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Stick with or sell a stock? 5 rules to help shareholders decide

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Written by: Russ Mould
24/01/2020
In many ways, deciding when to sell a stock is even harder than choosing which one to buy in the first place. Here are five rules to help you decide whether to stick or twist.

A classic mistake many investors make is to sell their winners too early while conversely they tend to hang on to their losers for too long.

To help avoid this setback, investors should look at these five simple rules to help keep their discipline when they are selling, as well as when they are buying stocks:

Keep a check-list of why you bought the stock – and refer to it

Before you buy a stock, you should do your research and draw up an investment thesis as to why you think the company is capable of providing you with your desired capital gains, income stream or (combining the two) total returns.

Ideally, you should have five points on a check-list that forms your thesis. When you review the stock when you assess your whole portfolio (perhaps every six to 12 months) you can check how many boxes have been ticked.

If the answer is none, maybe your thesis was flawed. You may just be early, but if nothing is happening then perhaps it is time to move. Equally, if all five boxes have been ticked, is it now all in the price and time to move on? You may be able to come up with new reasons to hold the stock but if not, it may be time to think about taking profits.

Valuation

This is related to reviewing your checklist. If all five reasons for owning the stock have happened, you can’t think of good new reasons (or feel your initial five are no longer relevant) it may be time to sell, especially if a stock looks expensive on earnings, yield, or book value relative to its history, or on a discounted cashflow basis.

You don’t want to get caught arguing ‘it is different this time,’ even if the fund flows generated by algo funds and passive trackers may mean that share prices are capable of running longer than you think in the momentum-driven market that we have right now.

Change in risk-reward profile or stock no longer fits your requirements

Before you buy a stock, you should do your research and draw up an investment thesis as to why you think the company fits with your overall investment goals, target returns, time horizon and appetite for risk (and by appetite for risk we mean your ability and willingness to suffer losses while pursuing gains).

If something happens that means it no longer meets those four criteria that could be reason to sell.

For example, if you bought a stock for income but management then announces a dividend cut it is possible your thesis was faulty and you need to cut and run. If management makes a ‘transformational’ acquisition (which is usually boardroom code for ‘we really wanted it and we know we have overpaid for it’), the balance sheet may now have too much debt for the company to meet your risk-reward parameters.

Portfolio and risk management

You may have nailed it and found a portfolio winner. But you do not want to be too exposed to any single stock, just in case management does something dumb or there is an unexpected event that knocks both the investment case and the share price.

You will know your own comfort level but you should think about rebalancing your portfolio once a year, perhaps adding to laggards where you think your checklist is valid and the valuation attractive, and top-slicing winners where the upside is now less than it was.

You spot a better opportunity

This ties together the first four points. Your research may just unearth a gem that has better prospects than something you currently own. You may want to keep a cash buffer for emergencies, so you have to liquidate a position that you already have. Applying the four points above may help you spot which stock is for the chop.

Russ Mould is AJ Bell’s Investment Director

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