How to decide when to sell

By David McEwen

Monday 8th April 2002

Buying shares is easy. Most people find selling a much trickier business. Many investors make life difficult for themselves by refusing to sell a share that has fallen below its purchase price.

They hold on, hoping the price will recover. They promise they will get out when the share regains its purchase price and like to think they haven't really made a loss until a sale takes place.

The trouble is, nobody can say when that happy break-even event will occur. It could be in a week or it could take years. In some cases, it never happens.

Some investors avoid with this trap by having rules, such as selling if the price rises by 20% or falls by more than 10%. However, this tends to encourage short-term trading, which is generally a wealth-destroying activity.

US investment adviser John Price advises people not to look back when deciding if they should sell.

"If you buy XYZ for $20 and it drops to $12, you now own a $12 stock. It does not matter how it arrived at this price. The question now becomes, 'If I had $12, would I buy a unit of XYZ or would I buy something else?'"

Likewise, if a share goes from $10 to $30 an investor should only focus on the fact that they own a $30 share. They need to ask themselves if they would be happy buying another share in the company at that price. If the answer is no, then that is a pretty convincing sell signal, he says.

I prefer to ignore a share's price and concentrate on the return it is generating for its owners.

Imagine you buy a share for $1 and over the next year the company makes 10c a share in net profit. That's a return on your investment of 10%, some of which you will receive as a dividend while the rest is reinvested in the business.

After five years, let's say the company's net profit has grown to 20c a share and its share price has risen to $2.

Many people might be tempted to take their profits at this stage. After all, turning one dollar into two over five years is pretty clever investing.

This is not necessarily the best move. Before you sell a share, it is important to find somewhere better to put your money.
The share mentioned above is generating a 20% annual return on investment. The chance of finding another share that can produce the same return straight away is extremely slim.

Given this, it doesn't make sense to sell a share simply because its price has gone up. Rather, one should move because a company's earnings are likely to fall or another's is growing at a faster rate.

Be careful though. A company delivering a 20% return only needs to improve earnings by 5% per annum over five years to beat another that generates 10c in the dollar and grows this by 20% a year.

Try this exercise on your portfolio: Divide each company's last reported earnings per share by the price you paid for each share. Then multiply the result by 100 to get a percentage.

That is your annual "owner's return" on investment. If you bought the shares a few years ago, you might be pleasantly surprised at the result.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz

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