Chapter 14: When to Sell Shares

Introduction

THIS CHAPTER OUTLINES some simple rules for deciding when to sell shares. It is hoped that these rules will provide a systematic process to guide decision making and help avoid common investment mistakes.

The selling rules are applied immediately to company shares that have been bought with a known breakeven buy price. This ensures you know exactly when to sell, while removing the uncertainty and stress involved with making this decision. The only thing you have to commit to is selling company shares when the rules tell you to do so.

Know when to cut your losses

Use a stop loss

When a company’s share price starts to fall, it is not uncommon to see people hold on to shares in the hope that the price will eventually recover and breakeven. This allows investments to move from moderate losses to large losses, which can damage portfolio returns.

By failing to realise a loss at the right time, your investment portfolio loses in two ways. First, you fail to sell loss-making investments before losses become large. When a company’s share price continues to fall it can create larger and larger losses that are hard to recover from.

Second, there is an opportunity cost of holding on to loss-making shares as the money invested could have been better invested elsewhere. You therefore want to sell shares in any company that starts to make large losses, both to limit further downside risk and preserve portfolio value.

Conversely, selling too early is also a mistake many investors make. When a company’s share price falls by a small amount it is tempting to sell the shares immediately; however, this does not allow the company enough time to prove its worth and make a profit. Small movements in price may simply be due to market noise, rather than the idiosyncratic fundamentals of the company.

Selling loss-making shares too quickly on a regular basis can result in too much investment turnover, which increases total transaction cost and hurts portfolio return. You therefore want to ensure that when cutting losses, you are not doing so prematurely.

While price does not dictate the underlying value of a company, if the price has fallen by 20% after purchase there is a strong likelihood that the share price will continue to fall. To limit damage to the portfolio it is advocated to sell holdings where a 20% price drop has occurred. At this point, investment in the company was probably a mistake as large falls in price mean something has gone wrong or has changed and made the investment less appealing or riskier.

Example

Suppose 625 shares of a company are purchased at £4.75 a share. To calculate the breakeven share price, you need to calculate the total cost of the investment, including the stamp duty and transaction costs.

The total value of the shares purchased is £2968.75 (= 625 × £4.75). Stamp duty is charged on share purchases at 0.5% and therefore the stamp duty cost is £14.84 (= 0.5% × £2968.75).

Suppose the transaction cost to buy or sell shares is £12.50, then the round-trip cost of buying and eventually selling later is £25 
(= 2 × £12.50).

Thus, the total cost of the investment is £3008.59 (= £2968.75 + £14.84 + £25).

The breakeven share price is the total cost of the investment divided by the number of shares purchased. Thus, the breakeven share price is £4.82 (= £3008.59 ÷ 625), rounded up to the nearest penny.

If the share price falls by 20% from the breakeven price the shares will be sold. That is, if the share price reaches or falls below £3.86 
(= (1 – 0.20) × £4.82 = 0.80 × £4.82), the shares will be sold. This price level is commonly referred to as the ‘stop loss’ level or ‘stop’ for short.

Choosing a 20% stop loss will typically ensure that you are firmly outside of the market noise when a stop loss is hit and that it is more likely to be investor sentiment over the fundamentals of the company that is driving the fall in share price.

Some investors may question whether a 20% stop loss is too large. After all, a 20% fall in the share price means you need a return of 25% in order to recover the initial amount invested. However, the loss should really be considered in relation to the overall portfolio value.

As you will see in the next chapter, combining stop losses with equity allocation rules ensure that, in the worst-case scenario, no more than 15% of the portfolio value is truly at risk at any point in time. That said, you should start to consider whether to sell the shares once the share price has fallen by 15%.

At a 15% price drop, you should re-assess the investment. If the company shares would no longer be considered for the buy list, you can voluntarily sell; but if the shares are still worth buying, then you should keep hold of them. However, if the price continues to fall and reaches the 20% stop level, the shares should be sold immediately.

Sometimes when you come to sell loss-making shares in a company, you will find that the shares remain on the buy list and the potential returns look enticing. In this case, you should still sell the shares and look to possibly buy them back at a later stage, once downward price momentum appears to have eased. However, one should carefully assess whether the investment case still holds before doing so.

The 20% stop loss is suitable for shares selected for their income or value. However, for growth shares, a tighter stop loss can be used. In this case, one could consider using a simple stop loss that is a few percentage points below the share price low of the previous two or three weeks. Alternatively, you may decide to place the stop a few percentage points below an identified support level. Most stops used for growth shares are in the 10% to 15% range.

