By low, sell high! That oft-used 80s catch cry is what all investors should aim to do. In most cases the first part – buy low – can often be the easiest part to do. I could have picked 10 random stocks from the ASX200 in March 2009 and I’d be on a winner because buying anything after a crash is a pretty solid strategy. There are also countless volumes of material written on when to buy stocks, from charting to value investing and every weird combination in between.
The irony is that the most difficult part of investing – the selling – is least-discussed. Once you’ve snared yourself a bargain and watch gleefully as the share price soars, your thoughts turn to selling. “Should I sell now? I’ve got a made profit but it could go higher. Or it could go lower.” Maybe that junk stock stayed junk and you’re wondering whether to cut your losses. “Should I hold out for some recovery? What if it goes lower?”
At Empire we apply a system to selling shares that is just as rigorous as the system we use to buy them. In fact, they’re both based on the same thing – value.
Value – what’s the share worth?
First things first – we need to know what the share’s value is. Note the emphasis – value is what you get, price is what you pay. To determine when to sell a share based on fundamentals, you need to know what it’s intrinsic value*.
Unfortunately this means our approach isn’t applicable to traders. Terms like “price action”,”trading range” and “moving average” don’t enter the value investing lexicon, so I’m afraid this won’t help the chartists and speculators.
* For more details, read anything about Buffet, Munger and Graham and eventually you’ll get the skinny on value investing. I won’t go into it here – it’s a topic that’d require several more posts.
Share Value vs Cash in hand
So you know the value. Hopefully you’ve bought below value and the share is now at or above value – giving you a nice paper profit. You are now faced with two choices: Hold onto the share or sell it, making a profit and paying capital gains tax.
In both instances you will be left with a certain measurable value. In the first option (holding), the value will be the value of the share. In the second option (selling) you’ll be left with value in the form of cash minus your capital gains tax liability (and brokerage). In other words your “sale cash”, which is your initial capital plus + net profit.
So when do I sell Q?
Easy – when your sale cash exceeds your share valuation. If you think a share will give you $10.00 in value and your after-tax sale cash is $9.00, why would you sell? Same in reverse – why hold onto a $10 value share when you’ll get $12 after selling and paying tax?
If you do your valuations right you’ll have taken into account business risk, tax and inflation so the two outcomes (share value and holding cash after sale) can be directly compared.
The Sell Formula
Your blogger happens to be handy with formulas, so I’ve come up with this one to help you figure out when to sell:
S > (V – B*t) / (1 – t)
Where S is sell price, B is buy price, V is value and t is your tax rate on the capital gains (this will change depending upon your tax bracket and/or any capital gains discount).
Recreate this in an excel file and you’ve got a ready-made sell calculator.
What if the Value Changes?
Well, let’s hope that happens. Good companies should increase in value over time as they add to their equity base. In which case your sell price will become higher.
If your company decreases in value the same approach still holds. Why hold onto a company you now think is worth $9 when you’d get $11 if you sold them? The fact you bought them at $15 might hurt your pride, but it doesn’t change the facts – it is better to have the cash in your hot little hand than hold onto a losing stock where your only strategy is hope
It Can’t be That Simple
Actually, from a mathematical point of view it is that simple. The only thing this approach doesn’t factor in is opportunity cost. You may have a share worth $10, and the cash value on selling will be $9.50 – so you should hold according to the math. However, if you identify another under-valued share elsewhere that will give you a superior return, you may be better off cashing in and reinvesting the profits into the new share. If you don’t, and that under-valued share doubles whilst you wait for a measly 50c price rise in the share you held, you’d be upset.
That is what we call opportunity cost. It’s something you’ll have to subjectively manage yourself with every sell decision.
So there you have it – a nice, simple and systematic approach that gives a pretty good sell price signal. Using this approach and some subjective cost-of-opportunity assessment, will aid you in selling at about the right time from a value point of view. The share price may soar beyond value, but then you’ve entered the realm of speculation as to where it’ll finish. I much prefer to book solid profits at a rational price then pray to Mr Market for another 5%, when the end result could be a 10% drop.