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There is no simple formula to determine when to sell. The answer is complex and individual according to one's personal circumstances and temperament.
There are really two problems. The first is whether or not to reduce the general level of your portfolio and the second is when to sell particular stocks. If you are unhappy about the percentage of your money invested in the market and about the performance of particular stocks, the remedy is obvious - sell the stocks. However, if you are happy with the general level of your portfolio, but worried about particular shares - that is a very different matter. The general problem of the percentage you invest needs to be considered first.
The key point is to invest only 'patient money' that can be locked up for the long term and will not be needed suddenly. Shares should be bought systematically and well and held for the longer term. They should be selected with the greatest care and attention to detail.
When the Coppock Indicator gives a bullish signal, it usually pays to have your patient money fully invested. After Coppock buy signals, the bullish trend, on average, lasts about fourteen months and the average gain is about 30%. Unfortunately, Coppock does not give reliable sell signals, but a year after the buy signal (the last one was in April 1995) it usually pays to become more wary.
There are also a number of other tell-tale signals of an impending bear market:
As you can see some of these factors are already in place, but against that too many investors seem worried about the market and the institutions are relatively liquid at the moment. The bear is a wily animal and each bear market seems to have a few different characteristics from the last one. As always with personal investment, you have to make the final decision.
When there is too much complacency in the air, it is tempting to become more liquid. Even then, I would advise active investors to leave about 75% of their patient money invested in the market. The main reason for this is that they could easily be wrong. Also, it is almost impossible to judge the top of the market and the bottom when the time comes to re-enter it, and costs and capital gains tax have to be taken into account. For most investors therefore it pays to weather the storm with their patient money.
Everyone's temperament is different, so in a very bearish climate some investors prefer to tune down their investments to 50% of their patient money. If your investments are keeping you awake at night, it obviously makes sense to reduce the percentage invested down to your sleep level.
When making any sales of this nature, it is vitally important to sell off those shares that you are least certain about and those that are most speculative. Shares with very high PEGs and high PERs, for example, would be obvious candidates. In this way, the average PEG on your residual portfolio will be reduced to a lower and more attractive level with a greater margin of safety.
Now we come to the problem of when to sell particular stocks. Let us first examine how Warren Buffett manages his own portfolio. You would be forgiven for thinking that he never deals, as he is often credited with being the kind of investor who ignores the market and likes to hold shares forever. Investors studying his very successful methods should distinguish between his company's core holdings (quasi-partnerships) and more general investments. Of course, if a company is doing well and its shares are going from strength to strength it pays to run the profits. The oldest and best axiom in investment is to run profits and cut losses - that way profits are likely to be large and losses are bound to be small.
In the 1987 report of Berkshire Hathaway, Warren Buffett spells out his approach to selling marketable investments. He first makes it clear that he judges his holdings not by their market prices, but their operating results. As Benjamin Graham said: "In the short run, the market is a voting machine, but in the long run it is a weighing machine". His point was that eventually the market will recognise superior operating results (and increased value) but he did not worry unduly if this took a few years to happen. Buffett is completely confident of his ability to judge the value of a company and confident that, in the end, the market will recognise that he is right. He goes on to explain that his monitoring of operating results is to ensure that: "the company's intrinsic value is increasing at a satisfactory rate". The implication is that if this is not the case he sells, as indeed he did with his company's first British investment, Guinness.
Warren Buffett draws attention to two other reasons that would prompt him to make a sale:
Buffett further qualifies his approach by saying that he does not sell holdings simply because they have risen in price or because they have been held for a long time. He scorns the Wall Street axiom 'You can't go broke taking a profit' and is happy to remain both a holder indefinitely provided the return on capital is satisfactory, management is both competent and honest and the market does not over-value the business. As you can see, these are heavy provisos.
Another reason put forward by Buffett for holding on to exceptional growth shares with competent and honest management is that they are very hard to find and that dealing in shares costs money as well as sometimes crystallising a capital gains liability. When a share, that is not held in a PEP or a personal pension plan, has had a really good run in the market, the potential capital gains tax liability can be many times the original cost. Provided you continue to hold the shares, the Government, in effect, makes you an interest-free loan of the tax that will eventually have to be paid. This loan helps to increase very substantially the capital appreciation on the investment as there are no interest charges and your investment is geared without the usual worry of how the loan will be repaid.
In The Zulu Principle, I suggested that the main reason to sell a share was if the story had changed. By this I meant was there any change in the key factors that had attracted you to the shares in the fist place? If, for example, the company's profits were faltering, a major new competitor had entered the arena and begun a price war or the company had lost a major source of business, the shares should be sold immediately.
In normal market conditions, with an exceptional growth share that is continuing to do its thing and produce excellent year on year results, it pays to retain your holding even if the PEG rises to a slightly uncomfortable level. A PEG of 1.2 (in relation to a market average of 1.5) is as high as I would personally allow, as the margin of safety would have shrunk to a level that would make me feel ill at ease. However, I could well understand some investors deciding to hold on to their favourite investment, even if the PEG rose to the market average.
Above that I would recommend selling and bidding a reluctant au revoir to the shares. If you keep an eye on them, there will almost certainly be another opportunity to buy at a much more favourable price. Meanwhile, your money can be better used in s share that is due for an upward status change, not a downward one.
The most difficult problem arises when a share suddenly begins to perform badly in the market for no apparent reason. After a substantial rise, great growth shares often encounter profit-taking so from one month to another, their relative strength might be poor. If the trend persists and they show poor relative strength over the previous three months that is definitely a cause for concern.
If one of your shares performs badly for several weeks, you should ask your broker for an explanation. There may be a market story that accounts for the poor performance. For example, a key executive may be planning to leave the company, there could be news of an impending major lawsuit or fresh competition entering the market. The other obvious source for this kind of information is press cuttings and a final option is to telephone the company and ask one of the directors or the company secretary if she or he knows of any reason for the shares poor relative performance.
If you can find an explanation, the key question then is whether or not the underlying story (what persuaded you to invest in the shares in the first place) has changed. Re-examine the share in light of all the available facts, including, in particular, the current brokers' consensus forecast and ask yourself if you would still buy the shares today. If the answer is yes, grit your teeth and hold on.
Some people believe in averaging, which means buying shares on (hopefully) short-term weakness to reduce the average cost of their investment. I recommend you resist this temptation. I prefer to buy more of a share that is rising - reinforcing success seems to me to be a better approach than compounding failure.
Some investors will find that they cannot stand the worry of a share continuing to fall, particularly when no explanation can be found. Many commentators recommend stop-loss systems and if this is going to make you sleep better, by all means use one. You can for example set a stop-loss at 20% below your purchase price or a trailing stop-loss of say 20% - 25% below the highest price registered by the shares. The trailing stop-loss means that if the share does very well in the early stages, you can make sure of locking in some profit.
My preference is to hang in there, until I can find a reason for the fall. A low PEG provides a margin of safety and buying shares in a systematic way is very different from speculating in, for example, bio-tech and concept stocks, which often have no earnings and no commercial products. With these kind of shares a trailing stop-loss is mandatory. I do not recommend them though - why gamble when you have a formula that works?
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