Saturday, June 24, 2023

When to Sell?

When should you sell a stock?  

This is a tricky question that many investors grapple with: When is the right time to sell a stock? It's a dilemma that has crossed my mind countless times. One approach I've found helpful is to frame the question differently: Would I buy this stock at its current price? This perspective shift forces me to reassess the stock's value and consider its potential from a fresh angle.  But after listening to a talk from Li Lu, I find a more structured way to think about it.

The decision to sell depends on various factors and your initial investment thesis. In this post, I want to share my thoughts on the sell decision process in 3 different scenarios, as each situation calls for a different mental model. 

Gain Scenarios

First consider when a stock is showing unrealized gains. When do you decide to sell and cash the profit?  Let's break it down into two situations: 

#1 A superb company with long run-way business

Let's begin with a scenario that often caused regrets for a lot of investors - when is a good time to sell a fast-growing company. Some people cannot resist the psychological satisfaction from realizing gain. 

First of all, make sure you consider the tax you have to pay on that gain. Unless you invest through tax-exempt/deferral accounts, selling and buying back at the same price will result in an incremental loss compared to just holding it due to the tax you pay on that gain.    

If you have found a truly exceptional company with significant long-term growth potential and durable competitive advantages (moat), then according to Li Lu/Buffett/Munger, you should hold on to it indefinitely. 

My 2 cents on this is that it helps when you can identify whether the price spikes are driven by the growth of the business or purely hype. How to tell if it's hype is a separate topic for another time. But for an extreme example, in my opinion it's okay to take some profit when a mature business is trading at 100x price/cash flow.  

#2 Investment in average but cheap companies

These sell decisions are simpler - you sell when the price materialized to the level you want.  In an oversimplified example, let's say you bought Company A (a cash cow with little growth) trading at a price/cashflow multiple of 2x.  After a couple analysts started covering and the stock now is trading at a multiple of 11x which you think it's fair for the boring stock, then it's a straightforward decision to sell.

Similar to asset-play cases. Imagine a burger company with valuable real estate holdings. Despite having little profit, the company owns 15 shops in the greater Toronto area with no debt. These shops were purchased 20 years ago and recorded on the balance sheet at cost. 

You see the company's current market cap is about 1/3 of the value of its real estate deducting all liabilities, so you bought the stock. Subsequently, a fund acquires a controlling interest and announces a leaseback sale on the properties. The market cap now has risen to reflect the value of those 15 shops. 

In this case, selling becomes an easy decision because you had an exit price in mind before you buy the stock.

Loss Scenario

Now let's talk about cutting losses. If the fundamentals have deteriorated or the company's strategy has taken a different turn, it might be time to let go and cut losses. It's never easy to admit that a stock isn't performing as expected. However, if the facts have changed and no longer align with your original investment thesis, and you still keep it, the obstacle to selling is likely psychological - we don't want to see the paper loss come to life. 

If you notice you have revised your investment thesis to keep the stock. Think about whether you are making up a new thesis to avoid putting the loss on your record. 

Bottom line, if your original investment thesis is no longer valid, doesn't make sense to keep it. Make sure to incorporate some of the cognitive biases that are common in investing in your decision checklist. 


Below is a list of 5 common biases in behavioral finance, with explanation generated by chatGPT: 

  1. Sunk Cost Fallacy (Sunk Cost Effect): This bias occurs when individuals continue to invest resources into a project or decision based on the cumulative investment they have already made, even when it's no longer rational or beneficial. They mistakenly believe that the past investment justifies further investment, disregarding the current circumstances or potential future outcomes.
  2. Loss Aversion: Loss aversion refers to the tendency of individuals to strongly prefer avoiding losses over acquiring equivalent gains. People often feel the pain of losses more intensely than the pleasure of equivalent gains. As a result, they tend to be more risk-averse and make decisions that prioritize avoiding losses, even if it means forgoing potential gains.
  3. Anchoring Bias: Anchoring bias occurs when individuals rely too heavily on an initial piece of information (anchor) when making decisions, even if it's irrelevant or arbitrary. The initial anchor can influence subsequent judgments, leading to an underestimation or overestimation of other relevant information or alternatives.
  4. Confirmation Bias: Confirmation bias refers to the tendency to seek, interpret, or remember information in a way that confirms one's pre-existing beliefs or hypotheses. People often selectively notice or remember information that aligns with their existing views while disregarding or downplaying contradictory evidence. This bias can hinder objective analysis and lead to flawed decision-making.
  5. Availability Heuristic: The availability heuristic is a mental shortcut where individuals make judgments or decisions based on the ease with which examples or instances come to mind. If something is more readily available in memory (due to its recent occurrence, media attention, or personal experience), it is perceived as more likely or more important, even if it's not statistically representative or accurate. This bias can lead to overestimating the likelihood of events that are easily recalled while underestimating the probabilities of less memorable events.

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