Today, many seasoned investors are sounding the alarm that the Indian stock market is over-heated. As a long-term investor, you may also be looking to sell some shares to rebalance your portfolio to your preferred asset allocation, lock into unexpected gains or raise cash to capitalise on a future fall.
However, it can be very hard to decide what to sell. Most of us, as amateur investors, are strongly tempted to sell our big gainers and hang on to the losers in our portfolio. This is the equivalent of cutting the flowers and watering the weeds, which Peter Lynch warned about. Selling the most promising holdings too early is the reason why many retail folk lose out on multi-bagger opportunities.
So how do you identify your sell candidates? Apply the following tests.
Re-rating or earnings growth?
When we run through our portfolios trying to identify sell candidates, we are strongly tempted to sell positions sitting on big gains, as we fear the gains may soon disappear. We are reluctant to sell loss-making positions as we hope against hope that they will get back to our buy price. This is our behavioural biases getting the better of us. If we want long-term compounders in our portfolio, we must learn to hang on to winning stocks as long as the business has a growth runway.
Therefore, the first rule to selling right is to focus on the valuation of stocks we own, and not their absolute (or percentage) gains. To figure out your top sell candidates, identify the stocks trading at the biggest valuation premium to the market, the sector and their own historical valuations. You may define valuation as price-earnings (PE), price-to book value (P/B), dividend yield or any other measure.
Refer back to the valuation at which you bought the stock. Gauge how much of the stock price gains can be attributed to earnings and book value growth and how much to market re-rating of PE, P/B. This gives you a good handle on whether the gains have been driven mainly by fundamental improvements or market perception. The higher the contribution from valuation re-rating, the more susceptible the stock is to giving up its gains.
Is growth cyclical?
When evaluating earnings growth, it is critical to understand if it is sustainable or cyclical in character. Some sectors and businesses are by their very nature cyclical. They deliver in a few years of blowout growth in a favourable business cycle, followed by anaemic growth when the cycle turns.
In a bull market, investors can develop amnesia about business cycles and begin to view cyclical businesses as secular growth stories. This leads to PEs expanding on cyclically-high earnings. Today, good examples of such re-rating are stocks from capital-intensive sectors such as hospitality, travel, real estate and discretionary consumption. Spending on travel and lifestyle products/services has rocketed in the last four years because the Covid unlock (like a post-war economy) prompted consumers to splurge like there was no tomorrow. As this sentiment prop wears off, these sectors could see a sharp moderation in both volumes and pricing, which can disproportionately dent earnings. Selling down cyclical stocks that are sitting on high valuations on high earnings can help you avoid big draw-downs if and when a downtrend hits.
Shifting ownership
If there’s one set of stakeholders who know more about where a business is headed than anyone else, it’s the promoters. Therefore, the price at which promoters of a company think it is a good time to offload shares, is a good time for you to exit too. Here, cues from private sector promoters are more useful than cues from the government as a promoter, because its sales may not be driven by valuation considerations.
In the last five years, promoters of many Indian companies have used sky-rocketing valuations to offload stakes. Data from Primeinfobase shows that private promoters trimmed their stake in NSE-listed companies from 45.1 per cent to 40.8 per cent in the last three years alone. Some of them have steadily sold down their holdings in the market. Some have sold out through large deals with private equity or strategic investors.
Once you identify stocks trading at a high valuation, taking stock of how their promoter holdings have moved over the last four years can be a good cue to whether you, too, should be selling out. The counter-parties to promoter sales matter too. Stocks with mainly retail and low institutional holdings will be more vulnerable to a market meltdown, than those with higher institutional ownership. This is because retail investors typically have lower conviction to hold on in an adversity than institutional investors.
Conviction levels
In bull markets, even the most disciplined of fundamental investors are tempted to take a punt on tactical trades and stocks that look good on the charts. You may also skip your normal due diligence to capitalise quickly on opportunities you’ve spotted. But when you buy a stock without a complete understanding of what makes the business tick, it can be very tough to decide how long you should hold on or when you should exit.
Therefore, one good way to decide on your sell candidates is to get out of positions where you have lower knowledge and conviction about the underlying business.
In fact, if you framed a really water-tight investment thesis when buying a stock, the time to sell it will be very clear because you would know whether your thesis played out.
Comments
Comments have to be in English, and in full sentences. They cannot be abusive or personal. Please abide by our community guidelines for posting your comments.
We have migrated to a new commenting platform. If you are already a registered user of TheHindu Businessline and logged in, you may continue to engage with our articles. If you do not have an account please register and login to post comments. Users can access their older comments by logging into their accounts on Vuukle.