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Deciding to Sell: The Key to Mastering Stock Exits

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Welcome to the Supernatural Stocks Podcast on Moneyweb hosted by The Finance Ghost, your source for local and international insights tailored for investors and traders.

Recently, I received a social media request to discuss the concept of deciding when to sell a stock on Supernatural Stocks. This topic is perhaps the most challenging aspect of investing, but I’m giving it my best shot. Thank you for your suggestions, and please keep them coming!

Option 1: This stock is for sale in two-thousand-and-never!

Once, people believed that ‘Diamonds are forever’. That’s what De Beers promoted, at least. However, the rise of lab-grown diamonds has taught us otherwise.

This is a crucial lesson for anyone who thinks they can hold a stock indefinitely.

Even Warren Buffett makes the decision to sell shares at times, and he has regretted it when seeing the stock price climb after a sale.

This brings us two more insights:

  1. Being a long-term investor doesn’t mean you should never sell; and
  2. You’ll drive yourself crazy if you analyze every decision retrospectively with the blessing of hindsight.

That said, it’s essential to learn from mistakes. However, distinguish between genuine errors and the unachievable aim of perfect timing.

Here’s a personal lesson I learned in a tough way: Transaction Capital.

Among local stocks, this was my ride-or-die; my “forever” stock.

SA Taxi seemed like a fantastic business. Sure, hindsight is 20/20 – but if Sabvest faltered and Chris Seabrooke was nearly entangled with Transaction Capital, how could we lesser investors grasp the underlying issues?

Also, Transaction Capital Risk Services (now Nutun) was a solid base, with WeBuyCars seen as the growth engine I was quite confident in. I had collaborated with the Transaction Capital management team years earlier, which led me to believe I understood their ability to allocate capital effectively.

The stage was inevitably set for disappointment. Why? Because I was naïve. I’m not just referring to the business collapse amid the pandemic’s impact on SA Taxi – that’s market randomness that you can’t predict, which is why it’s termed risk. I’m referring to the valuation.

I should have sold when the share price skyrocketed.

I particularly should have sold when the head of the TCRS business at that time sold shares. I remember contemplating it and ultimately chose to be greedy.

What’s that phrase about pigs? Ah yes, bulls and bears make money, but pigs – pigs get slaughtered. I was the pig. I got slaughtered.

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While I suffered due to what ultimately revealed a severely flawed balance sheet, I must admit I deserved it. I had branded a stock as “forever.”

Conditional love. That’s the kind of love you need for your stocks.

Reserve the unconditional, forever-nothing-will-change love for your children, and maybe your dog – or my case, my cat. And definitely pay attention when executives are selling shares that are clearly overpriced. Such information is critical, regardless of your affection for a stock.

Option 2: There’s a price and I’m sticking to it

Enter the realm of trading. You establish a target price. You incorporate technical indicators to identify the right entry points, using everything from momentum indicators to the more obscure techniques that somewhat resemble tea-leaf reading.

However it is that drives your initial decision, there’s generally a clear strategy for your exit. You determine a price at which you’ve previously committed to selling. In fact, you likely input that order into your trading system already.

This is trading, not investing. If held longer, it may enter the domain of swing trading, where positions are allowed more time to develop. Regardless, the sale price is guided by factors like key resistance points or Fibonacci levels, not the cash flow multiples at that time.

Top traders excel at two main skills:

  1. Reading charts – interpreting the market; and
  2. Adhering to a plan.

Conversations with traders or listening to trading podcasts reveals a notable insight: most regrets stem from failing to follow their trading plans. In other words, it’s about not selling at the target price they had promised themselves – holding on for more instead.

It turns out traders and investors have more in common than expected, right? The pigs get slaughtered in both scenarios.

Option 3: The best of both worlds

Declaring that you’ll hold onto a stock indefinitely is certainly problematic. Setting a specific target price for a short-term sale categorizes you as a trader rather than an investor, compelling you to routinely seek fresh opportunities rather than letting your money compound over time.

So, is there a middle ground?

Absolutely. A broad spectrum exists in between; numerous styles and strategies. This complexity renders the topic fascinating. It’s also why establishing the two extremes is crucial, as we comprehend the different approaches available.

