There are few certainties in the world of investing but here are two: dividend income aside, of course, if you are going to make money in the stockmarket, first you will need to buy shares and then, at some point, you will need to sell them.
Until you do sell a share, the money you have made (or, of course, lost) since buying it is only theoretical – and yet, when you look at how investment is covered in the media, buying always commands the lion’s share of attention.
And yet it turns out it is not just the media that is way more interested in buying shares than thinking about why, how and when one might best sell up in order to lock in the most gain.
According to a paper published earlier this year – the winningly titled Selling Fast and Buying Slow – professional investors can also be pretty casual when it comes to that part of the investment equation.
When researching their paper, the authors canvassed the views of institutional investors with portfolios that averaged $573m (£441m) in size and came to what they describe as a “striking” conclusion – that “while there is clear evidence of skill in buying, the investors’ selling decisions underperform substantially, even relative to random selling strategies”.
Furthermore, the researchers say, this finding holds true “despite the similarity between the two decisions in frequency, substance and consequences for portfolio performance”. And they go on to argue “the stark discrepancy” in performance between buys and sells is consistent with “an asymmetric allocation of limited cognitive resources” – in other words, the pros pay a lot more attention to buying than to selling.
Buying and selling is psychologically different
The paper goes on to suggest selling and buying decisions involve different psychological processes, with experiments finding the latter “more forward-looking and belief-driven” and anecdotal evidence supporting that view. “Extensive interviews suggest managers appear to focus primarily on finding the next great idea to add to their portfolio and view selling largely as a way to raise cash for purchases,” the researchers add.
Given one of the principal objectives of value as an investment strategy is, as far as is possible, to remove emotion from the decision-making process, regular visitors to The Value Perspective would expect us to have rather different drivers when it comes to selling – and they would be right to think so.
In our view, there are three broad reasons why a value investor will sell a stock they own in their portfolio.
Reason #1 - Fair Value
The first reason to sell a stock is actually tied up with the original decision to buy it – and that is because, before you even buy into a company as a value investor, you should already have come up with a price that you consider to be ‘fair value’ for its shares.
Then, if you are proved right in your analysis and the stock rises to reach that level, it is the strongest ‘sell’ signal a value investor can have. So sell.
Aside from having the discipline to stick to their process, value investors should sell at this point to avoid ‘style drift’, which we have previously described as “one of professional investing’s disqualifying offences”.
A stock that has reached fair value should no longer be owned by a value investor but be sold on to those who target, for instance, ‘growth at a reasonable price’ as the driver of their portfolio performance.
Reason #2 - Acquisition
The second reason to sell is the odd-one-out here because the owner is afforded little say in the matter.
Value investors are not the only ones scouring the market for undervalued businesses and sometimes an acquiring company will buy your shareholding – and everyone else’s – at a price you consider less than fair value.
Losing potential upside is frustrating, of course, but corporate acquisitions are a fact of investment life.
Reason #3 - Reappraisal
Alongside ‘fair value’ and ‘acquisition’, the third reason why value investors would sell a stock might be termed ‘reappraisal’.
The future, as we never tire of saying, here on The Value Perspective, is uncertain and there will be times when a material change in a company’s circumstances means the assumptions we made when we purchased the stock are no longer valid.
Such a change could negatively affect either the risk or the potential reward element of the investment equation. On the one hand, a company taking on more debt or making an expensive acquisition could increase the former; on the other, a regulatory change, misappraisal of a structural threat or normalised profits looking set to be lower than first anticipated are examples of how the latter could be reduced.
Whenever a value investor sells a stock in their portfolio, their reasons for doing so should fall into one of these three categories and that is because they are all tangible or measurable – no instinct or emotion here.
And while we are bringing cool reason to bear, we should also point out in the context of ‘reappraisal’ that you need to be very clear that circumstances have changed materially enough to warrant selling.
If something has happened along the lines of one of the examples mentioned earlier, selling may indeed be the best course of action.
If the company’s fundamentals remain robust, however, and it is more that market sentiment is affecting the business’s share price, the better option might be to ‘average down’ and buy more shares at a lower price – a process we have discussed in more detail in Falling share price and On the double.
That will not be the case every time – which is when it becomes important to have the rationality, discipline and strength of mind to press the ‘sell’ button – but the overriding point is that you have in place a fundamental investment process that prevents you being caught up in the short-term emotion, hubris and noise of the day.