Trade shares the right way

Even the most casual investor has heard about what stocks to buy and when to buy them. Knowing when it’s time to sell is just as important, yet rarely discussed.

The one constant when deciding to buy or sell is how the stock price compares to intrinsic value. Don’t think of stocks as pieces of paper to trade, but instead as a piece of the business you own. With this attitude in mind, you should focus on quality businesses you understand, with superior economics and a first-rate management team.

And you should aim to purchase shares when they’re undervalued. In an ideal world, the stock price would grow, the company would continue to increase its intrinsic worth, and you could hang on to your shares for years to come.

But it’s not always that easy. If it were, then “the best time to sell a stock [would be] never,” says Warren Buffett.

The problem is that over the short or medium term, the stock market is often influenced more by crowd psychology, which fluctuates between extremes, than it is by fundamentals. As a result, stocks don’t always go from undervalued to fairly valued. Instead, they sail into overvalued territory.

And when the share price is higher than what the business is worth, it’s a great time to sell. After you’ve sold, don’t be surprised if the stock price continues to rise. Although it’s painful to miss out on these gains, we all know that what goes up eventually comes down.

A market correction brings stocks back to reasonable levels and even presents opportunities to purchase more shares, or buy other great businesses at bargain prices.

Often, the wisest decision to sell is based on a change in business fundamentals. Although this seems simple, in practice selling is not that straightforward.

Consider the following factors.

1. The costs of selling.

Beyond the transaction costs associated with brokerage fees and commissions, for every sale you must also consider other frictional costs, such as foreign exchange rates and capital gains taxes.

With every trade, there is also an opportunity cost related to determining what to do with the proceeds of the sale. With every sale, you will need to find another equally good or better investment to make with the proceeds. This is not an easy feat.

2. Whether the change is permanent.

Determine if the change in business fundamentals is likely to be permanent. Selling a company because of changes in its economic characteristics can be risky.

For instance, if the company’s weakened state is only temporary, sellers could be overreacting, causing the share price to suffer. This situation is actually an opportunity to buy.

Temporary losses in the portfolio are nothing to fret about, as long as the decrease in price is not caused by erosion in a company’s intrinsic value. In order to make this important distinction, you should decide if a company’s business model is viable. To do so, ask the following questions:

• Have the long-term economics of the business or its industry changed?
• Has the risk profile of the business changed?
• Is the business no longer insulated from competition?
• Has the capital allocation strategy changed?
• Does it earn a high return on capital, and can it continue to do so?
• Does the management team consist of capable operators?

These are essential questions that shouldn’t be answered too quickly. You, or the advisor you hire, should have a full understanding of the business, and those opinions shouldn’t be based on short-term business results.

When it comes to selling, there is no magic formula. Whether you’re cashing in on an overvalued stock, pursuing better investment opportunities or dumping a failing company, trades shouldn’t be made lightly.