Use a time stop loss

Ideally, you should be investing with a minimum investment horizon of three to five years, so that there is no need to react to every market fluctuation. However, if shares are still making a loss (factoring in dividends) after three years of holding them, then there are probably more profitable investment opportunities available.

Growth companies are supposed to be growing earnings rapidly, which should start to drive the price upwards over a three-year period. If a growth company’s share price has not risen after three years from the purchase date you should sell the shares.

For shares bought for income, a small loss of capital after three years is bearable, provided the dividend is maintained, as the income stream should eventually be sufficient to offset a small loss. Thus, for income shares, if the shares have made a loss of less than 5% after three years and the dividend has been maintained (or increased) over the period, the shares do not need to be sold. However, if the shares are making more than a 5% loss (once the dividends paid have been factored in) the shares should be sold. Similarly, if an income share is not profitable after three years and the dividend has been cut, the shares should be sold. For loss-making shares that are not sold, you should check the size of the loss and dividend every quarter thereafter.

Companies bought as a value play may need more than three years for their true value to be recognised. Provided the shares remain on the buy list, the time stop can be extended up to five years. However, should the shares no longer be on the buy list at any time after three years, the loss-making shares should be sold immediately. If value shares are still making a loss five years after purchase, they should be sold in order to take advantage of new opportunities.

Example

Suppose a company is an income share purchased at 150p with a dividend yield of 5%. This means each share is expected to provide at least 7.5p in dividends each year.

Three years later, the share price is 120p and 22.5p (= 3 × 7.5p) has been paid out in dividends. Thus, the price including the dividends paid out is 142.5p, which means the shares have made a total loss of 5% 
(= (142.5 – 150) ÷ 150).

However, a quick check of the underlying fundamentals and broker forecasts suggests that the dividend is unlikely to be cut. The shares are not sold at the end of the three-year period and the sell decision will be re-assessed in three months’ time.

Now suppose the dividend was instead cut in the second year to 4p, reducing the total amount of dividends paid out over the three years to 15.5p (= 7.5p + 4p + 4p). The price including the dividend payout is now 135.5p. This would mean the shares have made a loss of 9.7% 
(= (135.5 – 150) ÷ 150) and should therefore be sold.

Sell if the investment thesis no longer holds

If there are signs of fraud or accounting irregularities it is difficult to make an investment case for holding the shares as the underlying numbers may not be correct. Furthermore, there is an increased likelihood of more negative price shocks ahead. You should therefore sell immediately if there are any signs of fraud or accounting irregularities.

Whether you should sell shares when a profit warning is issued is harder to gauge. For small companies, a profit warning indicates you should sell immediately as there is usually a higher probability of bankruptcy than when larger firms get into difficulties. For large companies (i.e., greater than £1bn) a profit warning is likely to have been priced in very quickly. In this case, assess whether the investment case still holds. If you would still buy the shares today, even if you didn’t already have a holding, then it is worth holding on to the shares, since large companies are much more likely to survive and recover over time anyway. However, no further additions to the holding should be made until a full recovery in profits has been made.

Don’t fall in love with investments

Too often, when you see a company you have invested in do well, it’s easy to fall in love with it and forget that we bought the shares as an investment. At the end of the day, investments need to make money. The quantitative and qualitative analysis should be reviewed at least once a year. If the fundamental investment case for owning shares in a company is no longer viable, you should consider selling the shares.

Know when to take your profits

When company shares become profitable, a common mistake made by investors is to sell and take profits too early. Snatching at profits limits the potential upside and should be avoided.

Conversely, another investment mistake is holding on to shares for too long and letting a large gain turn into a loss. Allowing a profitable investment to fall back into a loss is just not smart, no matter what the reason. You work hard enough to gain an edge in the stock market without allowing the winners to turn into losers. You should aim to run your winners until the share price starts to move against you.

To avoid these mistakes, when a company’s share price rises sufficiently you should start to use a trailing stop loss. That is, you should gradually raise your stop loss as the share price rises to reduce risk and eventually remove it entirely.

When the current share price has risen above the breakeven purchase price by 11%, the stop loss should be moved to 2% above the breakeven share price, locking in a little over 18% of the profits made so far. This ensures that you don’t let a profit turn into a loss.

Similarly, when the share price has risen above the breakeven price by 15%, the stop loss should be moved to 5% above the breakeven share price. This locks in a third of the profit made so far. The use of these stops ensures that when the price falls by more than 8% you will sell and make a small profit. You can then look to repurchase the shares at a cheaper price later or use the opportunity to rebalance and invest in a company with better prospects.

These stops are appropriate for most large and medium companies, which tend to be less volatile than small companies. The disparity between underlying value and market price tends to be no more than plus or minus 10%.

