Here at the Fool, we’re focused on finding, buying and holding quality stocks for the long term. That said, we also recognise that selling can be something all investors need to do now and then for a variety of reasons.
I’m not going to dwell on those reasons today. Instead, I’m going to suggest three questions investors should ask when it comes to selecting which stocks should be dumped first.
1. Has the story changed?
It can happen that companies which seemed great buys a few months/years ago have come unstuck.
Perhaps the technology they sell is now outdated and demand has dropped accordingly. Perhaps the firm has become complacent and a competitor has started to steal market share.
Perhaps a promising new product has failed in tests, or the next-big-thing isn’t quite as groundbreaking as management once suggested. Perhaps a new, highly motivated CEO is taking the firm in a direction you believe could actually damage its long term future.
Whatever the reason, it can sometimes be best to sell out and look for a more secure home for your cash. As the great economist John Maynard Keynes is rumoured to have remarked, “When the facts change, I change my mind. What do you do, Sir?“
2. Will things really get better?
As painful as it can be to ditch a company you once believed in, it can often (though certainly not always) be right to do so. Some stocks never, or are very unlikely to, recover. Think Carillion or Debenhams or, more recently, Thomas Cook.
The question is, how big should you allow your losses to get before pulling the plug? Although this is very much down to personal preference, many investors allow their holdings to dip 20% in value before selling. There’s a mathematical reason for this.
If a stock you own falls by this percentage, you’d need it to regain 25% to break even. That’s possible, but it’s also a challenge. In the meantime, you could be invested in a company with a far brighter future.
If your investment is down by 40%, you’d need a gain of 67% just to get back to what you paid for it. If you’re down by 50%, you’ll need the stock to double in value. You get the picture.
3. Are directors selling?
I’m heartened when I find a company where senior management owns a large proportion of its shares. Theoretically, those with lots of cash tied up in a business should work harder to make it a success.
I’m somewhat less impressed when I see them dumping amounts of said stock on the market. There are, of course, legitimate reasons for these sales. A new home or a costly divorce bill being two examples.
Since the seller is unlikely to give his/her reasoning, however, it’s better to look for two things. The amount they are selling relative to their overall holding and whether other members of the board are following his/her lead.
But a leader drastically reducing their stake could indicate concerns about the future of the business. Even if none of the above apply and the manager is simply taking a profit on their investment, the sale sends a message that they now consider the company to be over- or at least fairly valued, and any upside in the near term could be limited.