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Ray Merola
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Private investor focusing upon a diversified portfolio emphasizing dividend growth / income. Advocates fundamental investment analysis, confirmed by the technical charts. Options strategies employed to generate additional income, reserve a long position, hedge downside risk or stake a short-term... More
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  • When Should I Sell? Determining an Exit Strategy for My Shares 0 comments
    Feb 3, 2011 8:11 AM

    As the market continues to move higher, many investors ask themselves, “When is it time to sell my stock?”

    Let's explore that question a bit.

    I will begin by focusing upon three basic questions leading up to the tag line:

    • Did I take the original position as an Investment or a Trade?
    • What was my initial thesis for taking the position?
    • What is the corresponding exit thesis?

    Before one can decide when to sell, the security owner must sharpen their thinking around why they bought in the first place.
     

    Did I take the position as an Investment or a Trade?

    For purposes of this article, I define an Investment as a position in a marketable security with the intent to hold it for more than a year. The decision to buy is primarily based upon fundamental investment analysis, often coupled with studying technical charts. Certainly, there are cases whereas a chartist may premise a long-term investment through the using technical analysis alone, but this is less common.

    Fundamental investment analysis include reviewing financial statements, company reports, investor communications, quarterly earnings conference calls, and the news wires. The fundamental investor wants to understand the underlying business, not just the price action.

    The investor may determine an investment is worthwhile because it is undervalued, or has extraordinary revenue / earnings growth potential.

    A Trade is typically associated with a shorter ownership time frame: less than a year, or as little as a few trading sessions. The decision to purchase leans most heavily upon technical charts and / or a shorter-term market swing or corporate event. The intent is not to dissect and understand the business metrics, but to profit from the current price action; as influenced by the market, industry or short-term events.

    Technical charts may include momentum indicators: the MACD or Stochastic studies. Moving averages, Money Flow (NASDAQ:MFI), and Market Strength (Chaiken Oscillator) charts are also common. There are dozens of good technical studies.

    Let me be clear: Investments do not mean Buy-and-Hold, but they tend to have a longer-term horizon. Trades tend to move in and out of the market or a security more quickly, but they are not limited to utilizing only the technical charts, nor must all a Trade be short-term by definition.

    Given the same information, an investor and a trader may come to very different conclusions as to when to buy and sell. Therefore, it's important to determine upfront if one is taking an equity position as an Investment or a Trade. Later in this article, I will come back to this point. Don't take a bad investment or trade and try to re-imagine the premises mid-stream. It's a losing strategy.
     

    What was my initial thesis for taking the position?

    Prior to buying a security, I encourage everyone to have an investment thesis; a clear set of reasons for wanting to own it.

    An Investment may include careful reasoning around a company's strong balance sheet or future EPS projections. Cash flow, dividend or revenue growth prospects may be appealing. Perhaps the company is on the verge of a competitive breakthrough in some market or new technology or is staffed with an exceptional management team. Via metrics, ratios, historical statistics, and business intelligence may prove to the investor a given investment is undervalued, has an exceptionally strong future, or a competitive advantage.

    A Trade, on the other hand, usually requires consulting the charts for to an entry or exit signal. The corporate financials, business strategies and management strength are of less interest. Indeed, Trades may not require the company to be making any money, nor even have a bright future.

    Nevertheless, an Investment or Trade share a common goal: it's not important where the stock has been, but where it's going. The individual's thesis provides the rationale for why such an investment will make money.

    Unfortunately, it is not uncommon to find investors who have no clear thesis as to why they entered into an equity position. Sometimes, it's little more than a hot tip from another person. I've never had much luck with tips. Tips are for waiters.
     

    What is the corresponding exit thesis?

    Now to the heart of the matter.

    The corollary to having a thesis to buy is having a clear thesis by which to sell. This is often the most challenging part of investing. It's the upshot of this article. And it's imperative.

    Even some generally sound investors fall prey to having a hazy view of what they expect an investment to do: and therefore a corresponding hazy view of when they should sell it.

    I submit knowing the proper time to sell is a direct function of having a divestment premise in advance of the sale event.

    “Waiting to see what happens,” is a recipe for disaster. Without a clear thesis to sell, the Investor or Trader is likely to be swept up by those two great impostors: Fear or Greed.

    There are myriad potential exit strategies for any given stock, and any may be appropriate. The key is to have a set of sell premises or signals.

    Selling an Investment

    I offer two straightforward concepts for creating an Investment “sell” strategy:

    • Create a target “sell” price via forecasting future EPS and P/E ratios

    Forming a reasonable opinion of a company's future earnings can be forecast by reading previous corporate earnings reports, reviewing investor presentation materials, and listening to the quarterly investor teleconferences / reading the transcripts. Company management often provides “guidance” on future earnings, cash flow and plans. Years ago, these sessions were generally closed to the small investor. Not anymore. I can assure you that some management teams are very good at providing and meeting their guidance. Others are not.

