Highlights in this issue:

*** Base your investment choices on knowledge, not chance…
*** Classic red flag include earnings no longer growing…
*** 3 ways to get out before you stack up your losses… and more…

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From the pen of Karin Iten

Dear Investment Academy Reader,

Knowing when to sell is the single most important strategy every investor needs to be truly successful at. So today, I’ve asked Tim Bennett – our regular MoneyWeek investment strategist – to help you discover when the best time to sell is.

Over to you Tim…

How to tell when it’s time to sell

“I made my fortune by selling too early,” said US financier and speculator Bernard Baruch. With stock markets around the world on a tear since March, plenty investors must be wondering whether it’s time to follow Baruch’s example and get out while the going’s good.

So how do you know when it’s time to sell a share?

Why losses are hard to recover

There’s plenty of advice around about what shares to buy and when, but far less on when you should sell your shares. But selling is a vital skill to master. Why? Because losses are very hard to recover – the numbers are against you all the way. For example, if you pay R10,000 for shares, which then drop by 25% to R7,500, you need them to rise by a third just to break even. If the same shares fell by half, you’d need them to double. In other words, losses are disproportionately tricky to recover.

And watch out for “geometric averaging”.

Say you invest R10,000 in year one. You make 25% on that, then 25% the year after, but suffer a 50% loss the next year. The simple average return is 0% – (25+25-50)/3. But you won’t have R10,000 at the end. That’s because after one year, your R10,000 will have grown to R12,500. Assuming it stays invested, a year later, it’ll have grown to R15,630 (R10,000 x 1.25 x 1.25). But the 50% loss then slashes that to R7,810. So avoiding losses is vital – and the best way to do so is by remembering why you bought in the first place.

Know why you bought

If you took a punt on a company you knew next to nothing about, and by some miracle the share rose sharply, then sell now and be grateful. A lucky R5,000 profit may buy as much beer as a R5,000 skillful one, but luck doesn’t last. A much better approach is to keep a note of the criteria you applied to buying and react to changes before a share tumbles.

Here are my top 3 sell signals

1. Shifting fundamentals
Many investors use fundamental analysis (key ratios, such as price to earnings and price to book values) and a slice of judgement (the brand is good, the new management team is strong) – to spot a buy.

Fine, but once you’ve bought, you need to keep an eye out for signs that the share is no longer worth holding on to. Classic red flags include earnings no longer growing, top management leaving or, in some sectors such as pharmaceuticals, a lack of new products or product approvals.

But don’t stop there – monitor half yearly or quarterly updates. Watch out for asset “impairment” write-downs. Acquisitive firms – in sectors such as telecoms – are especially vulnerable. Rapid growth often results in companies overpaying for rivals. Any dip in activity forces management to come clean on just how badly they overpaid, which means profits suffer.

Next, do two quick checks to make sure that growth isn’t out of control:

*** Is operating profit (mid-way down the profit and loss account) growing much faster than operating cash flow (at the top of the note that supports a cash flow statement)?
*** Are either stock or receivables (“debtors”) rising much faster than sales?

These are unsustainable trends beyond the short-term and they’re useful early warning signs to watch for.

2. Rapid growth
Let’s say you’ve picked your four favourite sectors and bought two shares in each, spending R1,000 in each one. One of your biotech shares races ahead and rises to R3,000, while the rest perform more modestly and rise by R250. It’s time to rebalance.

If your original aim was to spread your risk roughly equally over eight shares, sell, say, R1,750 of your biotech holding (to reduce it to R1,250) so that what’s left is still an eighth of the total. Never forget that a paper profit is just a promise – cash in the bank is a fact.

3. Hitting price targets
If constant rebalancing, according to portfolio weighting, sounds like hard work, then apply a simpler price target. Many investors will ruthlessly dump a share that drops say 25%, but you should just as ruthlessly take profits when a share rises. However, it’s always tempting – and often good sense – to let a strong winner run. So how can you balance the two?

One good option is a trailing stop. Basic stop losses are instructions to your broker to sell if a share drops by say 25%. Fine, but what about a share that’s rising?

Say you buy Vodacom shares for R53.20 and set a stop loss 25% below that price (around R39.90), but then Vodacom rises to R60.65. Here’s the rub. Leave your standard stop loss at R39.90 and it won’t be triggered unless the share falls over 34%. Ideally, you want the 25% stop loss price moved up – to nearer R45.49. Trailing stops do this – they follow your share as it rises, taking the stop loss price up too.

Unfortunately, not many brokers offer them. Some will let you set relatively small stop limits as part of their standard deal charge. Others will allow you to set bigger ones, but you may need to refresh them every 30 days. Don’t forget to do this. If you share falls, you’ll be glad you did.

Here’s to your financial freedom,

Karin Iten and Tim Bennett
For the Investment Academy