Friday, February 13, 2015

We all know when to Buy, but when do we Sell?

SMOL had a very interesting post today, and although it was directed at Value investors specifically, I think the scope has to be broader for me to have a more complete thought on this, which is why I decided to write a full post on this.

Much of the financial media is focusing on Buying. Buy, buy, buy. Rarely you will hear people outspokenly say to sell.

"What stock was that again Amanda? I'd buy anything that you, Kayla Tausche or Kelly Evans say"

However, just like you need two hands to clap, you need to know how to buy and sell.

Buying is not a problem, most people are good at buying. Just think of how many things you bought today. How many things you bought this month! However job aside, how many things that you own have you sold this month?

Personally, I think there there is a psychological, behavioral and emotional barrier that make sell decisions so much harder than buy decisions. Our whole lives we are so used to buying, but we are not used to selling. Seller's remorse, emotional attachment, FOMO (fear of missing out) and even irrational possessiveness are some of the many things that can hinder us from pushing the "Sell" button.

With all the infinite wisdom available in books and off the internet, I personally believe that when it comes to money, finance and business, there is only 1 golden rule:

Buy low, Sell high

I know it sounds almost stupid to keep saying this, but if there's is only one thing that you should ever remember, this is it.

However, the problem comes when people no longer sell. Some people never sell. This is because of the new buy-and-hold-forever-investor which financial literature and indexing investing has promised to deliver market returns. There is also the onset and popularity of "Income Investing" where people search for investments that pay out cash periodically. The aim is for this paid out cash is to cover expenses, and thus the holy grail of "financial freedom" is reached.

I too must admit this this style of investing is very attractive. Having dividends paid out periodically helps you to psychologically stick with an investment by getting small treats along the way. But it also removes the "Sell" ability in your toolkit, or at least makes it very unattractive to enact. Why sell it when you can just sit on it and it will lay out money?

The way that I see many income investors are that they are paying an upfront amount for a projected future cashflow. When you buy bonds, your cashflow is stable and more certain, therefore lower. If you buy stocks, your cashflow is fluctuating and less stable, therefore higher. This means that for example, every $100 spent is equal to $5 of recurring future cash returns in their eyes.

If you think of investing this way, then the capital gains or losses make no difference. Instead, the real driver of a sell decision in this scenario is if you think that future cashflows will no longer be sustainable, or are header lower to a certain threshold that you are not comfortable with. Then, it would make sense to cash out for investment and look to buy cashflows elsewhere. When cashing out and looking for an alternative, only then does residual value become important. However, if you never plan to sell, then really, does the capital gain or loss makes a difference?

Of course, the issue of opportunity cost is now the main issue. If your investment has appreciated from $100 to $200 in capital value, but the cashflows are still the same at $5, what should you do? Do you sell it? Personally, I believe that in this case, sell the investment and use the capital to buy 2 X $100 investments and get 2 X $5 cashflow, which doubles the cashflows that you are getting. Why not? As long as there are better valued investments.


Maybe this might go against some people's investment belief, but I believe at a certain price, ANYTHING can be attractive. Anything. Like a ship filled with cow dung. And at certain price, I will sell ANYTHING. Like my small finger. If you paid me $10 million for it, I'll be booking my surgical appointment later.

Few investments are so fundamentally horrible that at 1 cent they are not attractive. And few investments are so fundamentally awesome that they are worth the Sun and the Moon.


Would I buy a Chery QQ for $1000? Yes, I would. Even if I sold it for parts, I would make money.


Would I buy a Lambo for $100 million? Go fly kite.

This is the concept of undervalued and overvalued. There is no perfect underlying investment. It all depends on the valuation.

Even though I would like to consider myself a value investor, I think the main driver of buy and sell decisions is valuations. It is also a bit of feeling and experience. Sometimes an investment might rocket out from being severely undervalued to nosebleed valuations. Maybe Taylor Swift tweeted about it or something, who knows. I'll definitely sell it. If it was a good underlying investment, I'll hope to buy it again when it's price is no longer ridiculous. Other times the stock just slowly drifts upwards from undervalued to fairvalued. At this point of time, you need to assess if you are willing to sit on this stock to collect cashflows with some margin of safety (the unrealized capital gains) or if you wanna cash out. Other times the stock falls further into deep value territory. Is it a value trap? Only doing your homework might tell you if it is.

Perhaps, let me pose this question to you. If you could only know ONE thing about a stock, would you rather know it's unit price or it's valuation? Unit price of a stock is utterly meaningless without knowledge of amount of shares issued, at the very least. However, with valuations, even rudimentary ones like P/E or P/B, you would have much better odds of making better investment decisions.

Selling off some of your stake and holding on to some is a good psychological way to help encourage you to realize your profits and lock in some gain. The world of investing is not so black and white. There is no need to be 100% stocks, 100% long, 100% REITs or 100% anything. You don't have to be 100% in or 100% out. In fact, I think scaling in and out is the more conservative and rational approach!

In summary, I think that knowing when to sell is equally as important as when to buy. Selling to cut losses or to lock in a profit both have to be tools that an investor should be comfortable using. Of course, what do I know? I'm just 25.

The beauty of investing is that, like Rome, there are many ways to get to where you want to be. But like I said, of course some paths are easier than others and will get you there quicker. The most important thing is actually to make sure you know where your Rome is and where you are. How you want to get there, well, that is your choice.


4 comments:

  1. Hi GMGH

    Very good post.

    Sums up everything that an investor is required to understand about buying and selling.

    When you find a great business that keeps producing great returns, why do you even need to think about selling??

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    1. Thanks B!

      Actually, I feel great underlying businesses that have their stock prices recently run up is a tough one to think about, since it is possible that their overvaluation can be eased down by earnings growth, making them more of an exception rather than the norm when it comes to mean reversion.

      Do you sit on it and happily collect dividends while having a nice fat margin or safety from unrealized capital gains?

      Or do you lock in the gains and exit, since you know their current run-up in stock prices is not sustainable? The valuations are really nosebleed. You think that the odds are that you can get back in at a lower price in the near future.

      I think in this scenario, I think the answer is not only found by inward looking at valuations and future earnings growth potential. The answer should also incorporate the attractiveness of other alternative investments to put your capital at work. If everything else is also elevated in valuations, then moving your capital from one stock to another provides no reduction of risk. The decision then becomes to either continue dancing since the music is still playing, or to leave the party early and come back another time.

      I am not a good dancer, I think I would leave the party early, haha!

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    2. Hi GMGH

      Valid points there.

      It is precisely why there are so many things to consider there that we shouldnt over complicate the situation.

      Take for instance you are owning a chicken rice stall and is doing well. Do you constantly think about the alternatives on whether fish soup or duck rice is more profitable and if so should you wind down your business and move to become that stall owner? Or when you foresee an economic downturn do you sell your stall first and hope when economy bounces back you reinstate your business?

      Again this is very hypothetical but I think you get my point. Find a great business and a winner, dont sell the winner unless like you said you are extremely certain you have found a better winner. But never move on to losers without justification. At least thats where I stand but understand this is very subjective

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    3. Hi B,

      Love your hypothetical example! Your chicken rice stall example is a very good one example of what it means to own a good business that is doing well. Especially if you owned it at a reasonable price and it is generating the cash flows you predict and expect. Why sell and move away from your comfort zone and expertise to take a risk on something which only looks marginally more appealing on the surface?

      But if I was happily running my chicken rice stall and some person decides to offer to buy me out for 100 times my annual profit, similar to Shack Shack's current PE, I think I would cash out straight away though, haha!

      Shack Shake 100 PE

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