There’s an old Wall Street maxim: “You never go broke taking a profit.” However, for most investors, especially those of us who are humans, that’s easier said than done.
We’ve always got “buy” disciplines and criteria: prices, forward PE ratios, dividend yields, etc. Or, if you’re a technician (aka “wiggle reader”), you look at 200 day moving averages, reverse head and shoulders patterns and other indicators.
But, in my experience, one of the hardest things for individual investors to do is sell a position, be it a winner or a loser. When we pick a winner, we fall in love and tend to convince ourselves that the good times will roll forever.[ad#Google Adsense 336×280-IA] When we pick a loser, we hate to admit we were wrong, so, we wait.
And we wait. And we wait. Hoping.
And in my experience, I’ve learned that “hoping” is not an investment strategy.
In a volatile market environment like we are currently facing, smart investors need to develop a sell discipline on both the profit and loss side.
When I first got into the investment business 20 odd years ago, the famous Tech bubble was in full bloom.
A guy on my firm’s equity research liaison desk had a pretty good discipline: if you get a good gain in an extremely short amount of time, my rule of thumb has always been three months or so, automatically take at least one third of the position off of the table. Another strong reason to sell is a change in the company’s fundamentals. If you bought the stock based on fundamentals and your thesis changes — it’s time to consider selling.
Here’s a real world example from my business. Last summer when energy stocks were being liquidated wholesale, I bought shares of Chevron (NYSE: CVX) in managed client accounts. The reason for the buy was purely based on price. The stock had been battered down 35% from its 52-week high. Long term, Chevron’s fundamentals are probably ok — but they’re not great, because the stock price is almost handcuffed to the behavior of energy prices, which are currently bogged down in a mauling bear market.
Was I ok holding the stock long term? Yeah, mostly. But I knew it would be a hard row to hoe of the near to medium term as investors and the company waited on some kind of recovery in oil and gas prices.
I got the bounce I wanted. But on the first opportunity, obviously, I hesitated. Why? A little greed, perhaps. We always want to get paid a little more. I had also decided that I was comfortable holding Chevron longer term. Then the fundamentals changed.
As the price of oil continued to decline going into the first of this year, the company, like all oil companies, struggled with executing in a depressed price environment, analysts cut their earnings per share forecast for 2016 by more than 50% from $2.75 to $1.32. That’s a change in fundamentals. I set a price target of around $90. A few weeks later, I got my wish and was out of 40% of the position at $89. Factoring in the dividend, we made a 23% total return. Not bad for six months work. Annualized, that’s nearly a 50% return. The S&P 500 turned in barely 4% for the same time period.
I kept more than half the position on the books. Chevron is still a high quality company I want to own longer term. Although the company is committed to paying a dividend, there is concern about sustainability of the current 4.5% rate. Management has chosen to protect the dividend over increasing capital spending which would result in higher production, revenue, and earnings growth when energy prices rebound.
However, Chevron has monster annual cash flow in excess of $25 billion and very low long term debt to capitalization of just 17% — about half that of its peers. But, despite the solid balance sheet, the situation bears watching.
Risks To Consider: The biggest and most obvious risk when crafting a sell discipline is opportunity cost — leaving money on the table. Selling just part of the position allows the investor to remain exposed to further upside in the stock while preserving gains and managing risk.
Taxes are also a consideration. In non-retirement accounts, capital gains are taxed at both short AND long term rates. While taking that gain looks good on the surface, a short term capital gain (a holding period less than 31 days) is taxed at the investor’s ordinary income tax rate while long term gains are taxed at a standard 20%. Individuals in higher tax brackets should take this into consideration. Again, the tax implications can be mitigated by selling only part of the position. Investors should always evaluate their tax position and consult their tax professional if necessary.
Action To Take: I still firmly believe in owning high quality dividend paying stocks for the long term. But in today’s low return investment environment, investors should strongly consider taking, at least, partial gains if the opportunity arises. If the market is returning 6% and you’ve made 20%+, you probably need to take some off of the table. The first place to start is formulating an articulated sell discipline. Speaking from experience, missing an opportunity is no fun.
How do you cut a loser loose? I’ll discuss having a sell discipline for the down side next week.
— Adam Fischbaum
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Source: Street Authority