Whenever Cynthia Basden is concerned over negative news reports about a company that she owns stock in, she calls her financial adviser and tells him to sell. Fortunately, her adviser, Charles Jenkins of Wachovia Securities, usually talks her out of it. “When I get those calls from Cynthia, I take a look at the company. And if nothing fundamentally has changed, I tell her to hold on to it,” says Jenkins.
All too often, investors act on their gut reaction to bad news reports about a company and end up selling a stock prematurely, sometimes taking an unnecessary loss. As Lynnette Khalfani points out in her book, Investing Success: How to Conquer 30 Costly Mistakes & Multiply Your Wealth (Advantage World Press; $24.95), there comes a time when all investors must sell their holdings, either to reap the profit or to cut their losses. But when and how that happens takes planning.
“It’s foolish to sell shares in a pharmaceutical company because that company gets turned down trying to put a new drug on the market,” says Khalfani. “People sell on news like that all the time, but that’s just a short-term blip that can be overturned with more research and development,” she explains.
Selling a stock should be considered for one of two reasons -either to achieve desired asset allocation or because of deterioration of a company’s fundamentals. “You should sell an individual stock because you are not confident of the future of the company,” advises Pat Dorsey, director of stock analysis at Morningstar Inc.
STRATEGIES THAT WORK
According to Khalfani, the single biggest mistake an investor can make is to purchase a stock without a plan for when to let it go. Establishing a sell strategy at the same time you buy a stock will help safeguard against making impulsive selling decisions. It should also help investors establish realistic expectations for a particular company’s growth -investors shouldn’t expect every stock they buy to double or triple their investment.
Basden, a 52-year-old branch manager at a bank in Long Island, New York, sets a high and low sell price for every stock she owns. “I will sell if a stock is capping out, or if I’ve made my expected profit,” says Basden, who admits she sometimes pushes the limits.
The economic health of industry sectors is also a key factor when deciding to sell. If an industry experiences a downturn or a crisis affects a particular sector, investors should carefully consider whether the conditions really affect the stocks they own. If not, there is no reason to sell. “After 9-11, people had a lot of worries that there would be a lot less travel. Carnival Cruise Lines stock dropped quite a bit after 9-11, and it was rational to think that maybe the value of the stock had left,” says Dorsey. “As it turned out, that wasn’t the case. People returned to travel a couple years later, and all was back to normal.”
Khalfani reinforces that selling at the first sign of bad news is not always the best thing to do. “After wars, recessions, political strife, or external shocks to the market, we typically see that people who hang in there [and don’t sell] are usually rewarded within an 18 month period or so,” she says.
Jenkins says investors should consider more than just price when developing a sell strategy. Other situations he takes into account when managing Basden’s investments are: if a company restates its earnings, if the fundamentals at a company change significantly, or if a stock becomes overweighted in the portfolio. When a company restates earnings downward or when its fundamentals change significantly, it’s sending a signal that it may not be as profitable as was once thought. Investors may want to take the profit they already have or reevaluate the stock price at which they might consider selling.
For Dorsey, the biggest reasons to sell include when fundamentals change, competition is heating up, growth is slowing down, or the market has become saturated.
When a portfolio contains a high volume of one stock or industry sector, that is a sign of overweighting, which sends the signal that the portfolio needs a more diversified mix of investments. “If a stock doubles in value and becomes 20% of a portfolio, I may scale it back to 10% and make it in line with proper asset allocation,” says Jenkins. “This is so that one asset doesn’t become too big and determine most of one’s net worth.”
TAKE THE MONEY AND RUN
Properly executed, a sell strategy can be an important part of your financial plan, particularly in times of crisis. If life throws you a curve and you need to sell stocks quickly to raise funds, the sell strategy you execute should be designed to limit the damage to your overall financial goals.
Since stocks are a liquid asset, cashing out for an emergency or for a planned expense can be handled fairly easily. Basden’s emergency came when she was determined to give her daughter the 300-guest wedding of her dreams after she graduated law school. Unfortunately, Basden’s husband became ill, which caused a decrease in the household earnings. Undaunted, Basden turned to Jenkins to come up with a plan to make sure the show would go on. “We looked at every item in the overall portfolio and sold proportionally across the account, selling 10 different positions in varying degrees,” explains Jenkins. He also cashed out some stock dividends during that period instead of reinvesting them as he normally would have. That strategy seems to have worked for Basden. The wedding was two years ago, and Basden still has a healthy 35% equity, 65% fixed-income portfolio.
A sell strategy should also have a lot to do with how soon you plan to use the money that you have invested. “If you want to start your own business in five years or need the money for your child’s education in six years, you may want to set up stop-losses,” advises Khalfani. Setting up a “stop-loss” order when you purchase a particular stock will ensure that it will automatically be sold if it falls below the specific price you designate.
SELLING LIKE A PRO
Franklin Morton, senior vice president of portfolio management at Ariel Capital Management, says another value of having a sell strategy is that it can help keep investors from “falling in love with their holdings.” “In 1999, during the market bulge, the value of Yahoo! equaled the value of every stock in the Ariel Appreciation Fund combined,” says Morton. “Some stocks could stay overvalued like that for a while as Yahoo! did, but in the long run, the laws of economics will win [and the stock will decline in value].” (Yahoo! is not an Ariel holding; some holdings in the Ariel Appreciation Fund are McCormick, Carnival, and Clorox.)
As part of Ariel’s buy process, it establishes a private market value (PMV) for each stock, which is updated at least quarterly. When the stock reaches its PMV, Ariel’s sell discipline requires that it sell the stock.
Morton says there are four criteria Ariel uses to decide when to sell a stock in one of its mutual funds:
- When a company reaches full valuation. Ariel reviews and reevaluates a company’s value each quarter.
- When there is a change in the competitive landscape. “Not a short-term issue, but a real change,” says Morton.
- When there is a substantial change in company fundamentals. “Not just a bad quarter, but when the company loses the ability to generate new products.”
- When faith in the management is lost. “Whenever there is a change in management, we have to do research on the new person to make sure they are the right person for the job.”
By combining the systematic approaches used by Morton with some of the measures Basden uses, which are based on her personal risk tolerance, all investors should be able to begin crafting a sell strategy that
makes sense for them.
SIGNS TO WATCH
Deciding when to sell should be viewed as part of the discipline you exercise as a proactive investor. You should understand that you are not “married” to a stock (till death do you part), nor are you in for quick buying and selling to make a fast buck. Watch companies for the following signs, then research them carefully before you pull the trigger:
THE SECTOR IS EXPERIENCING HARD TIMES
If you own a company in a sector that is going through a downturn or major restructuring, you want to make sure the company you own stock in will be able to weather the storm.
THE CAPABILITIES OF MANAGEMENT ARE UNCERTAIN
The strength of the company will rely considerably on the vision of the team at the helm. Pay close attention to a weakening internal structure or any changes to the current management.
FUNDAMENTALS CHANGE SIGNIFICANTLY
Revenues and earnings -both past and forecasted results -are key to understanding a company’s future prospects. It’s important to explore not only the change, but the potential reasons behind it. (For example, if a company restates it earnings, you want to understand why its estimates were so far off.)
Whenever you choose to execute your sell strategy, ensure that you don’t disrupt the balance within your portfolio. Continue to monitor how you allocate assets to each industry sector or volume of stock so that your overall investment position remains intact.