For companies in certain sectors, such as technology or biotechnology, or for small companies, the proposed stops will not be appropriate as prices tend to be more volatile. You should instead look at the price chart and ensure that your intended stop loss has at least one significant area of horizontal price support between your stop and the current price level. Adjust your percentage stop loss appropriately.

Example

Suppose that shares of a company are bought at a breakeven share price of 200p. At the time of purchase the stop loss is placed 20% below the breakeven share price at 160p (= 0.80 × 200p). The amount risked per share is therefore 40p (= 200p – 160p).

Over the next six months the share price rises 5% to 210p. No action is taken, as you are not going to make the mistake of snatching at small profits. By the end of a 12-month period the share price has risen 11% above the breakeven price, to 222p (= 1.11 × 200p). At this point, the stop loss is moved to 2% above the breakeven price, to 204p 
(= 1.02 × 200p). This locks in a small profit of around 4p per share, if the price falls back to the stop level.

The share price eventually rises to 230p, which is 15% above the breakeven share price. The stop loss is moved to 5% above the breakeven price to 210p (= 1.05 × 200p). If the share price falls and reaches the stop of 210p, the shares will be sold and a profit of around 10p per share will be made.

Once a company’s share price has risen above the breakeven price by 25% or more, the investment is considered to have made a large gain. A trailing stop of 15% is then applied. A trailing stop sets the stop-price level at a fixed percentage below the highest closing price after the purchase date. Trailing stops are only ever moved upwards as new highs are achieved and are never moved downwards. Once the price falls below the trailing stop the shares should be sold.

Example

Continuing from the previous example, suppose that the current share price rises to 250p, which is 25% above the breakeven share price of 200p. At this point, the paper profit is 50p (= 250p – 200p) per share. The stop price level is then set 15% below the price high, at 212.5p 
(= 0.85 × 250p). This locks in a profit of 12.5p per share, which is 25% of the profit made so far.

The share price of the company subsequently rises to 260p, making a new high. The trailing stop is therefore moved up to 221p (= 0.85 × 260p), 15% below the highest closing price since the shares were purchased. If the price subsequently falls to 250p, the stop price level would remain at 221p as the stop level should not be lowered.

Additional rules for selling shares

Sell company shares when they become expensive

When a company share price looks expensive relative to its fundamental value, the potential upside for further price gains is limited. Furthermore, any negative news or underperformance by the company is likely to elicit large falls in the share price. So when shares are identified as being very expensive, it is time to sell them and move the money into new investments which offer greater potential for large returns.

Sell income shares when the current dividend yield falls below 2%

For income shares, you can use the dividend yield as the main measure of value. When the share price rises to the point that the prospective dividend yield is below 2% (i.e., the central banks’ long-term inflation level), the shares are considered expensive and you should consider selling. The money from the sale can then be reinvested in shares with a higher dividend yield. Reinvesting the profit also means that there is an additional boost to the amount of income received.

Example

Suppose that 1,500 shares in a company are bought at a breakeven price of 200p per share. At purchase, the shares are expected to pay a dividend of 8p per share over the next 12 months. This is a dividend yield of 4%, so the investment is expected to provide £120 (= 0.04 × 1500 × £2) of income.

Six months later the current share price has risen to 400p. The expected dividend for the following 12 months is now 12p, offering a prospective trailing 12-month dividend yield of 3%. The shares are not sold at this point, as the dividend yield is still above 2% and there is still the possibility of further capital gains.

Six months after that, the share price reaches 600p and the expected dividend for the following 12 months remains at 12p. At this point, the prospective dividend yield has fallen to 2% (= 12p ÷ 600p) so the shares are sold and £9,000 cash is received. The investment has made a capital gain of 200% and over the 12 months paid out a dividend of £120.

If the £9,120 is reinvested at a prospective 4% dividend yield, the investment would be expected to generate £364.80, which is £224.80 more than the previous year. Selling income shares that have become expensive allows you to lock in capital gains and reinvest in higher yielding shares, raising the amount of income that is likely to be received each year.

Note that the dividend yield (defined as dividend per share divided by share price) can fall below 2% if the price goes up substantially or if the dividend yield declines. This rule should only be applied when the yield has fallen due to a rise in price. When applying this rule, if the share price has strong upward momentum you may instead decide to tighten the trailing percentage stop level and sell when the stop is hit. This allows you to take advantage of the upward momentum and exit when this comes to an end.

