When do I sell? Part 1 of 3

26 September 2017

When do I sell? Part 1 of 3
25th Sep 2017
When do I sell? This is a question that we get asked most by investors. It is a difficult
question to answer. Selling is difficult to do. We estimate that selling is at least
twice as hard as buying. We also believe that selling is of equal importance to buying. In August of this year, champion investor Ed Seykota was asked on his website, “do you think exits (selling) are more important than entry in trading?”. Seykota cleverly responded, “they have about the same relative importance as breathing in and breathing out”.
Most time is spent by investors figuring out what to buy. Little time is spent figuring out what to sell. This
is despite it being harder and of equal importance to buying. This article is an introduction and will be the
first in a series of articles on selling that will hopefully provide some conceptual ideas to investors.

Introduction:
“The average lifespan of a company listed in the S&P500 has decreased from 67 years
in the 1920s to 15 years today”
– Richard Foster, Yale University.

John Ryder, the founder of Ryman Healthcare in New Zealand recently commented
that of the top 32 companies on the NZX 50 in 1987 are without exception no longer
part of the NZX in 2017, 30 years later.

Companies disappear. They go out of business, they merge or they get overtaken by
new market leaders. Compare the below table of the largest companies in the world
by market capitalisation in the second quarter for 2017 to the second quarter of 2010:

Only 4 of the companies on the list in 2010 make it to the list in 2017 and of those
Exxon has gone from number 1 to 10. Go back further to 1997 and only Exxon and
Microsoft appear on either list. 10 years from now it is probable that these companies
will have rotated again.

As investors, we want to own the best performing companies. If this is truly the case
then we have got to know when to sell and rotate into new leadership. This also identifies the risks inherent in a buy and hold strategy.

Whether you are a short-term trader or a long-term investor there are three reasons
investors will sell. Either to crystallise profits, cut losses or to find better opportunities.

Crystallise Profits:

One reason to sell is to take profits. At some point to realise a
capital gain on a stock an investor must take a profit. This point
seems obvious and is quite easy in retrospect but in reality, is easier
said than done. How often have you sold a stock for a tidy profit only to watch it double from the point that you sold it? (see A2 Milk). Or how often have you wished you sold at the previous peak, only to
hold on hoping it will get back up? (see XRO 2014). Taking profits is hard, picking the
peak like picking the bottom is rare. In later articles, we will cover some simple profit
taking rules to help investors with the decision-making process.

Cut Losses:

Another reason to sell is to cut losses. This is essentially admitting the point that you are wrong. Nobody knows what is going to happen in the stock market and in business
tomorrow. Technology is moving fast but as yet nobody has invented the crystal ball. Not even Warren Buffett is right every time. The best analysis in the world is not always right.
For this reason, investors must be able cut losses to protect their capital when they are wrong. The question is, how do you know when you are wrong? How many times have you sold at the bottom only to watch the stock turn around and go back up? How many times have you interpreted a piece of news as
detrimental to the stock and sold only to watch the company shrug off the bad news?

Better Opportunities:

We have all been in the situation where you buy a stock that does nothing for a couple
of years. All the while the market or other stocks you were looking at move strongly.
It is always important for investors to identify when there are better opportunities and
allocate capital appropriately to these situations.

How to Sell?

The first thing that you must realise as an investor is that you will never perfectly sell. You will never
sell consistently at the peak or at the highest price. Likewise, you will rarely consistently be
able to sell just before a significant drop. What investors need is a system that works okay in
most conditions. Because the perfect system for selling does not exist we are looking for a process
that is sufficient as opposed to excellent.

There are only 2 basic situations in which an investor needs to consider when selling:

1. Selling into weakness.
2. Selling into strength.

Investors can use fundamental, technical, statistical or a combination of factors that
can be used to define strength of weakness.

We believe that an investor can only act on their beliefs in the markets so what might work for one investor will not work for others. Investors need to define what weakness is and what strength is for them. Once they have defined weakness and strength they will be better equipped to spot it when they see it. This will allow investors to act without regret or emotional damage.

In the articles over the following weeks we will provide some common definitions of
weakness and strength from a fundamental and technical perspective. This will hopefully help investors conceptualise what selling is for them.

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