    While one can also review equity analysts' projections for future earnings, I prefer to use this information as an adjunct to my own personal analysis. Some analysts are quite good, while others are not as accurate. Analysts are subject to the role itself: workload, their knowledge of a particular industry, business relationships with their employer, or with the management team of the company being covered. Utilizing consensus earnings estimates have some element of safety in numbers. Nonetheless, I still believe the surest way to determine the future EPS for most stocks is to read and analyze the information yourself.

    How about that P/E multiple?

    This is where a combination of sound research and alchemy can provide pretty good results. The trick is to anticipate the future P/E based upon historic facts, a knowledge of the industry, and a general macro observation as to where the the overall market is heading. While I could write another article this subject alone, I'll offer some initial guidelines here.

    I suggest the baseline data for projecting P/E multiples come from two sources:

    1. the average multiple over the past five years and
    2. a summary of the annual high and low P/Es for the equity over the same period or longer

    They key is to have the data for a complete economic business cycle. The average cycle lasts about five to seven years. The average P/E multiple can be found on any number of web sites. The annual high and low P/E ratios may be found via the Standard & Poors investment stock investment reports.

    Armed with this data, one can make an educated guess as to what multiple to place upon the stock. It involves a bit of math, some philosophy, and an understanding as to how different stock sectors react at different points in the economic business cycle.

    The second concept is less granular, but just as effective.

    • Plan an exit strategy when the macro trends say so.

    I referenced the economic business cycle in the previous section of this article, and for good reason. Economic business cycles run for about five to seven years. Typically, the cycle ramps up on increasing industrial and consumer demand. Businesses increase production and such production meets increasing demand for goods and services. Initially, demand outstrips supply. Then they equalize. Towards the end of the cycle, businesses overproduce. Associated loose monetary supply tend to lead to inflation. As monetary supply is tightened, business contract. People lose their jobs and consume less. The overall economy contracts, often into recession. Finally, demand outstrips the reduced supply, interest rates are lowered, and the cycle starts all over again.

    Drilling a bit deeper, various business sectors have demonstrated somewhat predictable results based upon their time and place within a given economic cycle. Here's a shorthand list:

    Early Cycle, just after a recession: Benefitingfrom relatively low interest rates and starting from the bottom of the supply-demand curve, Financials, Consumer Discretionary, Technology and Industrials lead the way.

    Mid Cycle, as the economy charges ahead: Demand is accelerating, output is strong, and people are spending money. Technology and Industrials remains strong, and are joined by Energy and Basic Materials.

    Late Cycle, when interest rates are rising and things are looking a bit tired: A robust economy begins to show some fatigue as labor / material costs, and interest rates start to create a drag on businesses. While Energy and Basic Materials still have life, Consumer Staples and Health Care (think Food and Drug stocks) begin to take the stage. Investors look to safer havens and sectors that yield safe cash flows and steady, if unspectacular growth.

    Recession Phase, whereas the economy weakens or contracts: Since people always need Food and Drugs, the Consumer Staples and Health Care sectors are most strong. They are joined by the Utilities and Telecommunications stocks, likewise day-in-day out necessities that offer ratable demand and conservative business strategies.

    Follow the business cycle and invest accordingly. Take the macro cues from the economy and apply it to your stock portfolio.

    Selling Trades

    I likewise offer two simple concepts for selling a Trade:
    • Plan to sell when the chart says so.

    Sounds so simple.  Whatever your plan, stick with it. If your premise is that the MACD must be confirmed by the Chaiken Oscillator, coupled with the stock must falling below the 50-day moving average....then do it.

    Unless there is compelling reason to think you made an error in the initial “sell” premises, it's time to pull the plug.

    • Sell when the “event” that prompted you to buy in the first place has passed.

    This rule is pretty cut-and-dried. If a Trade is premised upon a specific macro or company event, and this event occurs, then it's time to sell. If the premise was correct, you will have made your money. If not, then take the hit and walk away. One no longer has a valid premise for holding the stock.

    Do not turn a Trade into an Investment (Jim Cramer has this point correct) since it means one has papered over one set of premises with another set of parameters. The result is all but certain: Fear or Greed will kill you.

    Conclusions

    Have a clear set of reasons before investing.

    Decide if you are Investing or Trading.

    Forecast what you expect the security to do and how you will know it's time to sell at the time of your purchase.

    The wise investor has two logical choices when the thesis, whether calculated or event-driven, is met:
     

    1. Determine if the “sell” premises require re-calculation and re-assessment based upon new facts and information. If they do, then reformulate your thesis.
    2. Otherwise, exercise discipline and pull the trigger.
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