Sell income shares when the current PE ratio is over 20

A second measure of value is the price to earnings (PE) ratio. When the share price rises to the point that the PE ratio is above 20, the shares are considered expensive and you can choose to sell provided the dividend yield is below 4%. Again, this allows you to take advantage of reinvesting the profits to obtain a higher income stream. If the dividend yield is still above 4% and looks well covered, the company shares are still fulfilling their role as an income share and do not need to be sold.

Example

Suppose a company is purchased at a breakeven price of 100p. For the next 12 months the earnings per share (EPS) is expected to be 10p and the dividend per share (DPS) is 5p. This means that the shares are trading on a forward PE ratio of 10 (= 100p ÷ 10p) and a dividend yield of 5% (= 5p ÷ 100p).

If the share price subsequently rises to 200p and the expected EPS and DPS remain constant, the forward PE ratio will rise to 20 
(= 200p ÷ 10p) and the current dividend yield will fall to 2.5% 
(= 5p ÷ 200p). The shares are therefore viewed as expensive and can be sold.

Sell growth shares when the PEG ratio is over 3

For growth shares, we try to buy company shares with real earnings growth at a reasonable price. If earnings growth falters or the growth potential is fully valued in the share price, the shares are considered to be expensive. The forward PEG ratio (which is the forward PE ratio divided by the expected earnings growth over the next 12 months) is used as a measure of growth at a reasonable price. When the share price rises to the point that the forward PEG ratio is above 3, the shares are considered expensive and can be sold.

Sell value shares when three out of five value measures signal the shares are expensive

Five value measures are used to judge whether value shares have become expensive. The value measures used are: the price to earnings (PE) ratio, the price to tangible book value (PTBV) ratio, price to sales ratio (PSR), price to cash flow (PCF) ratio and enterprise value to EBITDA (EV/EBITDA) ratio.

These measures indicate that company shares have become expensive when: the PE ratio is greater than 20, the PTBV ratio is greater than 5, the PSR is greater than 5, the PCF ratio is greater than 20 or the EV/EBITDA ratio is greater than 12.

When at least three of the five measures indicate that the shares are poor value, the company shares are considered expensive and can be sold. These measures are easy to check on a regular basis as Morningstar publishes the figures daily in their company profiles.

A cut in the dividend may signal a time to sell

Sell income shares when the dividend is cut by 50% or more

When the dividend is cut by more than half it is a strong signal that the company is suffering and may no longer be a reliable dividend payer. Further falls in the share price are likely to occur, so it is worthwhile selling the shares and reinvesting the money in a more secure dividend-paying company.

Sell growth shares if the dividend is cut

For growth shares, the dividend is usually a small proportion of earnings. Nevertheless, maintaining a dividend is a signal of good cash management. If the dividend is cut for a growth share, it may be a signal that there are future problems for the company. In this case, sell the shares if the growth story has changed (e.g., the chairman delivers a downbeat statement for the company) or the outlook based on the numbers looks unfavourable.

Knowing when to buy back in

When an investment in company shares has hit its stop (i.e., the share price has fallen to or below the stop level) the shares are sold and either a profit or loss is made. Reinvestment in the company can eventually be made provided the company is on the buy list, the downward price momentum has stabilised, and the share price has started to rise again.

The share price is judged to have stabilised once the company share price has risen above the high of the previous three weeks and the daily price trend is upward.

Summary

This chapter has outlined a simple set of rules for systematically selling shares. The hope is that by applying these rules you can avoid the behavioural investment mistakes and large losses that accompany them.

In summary, when an investment in company shares is making a loss the shares should be sold when:

1. the share price falls below its trailing stop level (usually set at 20% to start with);

2. the shares are still making a loss (factoring in dividend payments) after three years of holding them (for value companies, this can be extended to five years if the shares remain on the buy list);

3. there is a profit warning or signs of fraud or accounting irregularities.

When an investment in company shares becomes sufficiently profitable, some of the profit should be locked in using trailing stops. When an 11% gain is made, the stop level should be moved 2% above the breakeven price; when a 15% gain is made, the stop should be moved to 5% above the breakeven price. Once a 25% gain has been made, a 15% trailing stop should be used.

If company shares become overvalued the shares can be sold and the money reinvested in cheaper, more profitable shares. For income shares, this occurs when the forward dividend yield falls below 2% or the PE ratio rises above 20. For growth shares, this occurs when the PEG ratio is more than 3. For value shares, a number of value metrics need to be signalling the shares are expensive before being sold. When there is positive price momentum, an alternative to selling immediately is to tighten the trailing stop levels and sell when they are hit.

A cut in the dividend may also signal that it is time to sell. If an income company cuts its dividend by more than half (or a growth company cuts its dividend) it is a sign to look for higher yielding companies (or the earning growth story may be in trouble). It’s therefore time to sell.

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