstar journalist.

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