To Sell or Not to Sell: Perfecting the Strategy of Stock Exits

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Welcome to the Supernatural Stocks Podcast on Moneyweb, hosted by The Finance Ghost, your destination for insights from both local and international perspectives, specifically for investors and traders.

Recently, I received a request on social media to explore the idea of determining the right time to sell a stock on Supernatural Stocks. This might be one of the toughest challenges in investing, but I’m up for the challenge. Thank you for your input, and I encourage you to keep sharing your thoughts!

Option 1: This stock is for sale in two-thousand-and-never!

Once upon a time, there was a belief that ‘Diamonds are forever’. That was De Beers’ marketing strategy, at least. However, the advent of lab-grown diamonds has proven otherwise.

This serves as an important lesson for anyone who thinks they can hold onto a stock indefinitely.

Even Warren Buffett sometimes decides to sell shares and has felt regret when watching the stock’s price rise after he sold.

From this, we gain two additional insights:

1. Being a long-term investor doesn’t imply you should never sell; and
2. You’ll drive yourself mad if you analyze every choice in retrospect with the benefit of hindsight.

That said, it’s crucial to learn from your mistakes. Still, it’s important to differentiate between genuine errors and the unrealistic expectation of perfect timing.

Here’s a personal lesson that I learned the hard way: Transaction Capital.

Among local stocks, this was my go-to; my “forever” stock.

SA Taxi appeared to be a promising business. Admittedly, hindsight provides clarity – but if Sabvest had issues and Chris Seabrooke almost got involved with Transaction Capital, how could we less informed investors be aware of the underlying problems?

Moreover, Transaction Capital Risk Services (now Nutun) showed substantial promise, and WeBuyCars appeared to be the growth driver I was confident in. I had worked with the Transaction Capital management team years prior, which led me to believe in their ability to allocate capital effectively.

The stage was set for disappointment. Why? Because I was naive. I don’t just mean the business suffered due to the pandemic’s effects on SA Taxi – that’s market randomness you can’t foresee; hence it’s called risk. I am referring to the valuation.

I should have sold when the share price soared.

I particularly should have sold when the head of TCRS at that time sold shares. I remember considering it but ultimately chose to be greedy.

What’s that saying about pigs? Ah yes, bulls and bears make money, but pigs – pigs get slaughtered. I was the pig. I got slaughtered.

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While I suffered due to what ultimately revealed a significantly flawed balance sheet, I must admit that I earned it. I had labeled a stock as “forever.”

Conditional love. That’s the kind of affection you need for your stocks.

Reserve the unconditional, forever-will-never-change love for your children, and perhaps your dog – or in my case, my cat. And definitely stay alert when executives are disposing of shares that are clearly overvalued. Such insights are invaluable, regardless of your affection for a stock.

Option 2: There’s a price and I’m sticking to it

This is where trading comes into play. You set a target price. You use technical indicators to pinpoint optimal entry points, utilizing everything from momentum indicators to some obscure techniques akin to tea-leaf reading.

However you make your initial decision, there’s usually a well-defined strategy for your exit. You choose a price at which you’ve previously committed to selling, and in fact, you probably have already entered that order into your trading system.

This approach reflects trading, not investing. If held longer, it might shift into swing trading territory, allowing positions more time to develop. Regardless, the selling price depends on factors like key resistance levels or Fibonacci lines, and not the cash flow multiples at that moment.

Top traders excel in two primary competencies:

1. Interpreting charts – assessing the market; and
2. Adhering to a defined plan.

Discussions with traders or tuning into trading podcasts reveal a noteworthy insight: most regrets arise from not adhering to their trading plans. In other words, it’s about failing to sell at the target price they had committed to – choosing instead to hold out for a better deal.

It turns out traders and investors have more commonalities than expected, right? The pigs get slaughtered in both scenarios.

Option 3: The best of both worlds

Declaring your intention to hold a stock forever is certainly problematic. Setting a distinct target price for a short-term sale categorizes you as a trader rather than an investor, pushing you to constantly seek new opportunities rather than let your investment compound over time.

So, is there a middle ground?

Absolutely. There’s a wide range of styles and strategies in between; this complexity makes the topic so intriguing. It’s precisely why identifying the two extremes is vital, as it helps clarify the various available approaches.

