In earlier blog, we told you that the right price to buy a stock at a reasonable discount to its MRP. We also said that we need to sell, once it crosses MRP. Since no one can time the market, knowing when to sell is one of the toughest decisions, especially since greed usually takes over and you always hope for a higher price.
In theory, the perfect business to buy is, one we never have to sell. That’s our ultimate objective: To buy a company so wonderful and at a price so attractive, that we never sell it. Of course, this rarely happens in reality. Wondering why? Because not all companies stay wonderful forever. Also, the market at some point tends to grossly overvalue these companies, giving a sell opportunity.
At Moneyworks4me, we buy and sell on the following guideline – Buy at/close to Discount Price and sell once it crosses its MRP. But, what if the company ceases to be wonderful before the stock price crosses its MRP. Or the market has grossly overvalued the company! There are many such considerations you need to keep in mind, and they will guide you to figure out the right time to sell the stock. Let’s see them:
While taking a decision to retire from your stock, you can be in 2 situations. Either the stock price is
1) Well above MRP – If the current stock price is well above its current MRP i.e. 20%+ above MRP – consider selling the stock, as the market is overvaluing the stock irrationally above its earning capacity.
Considering that the market has overvalued the company right now, there are chances that it will correct in the future. In such a case it would be a great opportunity to sell the stock now, book great profits and later, wait till it is available at a good discount again. This time you can wait for a slightly lower MOS than before, considering by now you have confidence that the company is a sure-shot winner in the future.
2) Just above MRP – If the current stock price is just above the stock’s current MRP ( 0-20% above), you need to ask yourself –
a) Has the company ceased to be wonderful? : If the company’s MRP is stagnating and it is not a short-term trouble, most likely the company has ceased to be wonderful. In such a situation consider selling. This means that the company has ceased to have the sustainable competitive advantage, that earlier guaranteed great growth and is no longer attractive with a long-term perspective.
This will usually show up in the form of a poor performance in its financial track record. If the financial track record is no longer good enough to warrant holding on to the company/business, sell it. In such a case this will reflect in a stagnant or reducing MRP, due to our reduction in expectations of earnings capacity.
However, if the company is wonderful with an increasing MRP, consider holding the company till the market grpslly overvalues it i.e. (20%+ above MRP)
b) Is there a better opportunity available?: If you have found a better company, where the probability of growth and returns is higher and this company is available at an attractive discount. In such a case consider selling of your earlier investment, if you are sure there is a better opportunity available.
c) Are you are in requirement of funds? – If you are in need of funds, it is always better to sell off a stock that has crossed its right value (MRP), rather than selling one which yet has scope for appreciation in stock price
3) The company has ceased to be wonderful, before reaching its MRP – If there has been a sudden change in circumstance or you have received new information, that changes your opinion about the company that you once believed was wonderful, consider selling the stock; even though its current price may not have touched its MRP.
If the stop loss has been reached: When you buy a stock, it is usually with the expectation that the stock will go up and we will make a handsome profit. But what if the stock goes plummeting down! This is where a stop loss comes in. As the name suggests, it is the price level at which one should stop/limit the losses in a trade. The purpose is to define the maximum loss you are willing to take on your investment. One should not take unlimited risks in any investment, because if the stock starts going down, you may even face the risk of capital erosion.
Deciding the stop loss level will depend on a few factors like how much loss are you willing to take on a trade, how risky and volatile is the position, how is the market trending, etc. The trailing stop loss method seems to work the best amongst the different known methods.
Let’s understand how this method works with the help of an example. Suppose you bought a stock for Rs. 1000 and decide to set a trailing stop loss at 15% i.e. a stop loss will be triggered at Rs. 850 (You can also set a stop loss in absolute terms, say Rs. 150). If the stock moves up, the trailing stop loss goes up too. So, at Rs. 1100, the trailing stop loss will have moved to Rs. 935; at Rs 1300 the trailing stop loss will be Rs. 1105 and so on. However, if the stock turns south and comes down Rs. 1200 from Rs. 1300, the trailing stop loss remains at Rs. 1105. If the stock reaches Rs. 1105, the trailing stop loss is triggered and a sell trade will be executed, thus protecting a profit of Rs. 105 or 10.5% on your initial trade of Rs. 1000.
The discipline of following a stop loss will help you to not only minimize your losses but also protect your profits to a great extent!