When to Sell AAII Silicon Valley Chapter Computerized Investing Group February 21, 2006 Don Stewart Bob Smithson
When to Sell The when to sell topic is of greater concern to most investors than when to buy. It probably shouldn t be, because if you buy a stock that drops in price and never again reaches the purchase price, there s no time to sell that won t lose money. On the other hand, if you buy a stock that rises in price and never again touches the purchase price, then there s no time to sell that won t make money. However, buying a stock that subsequently wanders above and below the purchase price can make the sell decision difficult. The buy decision would seem to be more important because it controls the importance and difficulty of the sell decision. Why, then, do investors worry so much about when to sell? I believe that this is because people expect more from their sell decisions. When you buy one stock out of 9,000 possibilities on U. S. exchanges, you can t possibly do an in-depth analysis on all of them. Therefore if you don t pick one in the top ten percent in returns over the next year, you don t much care as long as on average you get reasonable returns. However, if you sell, you are selecting one of only a few stocks that you own. Surely you should be able to pick the one with the poorest performance to sell out of a small list with which you are very familiar! However, if you think about it, you probably don t know a lot more about the company when you sell it than you did when you bought it, and there s really no reason to think that your sell decision will be any better than the buy decision was. As the SEC says, Past performance is no guarantee of future success. The basic psychological problem is that when you don t buy a stock that subsequently goes up, you think, You can t pick em all. When you sell the same stock you think, I really blew that one! If you have been making reasonable returns on your stock trades over the years, relax and don t worry. You re probably doing a decent job of selling. There is, however, one rule that can make selling both more effective and easier to live with. That rule is: Before you buy, decide what would cause you to sell. When it happens, sell. Selling should be done in a way that is consistent with the buying decision.
When to Sell By Dr. Robert C. Smithson Anava Capital Management LLC 2 North First St., 4 th Floor San Jose, CA 95113 408-918-9333 Please Note: Individual companies shown or discussed in this presentation have been used as examples only and are not intended as recommendations of any kind by Anava Capital Management LLC or any of its representatives.
Selling and Investment Styles Consistency is the Key There are many different investment methods and styles. Fundamental investors attempt to determine the fair value of an investment as a business or as a commodity. They buy if they think the market price is unrealistically low compared to what the investment is really worth, and sell when they think the market price is unrealistically high. They reason that over the long term the market will reflect the true value of the security, and are willing to wait until it does. Technical investors attempt to predict changes in market psychology. They argue that at the end of the day it doesn t matter what the true value of a security is. The only thing that matters is the market price when a transaction is made, and this is mostly determined by psychological factors. They commonly look for repetitive patterns in price and volume that signal investor optimism or pessimism about a security. If you know why you bought a stock, you know why you should sell it. There are as many ways to make the sell decision as there are to make the decision to buy. The sell criteria should be consistent with the buy criteria. For example, if you bought a stock after extensive fundamental analysis showed that the company was a good bet for strong growth over a period of ten years or more, then it should be sold only if future developments indicate that the original analysis was wrong, or if the price rises to the point where the stock is overvalued even given the company s future growth prospects. Otherwise any price weakness is a buying opportunity. On the other hand, if you bought a stock purely based on technical indicators such as, for example, strong upward momentum, then it should be sold when the indicator turns negative, whenever it happens. One danger in selling a stock comes when it is done for reasons unrelated to the original buy decision. An example of this is if, after building a diversified portfolio that includes good companies in business sectors that tend to be uncorrelated with each other, you find that one sector is doing especially well, there is a temptation to move all your investments into the sector with the best performance. The problem is that such a move reduces diversification. If you chose a diversified portfolio because you don t have a trader s personality and don t tend to watch the market very closely, this would be a very risky move. Another danger is not watching your investments closely enough to know when your buying criteria no longer hold for a particular company. Whatever your methods, it is important to follow them. Doing nothing can be just as bad as doing things for the wrong reasons. Even buyand-hold investors should rebalance their portfolios once in a while. In other words, know why you bought a security, and sell it when that reason no longer applies. We ll give an example to start the discussion going.
BE CONSISTENT! WHY DID YOU BUY IT? FUNDAMENTAL ANALYSIS SHOWS A GOOD COMPANY? TECHNICAL ANALYSIS SHOWS A GOOD BUY? TO REDUCE PORTFOLIO RISK? THEN SELL IT WHEN FUNDAMENTAL ANALYSIS SHOWS THE COMPANY IS NO LONGER GOOD. TECHNICAL ANALYSIS GIVES A SELL SIGNAL. TO REBALANCE A PORTFOLIO. WHEN YOU BUY, DECIDE WHAT WOULD MAKE YOU SELL. WHEN IT HAPPENS, DO IT!
