Some investors prefer to hold on to shares for “eternity” to generate recurring and rising dividends. So, they tend not to sell very often.
That being said, there are good reasons to sell off shares, such as for capital gains or to cut your losses.
Here are four reasons for selling shares:
1. Investment mistakes
Mistakes on the stock market come in two categories.
The first is greed, trying to earn fast money by betting on stocks. Losses can happen because of speculation, betting on a higher and faster rise in price that does not materialise. This often happens to rookies.
Second, it could be a value trap. It is a common mistake made by investors in search of value, such as a low price-earnings ratio or price-to-book ratio, and high dividend yields.
It often happens to rookie value investors who understand the logic of investing in stocks that are guided by valuation ratios but lack the experience needed to avoid this trap.
But, in any of these two cases, there will be a significant drop in stock price (more than 15%) on your purchase price (the exception is 2020 due to Covid-19).
Before you decide whether to keep or sell, assess the objective of buying the stocks and why the prices fell.
• Were you caught in a frenzy?
• Did you buy without any research based on recommendations?
• Did you fall into a value trap?
Then, ask yourself, “Would I buy the same stocks at today’s prices?”
If you bought at RM10 a share, would you buy the same stock at RM8 a share and why?
This reveals whether you would keep the stocks you bought for eternity. If you don’t wish to hold on, then sell off your stocks at a price you are willing to accept.
2. Change in fundamentals
Great emphasis should be placed on a stock’s track record of delivering earnings that are consistently growing with the aim of earning rising dividends.
However, sometimes a stock that did well in the past begins to nosedive despite good times. You may want to reassess the future prospects of the stock and, if you don’t think it’s worth holding on to, sell it.
3. Swapping for better investments
You could swap the stocks with deteriorating fundamentals with a list of stocks with improving fundamentals.
But you may ask, “How do I know the stock I am swapping for will not also experience deteriorating fundamentals?”
The answer is, what in your opinion is a stock with solid fundamentals? Can you list your criteria? Why?
Some people buy lousy stocks believing them to be fundamentally solid. Different investors have different opinions as to what a fundamentally solid stock is.
Consider this:
• It has delivered consistent growth in profit and dividends for the last 10 years.
• Cash flow from operations is always positive and, better still, on the rise.
• Low debt or high ability to service the current debt.
• Ample cash to invest for future growth.
• Management has a game plan to grow the business.
If you say past results do not guarantee future results, in some ways it is true.
But successful corporations with a track record of financial prudence are more likely to replicate their financial success as they continue to adopt the right vision and strategies to manage the business.
4. Stock has become overvalued
This is sweet for value investors. Your goose that lays the golden eggs becomes a delicious Beijing roast duck meal in a restaurant.
Another person has a handful of stocks that achieved capital appreciation, but they opt to keep them in their portfolio as they continue to receive incremental golden eggs.
The exception is this – when the market is “frying” stocks bought at dirt-cheap prices with the intention of enjoying stable dividend yields.
Why is this an exception?
Let’s say, you have two stocks, A Ltd and B Ltd. Both are fundamentally solid and have attained a consistent 10% growth in earnings.
The stock price for A Ltd had risen about 10%, reflecting its earnings growth. Meanwhile, B Ltd has risen 100% on hype and excitement in the market. Which of the two would you sell?
The obvious answer is B Ltd. It’s as if someone offers RM1 million for an apartment that pays RM1,000 a month in rental income.
If you are the buyer, anyone would be delighted to sell their apartment to you. This analogy seems absurd but it is quite common on the stock market because common sense and logic are not that common there.
Conclusion
This article was written from the context of a dividend investor and not from the point of view of traders, gamblers or speculators. Investors aim to build their wealth from golden eggs and not on short-term profits.
This article first appeared in kclau.com.
Ian Tai is a financial content machine, dividend investor and author of over 450 articles on finance featured in KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’, and ‘Small Cap Asia’ in Singapore. He is a regular host and presenter of a weekly financial webinar with KCLau.com.