What follows is a framework I find useful and often use myself. I’ve devised it, and I’m always open to feedback, especially constructive criticism!

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Question 1: What is the chart indicating?

I purposefully begin with the chart rather than external factors you should consider independently. Why? Because the market is full of participants examining the same asset as you, and therefore, the chart is invaluable. Why not factor in their insights rather than working solo from the outset? It’s akin to polling the audience on Who Wants to Be a Millionaire? – except you can do it continuously, not just once in a lifeline.

Simply put, is the chart trending upward towards the upper right corner, or is it showing signs of consolidation or decline?

Momentum stands as the most potent force in the market, capable of pushing prices to irrational heights, greatly benefiting those who maintain their positions.

Traders ‘let their winners run,’ and with good reason. Yet, they also meticulously monitor for when the exit sign begins to glow brightly.

When a stock becomes over-extended, it’s time for concern. But if there’s still potential for growth and strong momentum remains, it may not be time to sell yet, or you might end up regretting it.

Start with the chart and observe what market participants think before applying your analysis.

Question 2: What does common sense suggest?

You won’t find this on a chart. Ironically, common sense isn’t always in abundance. People tend to latch onto beliefs that align with their current situations. When things seem perfect, they’ll scramble to discover more justification for those beliefs. This tendency is a classic manifestation of confirmation bias that we all exhibit.

Thus, you can’t solely rely on charts. Indeed, momentum is captivating – but once it fades, a stock’s price can plummet rapidly. In the time it takes to brew a cup of coffee, a stock’s price could fall by 15%, leaving you with irritations unless you’ve set trailing stop losses that adjust as the price increases.

So why focus on common sense? Because a simpler-to-understand business is generally easier, and arguably less risky, to maintain.

Returning to the Transaction Capital scenario – it was undoubtedly a complicated entity with numerous underlying risks, several of which I conveniently disregarded due to excitement around WeBuyCars. We know how that story ended. Thankfully, I now directly hold WeBuyCars, and that position has performed exceptionally well this year.

Am I risking the same mistake again with WeBuyCars? The distinction is that WeBuyCars operates as a straightforward business.

Numerous common-sense factors indicate they could continue to thrive and capture market share. There’s no need to sift through extensive notes detailing financial derivatives to comprehend their profit-making potential. A simple visit to WeBuyCars or selling them your car suffices. Unfortunately, I couldn’t experience SA Taxi as a customer, nor did I grasp all the intricate risks associated with that operation.

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I believe this makes it easier to continue holding WeBuyCars, though certainly not forever – we’ve already established that blind affection belongs to your children, not your investments.

Question 3: What do the multiples indicate versus averages?

Finally, when there’s a considerable trading history, examine the current multiples as compared to historical trading levels. Yes, a share price may have surged significantly, but if profits have kept pace and multiples align with historical averages, then who cares? It’s logical if price escalations correlate with profit increases.

There’s a critical distinction between a share price trading at a price-to-earnings (PE) ratio of 15 times following a 50% increase or 25 times under the same conditions.

If the long-term average sits at, let’s say, 20 times, then the former example presents a stock priced below its average despite the rally, while the latter indicates a stock that has outpaced its average and risks a retreat.

In both scenarios, the share price has gained 50%, hence the percentage return is equal. However, I would feel considerably more at ease holding the first stock and dreaming it rebounds to its average, while the second warrants trimming or a complete sale in anticipation of a multiple contraction.

Closing thoughts: Churn and taxes

Be cautious about overthinking when to sell.

Selling triggers taxes, which can significantly impact your long-term gains, especially since you may be taxed as income tax if selling within three years rather than capital gains tax. Consequently, you’re compounding annually using post-tax returns, whilst those who continue holding are compounding pre-tax figures.

This is partly why fund managers possess a competitive advantage in the market; fund structures typically avoid taxation when adjusting positions.

Lastly, be aware of the costs associated with frequent trading. It’s not only your brokerage fees but also the time spent observing the market (which also has a price) and the potential gains you might miss out on by selling prematurely.

Over the long run, markets tend to rise. Isn’t that the reason for your investment?

The most successful companies will consistently reach new heights. That’s what we aim for.

Exercise caution when selling, but don’t shut it out completely, as I’ve certainly learned the hard way.

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