Why breaking up is hard to do – part 2

In the second part of this series we suggest ten ways to make better decisions on selling.

In part one of this series we looked at why selling is so difficult. Now we’re going to examine how to make it easier and more profitable. And where better to start than at the beginning – the point of purchase.

Concentrating on the price we pay for a stock makes good sense. But it’s only the first leg of a three-legged stool that supports a good trade, from the initial purchase to the final sell.

The second leg hits the ground at the same time as the initial purchase. When we buy a stock we should also establish the mental framework and potential trigger points for evaluating when we might get out. By thinking about selling whilst we’re buying, then when the time to sell does eventually arrive – the third leg of a successful investment – we’re more likely to get it right.

There are four simple strategies that the analysts at Intelligent Investor, all of whom have sold poorly many times, including yours truly, employ to increase their chances of getting it right from the start.

When buying, ensure you have:

1. A clear idea of a stock’s intrinsic value

Anchoring can cause investors many problems but in this case it can serve you well. With a good idea of what a stock is worth, your potential exit price becomes that much clearer. And if the share price falls below intrinsic value, you won’t be so easily persuaded to panic. As senior analyst James Greenhalgh says: ‘If and when the stock ends up above my assessment of value, and that assessment hasn’t changed, I begin to sell down.’ Stay focused on the value, not the price.

2. A mental picture of the path you expect the business to follow

Naturally, value changes over time. This is where a road map can help. By having a mental picture of where you expect a business to be in a few years’ time, and the markers it should pass along the way, it’s easier to recognise departures from the expected course.

Of course, if a company surpasses the markers you have in mind for it, as good companies often do, you have less reason to worry, although it’s still vital to check on progress. Either way, your expected roadmap for a stock is a powerful tool, especially if written down.

3. A sell target in mind

Valuations change of course, but as Deputy Head of Research Gaurav Sodhi says: ‘I am pretty ruthless in setting a sell target at the point of purchase because it removes the temptation to hold a stock simply because it is rising.’ Think of your sell target as the endpoint of your roadmap, but be prepared to adjust it for changes in underlying value.

4. A maximum portfolio weighting

The idea of establishing a maximum portfolio weighting at the point of purchase is to focus on how much damage a stock might do in the event of a complete collapse. This can help shift thinking away from company-specific optimism to overall portfolio risk. James Greenhalgh says that as a result of this mental tool his portfolio is ‘quite diversified, with my most significant weighting currently at about 8% (which is high for me).’

Doing all these things should set you up to make good decisions about selling, but you’ll still have to overcome all the emotional and psychological pitfalls when you actually get there. Here are some strategies to help.

When thinking of selling:

1. Ignore recent price movements

The first thing you’ll need to do is forget about recent price movements. It’s all too easy to sell stocks just because they’ve fallen, for fear of further falls, or to hang on to those that have risen in the expectation of further rises. When a stock seems to be on a charge it’s always tempting to hang on for a little longer.

However, as James Carlisle noted when selling Platinum Asset Management a couple of years ago: ‘The truth is that stocks don’t possess momentum, so it’s an illusion that they’re rising or falling – driven by the human instinct to see patterns in things. In reality there's nothing to suppose that a stock that has risen will rise some more, or that a falling stock will fall more; you just have to decide what’s the best thing to do at any given price.’

2. Use tranche selling

Buying and selling in stages can make it easier to deal with price movements, by leaving room to buy more of a stock that’s fallen (assuming the investment case is still on track) and – conversely – by selling portions of stocks that have risen. Not only will this keep your portfolio weighting in check, but it can also help overcome the attachment to a stock that seems to be ‘rising’.

We’ve used this approach successfully with stocks like Sirtex Medical, where we consistently recommended locking in profits and sticking to our 3% maximum recommended portfolio weighting all the way up to above $30. Hopefully members will have made good profits despite the stock’s recent fall from grace.

We've adopted a similar approach with CSL, but in this case the stock has kept rising. We're fine with that, though, and again members will have made good profits while keeping risk in check.

3. Imagine your portfolio is 100% cash

Another good way of overcoming attachment is to periodically reimagine your portfolio and pretend you don’t own any stocks at all. With 100% in cash you can then ask yourself whether the set of stocks before you, at their current portfolio weightings and prices, is what your portfolio would look like if you had to start over.

As Graham Witcomb says: ‘This won’t completely eliminate the endowment effect, but it should help to minimise your commitment to previous decisions.’

4. If that doesn’t work, sell anyway and consider buying back

If pretending you don’t own a stock doesn’t work for you, here’s a more radical approach – actually sell it anyway, and then ask yourself if you’d be happy to buy it back at the same price.

Value investors aim to minimise transaction costs and this technique can obviously increase them, which is why the practice isn’t widespread. But by selling a stock and perhaps waiting a day before you decide whether you want to own it at current prices, you escape many of the psychological traps selling sets for us. It might be worth the brokerage.

5. Revisit the original investment case

As James Carlisle says: ‘It can be hard to notice when an investment case has changed – in the same way as a frog (so they say) finds it hard to notice as water gradually boils.’ This brings us back to the roadmap, which can help tell you how far a company has departed from the reasons why you originally purchased it.

In May 2015, we confessed that the original investment case for SMS Management wasn’t working out. The company’s move into managed services was going OK but it was the promise of a return of high-margin consulting work that had drawn us to the stock. When that failed to materialise we sold. The stock has since fallen a further 60%. Without checking the original roadmap we may have held on.

6. Use the broken thesis test

Where a company has departed from your expected roadmap, and not in a good way, ask yourself whether you’ve made a mistake. A recent example was iSentia. A month after it joined the Buy List we reversed that decision. Analyst James Greenhalgh explains why:

 ‘The commitment principle makes it hard to reverse a decision once taken, especially one like this, broadcast to thousands of members. But we all need to overcome the tendency to look for information that confirms our view and neglect facts that might contradict it. These days I’m much more ruthless about selling stocks, even if it means admitting a mistake in front of members.’

Good investment opportunities are rare. If one fails it’s unlikely to transform into another one of the same calibre. If you think the investment case has changed, but you're still hanging on, it's probably a sign that your psychology is making you do it. The lesson is to sell a stock where you’ve potentially made a mistake before it actually becomes one.

So that’s it, four strategies to get you thinking about selling at the point of buying and six more to deploy when you are thinking about getting out. If there are any techniques you’ve used with some success but aren’t mentioned here, please let us know below.

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