An Example Using Covered Calls This is an example drawn from an actual account. It was being used to try a simple covered call strategy in the current market, combined with company selection based on the rules in the AAII s Martin Zweig screen that is included with Stock Investor Pro. The strategy used to evaluate stocks for purchase was to first use the Zweig screen to select candidates, then to purchase only those companies that passed an extensive, Internet information only, fundamental analysis of subjective factors such as the quality of the company compared to peers, market stability, and the company s long term strategy. The portfolio was tilted somewhat in the direction of energy stocks. The purpose of this example is NOT to suggest that selling stocks should only be done in conjunction with covered calls. It is merely an example of a selling strategy that is consistent with the overall portfolio management objectives. In this case, the companies in the portfolio were picked with three criteria in mind. The first was that they are showing growth in sales and profitability over the past few years. Thus the intrinsic value of the company is likely to continue to rise in the near future. The second is that the market has recognized the increasing value of the company, as shown by strong price performance. The third is that the company is still undervalued by the market. In this strategy, then, there are three corresponding sell criteria: growth slows or stops, price performance weakens, or the company becomes overvalued. These fit well with a covered call strategy for sales. A covered call sale occurs when an investor owning stock sells the right to purchase that stock at a specific price within a specific time. For example, if you buy 1000 shares of SanDisk Corporation (SNDK) as of this time (April 11, 2006), you will pay $60.43 per share. If you then sell 10 May call contracts with a strike price of 62.50 (each contract covers 100 shares), you will receive $3.50 per share for the right to buy your stock on or before May 19 at a fixed price of $62.50 per share. If the stock stays at or below $62.50, the calls will not be exercised, and you get to keep the $3.50 per share, which represents an additional income, in about five weeks, of 5.8%. If the stock is above the strike price on May 19, or maybe before then, the calls will be exercised and you will be forced to sell your stock at $62.50 per share. If the call is exercised, you paid $60.43 per share and your total income per share is $2.07 on the sale plus the $3.50 for the call, so your total profit is about 9.2% in 5 weeks. This represents a compounded annual rate of more than 150%, assuming you can do as well every week, which you probably can t. Still it s a very good week. If the stock is above $60 when the calls were exercised you would have done better by not selling the calls and just selling the stock on the exercise date. Statistically, however, this is unlikely, and you certainly shouldn t be overly unhappy with the return you got. If the price of the stock remains about the same over the next month, you make 5.8% from the sale of the calls. If it drops, the price of the calls will drop too. If you want to sell the stock, you buy back your calls at a lower price before selling the stock, making money on the difference between what you were paid for the calls and what you had to pay to buy them back. This money can partially or completely offset your loss on the sale of the stock. The selling strategy in this case is simple. You sell calls when the effective stock price represented by the call price plus the strike price would put the stock at a fairly valued or overvalued level. You sell the stock when the call is exercised, because it no longer fits your value criterion. After it is sold, you re-evaluate it. If you feel it is still undervalued, you can buy it back and sell another call. If it is no longer undervalued you buy something else that fully meets your criteria. You also might sell the stock because of poor price performance or because of lagging profits. In this case, you will likely be able to buy back your calls at a low price, and the profit from calls will help offset any losses you might have in the sale of the stock. Strategies like this one should be done in a tax-free or tax-deferred account with low transaction costs. Most profits tend to be short-term and are taxed as ordinary income.
AN EXAMPLE THE SITUATION AN IRA ACCOUNT NO TAX CONSEQUENCES TO FREQUENT (OR INFREQUENT) TRADING COMPANIES PICKED USING FUNDAMENTAL ANALYSIS COMBINED VALUE AND GROWTH COVERED CALLS ARE USED TO ENHANCE PROFITS SALES ARE MADE WHEN CALLS ARE ASSIGNED. THE COMPANY NO LONGER MEETS THE VALUE AND GROWTH CRITERIA. REBALANCING IS DONE WHEN COMPANIES SOLD ARE REPLACED
The AAII Zweig Screen The Martin Zweig screen is a combined value and growth screen. It tends to identify small and mid-cap stocks that have shown solid growth for a few years, but retain reasonable value. Market analysts tend to describe these companies as good companies that for some reason have lagged other companies in their industry.
THE ZWEIG SCREEN
Portfolio Transactions This portfolio was being used to test a strategy of covered call writing in a retirement account. While the stocks shown were are part of an active portfolio, only those for which option selling was possible are included in this chart. Some companies were also present that did not have options available, and these are not shown. Actual tickers are not shown in this example.
TRANSACTIONS
Sales Results of the Strategy Two sales were made since the start of the experiment. The first was a sale of BBB Corp one month after purchase as the result of an assignment of an expiring option. The option was sold on the day the stock was bought, yielding $1.25 per share. The stock was sold for $85, the strike price of the option when the market price was $85.74. This loss on the sale was more than offset by the money received for the option, with the net proceeds being $86.25 per share or $0.51 over the market price. After the sale, a second fundamental analysis of the company was done, and although the company still passed the fundamental screening criteria, a better set of candidates were found, so the stock was not repurchased. Later, four other companies were purchased, and options sold on each of them and on the previously purchased AAA INC. About a month later the option on AAA INC. expired and was assigned. The stock was sold at $35, when the market price was $38.46. The amount received for the call was $0.75, so the total received was $35.75 or $2.71 under the market. In this case it would have been better not to sell the call. Nevertheless, a profit of $3.42 per share was made or about 10% in 3 months. The stock was sold as it was in order to remain consistent with the strategy by which the portfolio was being managed. The overall value of the portfolio on 2/21 was $25693.97 or $235.27 more than if calls had not been sold.
RESULTS