What follows is a framework I find beneficial and frequently apply myself. I crafted it, and I’m always receptive to feedback, particularly constructive criticism!

Question 1: What is the chart revealing?

I intentionally start with the chart rather than external factors you should independently consider. Why? Because the market is filled with participants observing the same asset as you, making the chart extremely valuable. Why not take their input instead of working in isolation from the get-go? It’s akin to polling the audience on Who Wants to Be a Millionaire? – except you can do it continuously, not just once in a lifeline.

Simply put, is the chart trending upward toward the upper right corner, or is it showing signs of stabilization or decline?

Momentum is the most potent force in the market, capable of driving prices to irrational levels, significantly benefiting those who maintain their positions.

Traders ‘let their winners run,’ and for good reason. However, they also carefully watch for when the exit sign begins to light up brightly.

When a stock becomes over-extended, it’s cause for concern. But if growth potential remains and robust momentum persists, it may not yet be time to sell, or you might end up regretting it.

Begin with the chart and pay attention to what market participants are indicating before applying your analysis.

Question 2: What does common sense suggest?

This won’t be evident on a chart. Ironically, common sense is often lacking. Individuals tend to cling to beliefs that support their current circumstances. When everything seems perfect, they scramble to find more validation for those beliefs. This behavior is a classic instance of confirmation bias we all display.

Thus, you can’t solely depend on charts. Indeed, momentum is captivating – but once it dissipates, a stock’s price can swiftly tumble. In the few moments it takes to brew a cup of coffee, a stock’s price could drop by 15%, leaving you frustrated unless you’ve established trailing stop losses that adjust as the price climbs.

So why emphasize common sense? Because a more easily understood business is generally easier, and arguably less risky, to manage.

Revisiting the Transaction Capital situation – it was undeniably a complex entity with numerous inherent risks, many of which I conveniently overlooked due to the excitement surrounding WeBuyCars. We all know how that story unfolded. Thankfully, I now hold WeBuyCars directly, and that position has fared exceptionally well this year.

Am I at risk of repeating the same mistake with WeBuyCars? The distinction lies in that WeBuyCars operates as a straightforward business.

There are several common-sense factors indicating they could continue to thrive and capture market share. There’s no need to sift through extensive notes detailing financial intricacies to understand their profit potential. A simple visit to WeBuyCars or selling them your car suffices. Unfortunately, I couldn’t experience SA Taxi as a customer, nor did I grasp all the complex risks associated with that operation.

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I believe this makes it easier to continue holding WeBuyCars, but certainly not forever – we’ve already established that blind affection belongs to your children, not your investments.

Question 3: What do the multiples indicate against averages?

Finally, when a substantial trading history exists, assess the current multiples against historical trading levels. Yes, a share price may have surged considerably, but if profits have kept pace and multiples align with historical averages, then who cares? It’s logical if price increases are in tandem with profit rises.

There’s a crucial distinction between a share price trading at a price-to-earnings (PE) ratio of 15 times after a 50% increase or 25 times under the same circumstances.

If the long-term average sits around 20 times, then the former case presents a stock priced below its average despite the rally, while the latter reflects a stock that has surpassed its average and may risk a correction.

In both situations, the share price has ascended by 50%, thus the percentage return is equal. However, I would feel decidedly more comfortable holding the first stock, hoping for a rebound to its average, while the second would warrant pruning or a complete divestment in anticipation of a multiple contraction.

Closing thoughts: Churn and taxes

Exercise caution regarding overthinking when to sell.

Selling incurs taxes, which can substantially impact your long-term gains, particularly since you may be taxed at the income tax rate if you sell within three years instead of being subject to capital gains tax. As a result, you’re compounding annually using post-tax returns, while those who choose to hold are compounding pre-tax figures.

This is partly why fund managers enjoy a competitive edge in the market; fund structures typically evade taxation when adjusting their positions.

Finally, be mindful of the costs associated with frequent trading. It’s not only your brokerage fees but also the time spent monitoring the market (which also has a price) and the potential gains you might forfeit by selling too soon.

Over the long term, markets generally tend to rise. Isn’t that the primary reason for your investment?

The most successful companies will inevitably reach new heights. That’s our objective.

Be cautious when selling, but don’t completely dismiss it, as I certainly learned through experience.

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