BackKnow when to hold them, know when to fold
It may be more vital to know how to identify a loss-making stock, and sell it; rather than how to pick a good stock
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Daily ups and downs in stock prices are a given and known to investors. However, what if the stock you hold has been relatively underperforming, either the broad market or other similar stocks within the sector?
Sample this: despite the benchmark indices having moved up around 8% in the last three months, some popular large-cap stocks such as HCL Tech, Infosys and Idea Cellular have corrected 10-13%.
Does this under performance reflect a fundamental change, which may be an adequate reason for you to sell? On the other hand, what if it’s more a case of negative market sentiment, should you still sell?
Buying a stock to add to your portfolio is not a difficult decision. However, it is probably the most challenging task to sell it at a loss, if the stock is not moving as expected. Of course, for an average retail investor, equity is about investing for the long term. Then why are we talking about selling—and that too at a loss? That’s because not just investors and traders, the best of fund managers can go wrong occasionally on the stock choices they make. Moreover, markets often play truant and stock prices fall more sharply than you may have expected them to.
The decision to sell isn’t an easy one: selling at loss is akin to accepting failure, it is psychologically difficult.
Nevertheless, cutting losses at the right time is critical for maximising returns, whether you are a trader or a long-term investor. For investors, the idea is not to sell just because a stock’s price is falling, rather they must identify if the fall reflects fundamental changes in earlier assumptions, which would increase the opportunity cost of holding on.
Traders and investors are likely to approach this differently. For a trader it’s all about price. For an investor it has to be about value. Let’s look at the investors first.
Cutting loss for investors
The assumption is that an investor buys a stock after due diligence on the fundamental value of a stock. Ideally, if the fair value of a stock is higher than the market price, it pays to buy or hold that stock. The opposite is also true—sell if fair value is lower than market price—but when?
Take the case of Just Dial Ltd, which was listed in June 2013 and immediately shot to fame: its stock price went up 3.5 times by August 2014. Two years hence, at 557, it’s almost back to the IPO issue price. Or Jaiprakash Associates Ltd, which fell from a high of 90 in June 2014 to a low of around 30 in a matter of four months. Today it trades at around 12 At what point should you have identified that the stock was perhaps overvalued, and cut losses? How do you find out when to sell and know why to sell?
Fund managers are clear on this: when there is a fundamental shift in the business that can impact earnings growth negatively, it’s probably time to sell.
“Ideally, the only reason to sell is when earnings aren’t progressing as you predicted. Market movement could be negative at different points in time but then everything moves down so that’s not a concern," said Anup Maheshwari, head equities, DSP Black Rock Investment Managers. Once a case for selling is identified, the price really isn’t important.
A fundamental change in a company alludes to things like change in asset value, management change and an earnings degrowth, among other things. If these aspects change, its more than likely that the value of a stock will also get altered. Understand, that in such cases the focus is not on what price you sell or if you make a gain or loss. Rather, evaluate the value of a stock given all the information available and determine its worth relative to the market price.
“We have a framework for stock selection. Decisions are based on assumptions around growth of a business and its drivers. These factors are monitored continuously and if the stock’s fundamentals and its price are not in sync with your expectations, it doesn’t make sense to hold on. On the other hand if the stock is correcting but the business case hasn’t changed, then we don’t shift our position," said Shailesh Bhan, deputy chief investment officer, equity investments, Reliance Nippon life asset management Ltd.
Bhan agreed that looking at your purchase price is futile, as it’s never too late to sell. Your decision has to be based on the price today, how a stock was valued previously is not relevant.
Cutting losses for traders
For trader, price is important and value has lesser importance. Traders usually think about making money in short to very short time, even intraday. They don’t have room to evaluate the fundamental value of stock, the intention is price gain.
In such a case, to prevent losses from becoming too large, the prudent strategy is to fix a strict stop-loss point.
“Many traders work with leverage, which means that they can’t afford the loss to be too high. Stop losses are set according to the trade tolerance; for intraday traders who trade 40 times a day, 3-5 points shift in Nifty matters. Others can set it at 5-10%," said Deepak Shenoy, founder and chief executive officer, Capital Mind, a capital markets and financial analytics firm. But a stop loss doesn’t have to mean a loss. It is the price at which you exit, he added. For traders, disciplined trading is very important. Nevertheless, the objective of both long-term investors and short-term traders is the same when they know that it is time to sell a stock that isn’t performing: minimise the loss.
Why it is difficult to sell
Behavioural finance suggests that investors and traders tend to often demonstrate loss aversion. This is not a new discovery, and academia suggests that it is widely prevalent. Loss aversion refers to the inclination to hold on to losses more dearly than taking the opportunity to pursue gains. This, among other things, can make you stick to that bad decision far longer than is rational to do so.
When it comes to selling stocks, fund managers identify this as a problem of looking at prices rather than the value. “Looking at prices for buying and selling is speculation. For investors the intrinsic value of a stock is more important. If that isn’t under stress, you can hold a stock for 5-10 years and then short periods of volatility don’t matter," said Bhan.
But this is easier said than done. Emotional attachment to a stock might mean that even when there is a reason to sell, you hold on. This isn’t productive because there is an opportunity cost involved. There could be a relatively better-valued stock in the market, which you may be missing out on. Moreover, you may not want to realise or book the loss, as long as it’s notional, because you haven’t given up the hope of revival.
“It’s very hard for an investor to let go of the cost bias. It is possible to avoid this by looking at the cost of holding as that of the previous-day closing, rather than the price you bought at. Everything else in terms of information and price is already accounted for," said Nilesh Shah, managing director, Kotak Asset Management Company Ltd.
Yet for investors, it’s also important not to act in haste. If you have a longer-term view on a particular sector, then sometimes it makes sense to hold on despite current earnings not progressing as you anticipated.
“You might want to sit through an interim downturn if you think that the long-term story in a stock is intact, despite present complications. In some cases, where this is true, we have built up the position slowly (even though market price could be falling) over a few months rather than exiting," said Maheshwari.
About mutual funds
It isn’t the same as dealing with stocks. You are entrusting the fund manager to have done all the above when it comes to buying and selling stocks. But you could find yourself in a position where you are holding a fund for a year or two and the returns aren’t picking up in an otherwise rising market.
Mint Money looked annual returns of 14 large-cap funds in the last 10 years. Except once for a period of two years in succession, not one of these funds has been the top performer for more than a year at a time. In fact, the top five schemes in terms of returns keep changing. Give your fund time to show results.
“We analyse and update our recommendations every quarter by evaluating returns across various time periods within the peer set. You can’t invest or sell on the basis of what’s happened the last 6-12 months, rather at least 3-4 years of performance is important. Recently, the consistent underperformance in some of HDFC MF schemes has led us to recommend our clients to sell and shift to other consistent out performers," said Karthik Jhaveri, founder and director, Transcend Consulting India.
This means you can’t be too quick to sell your funds. It’s only consistent underperformance over longer periods that should sway you. Often when a fund manager quits, you may be tempted to follow, but if it is an underperforming fund, then following the fund manager could be counterproductive.
The purpose of an investment is to grow and create wealth. To do that there has to be an underlying reason: it is the fundamental business strength in case of a stock, and fund-management skills in case of a mutual fund. Sell if either of the above deteriorates.
Cutting losses is important but don’t look back at the price or try to redeem your decision by holding on. The day you find out that a stock’s underlying value is less than its market price, that is a good day to sell—regardless of the purchase price.
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