Tuesday, August 15, 2017

How To Know When To Sell A Stock?

One of the most difficult decisions in stock market investing is to know when to sell a stock.

I've been investing for over 20 years now, but I still struggle with this decision. It is especially true when the stock in question is one of my top performing stocks. It can be quite tempting to take a profit and run; however, taking a profit may not be a good long-term decision.

To make a decision to sell such a stock, I go through a sequence of questions that I ask myself and then depending on the answers I get, I would either keep the stock or sell it for a profit.

Here are some of those questions:

Is the company overvalued?

There are several ways to determine company's valuation. The easiest of those methods are simply to look at the current Price-to-Earnings Ratio and see how it doing compared to historic P/E for the given company. One can also compare it to competitor's P/E to get a guage on company's valuation.

I normally like to compare company's current P/E to its 5 year average or normal P/E. For REITs, I simply substitute P/E with P/OCF (Price-to-Operating-Cash-Flow).

You may ask why I don't compare individual stock's P/E to a broader market P/E such as S&P 500?

My answer would be that individual stock valuations are much tightly linked to the company's earnings rather than what the overall market is doing at any given time. Yes, there may be a short-term correlation to the market ups and downs, but long-term it is the company's earnings that drives the P/E multiple and therefore, when determining individual stock's valuation, I tend to compare the current P/E of a stock with its historic P/E multiples. This gives me an idea of whether the stock is cheap or expensive relative to its historical multiples.

Let's look at an example of Boeing (BA) shares:


Since late 2016, Boeing's stock has been on a tear. It has since appreciated more than 80% and has a current P/E multiple of 27.1. Whereas a 5 year Normal P/E is 17.1. Therefore, the stock looks quite overvalued at current P/E multiple of 27.1.

Is the current dividend yield too low?

Current dividend yield is what you would actually earn if you were to buy the stock at its current market price. I use S&P 500 current yield as a benchmark to determine what the current yield should be for most of my stocks (excluding REITs).

For example, S&P 500 is currently yielding around 2.0%. Therefore, for an individual stock, I want the current yield to be 2.5% or higher. The extra margin is to compensate me for additional risk that I'm taking when owning an individual stock vs. a broader diversified market index.

A lower current yield may imply the stock is either overvalued or the dividend growth has slowed down and not keeping up with the stock price. Either situation could be a potential problem for an investor.

Using the same Boeing stock example, the BA current dividend yield is 2.4%. So it's right at the borderline of being too low when compared to my target yield of 2.5%.

Is the dividend growing too slow?

Before you can answer this question, you need to define what is a slow dividend growth. So let's do that:

  • For general C-corp companies, I consider a dividend growth of less than 5% as slow.
  • Utilities are slow growers and therefore a 2-3% dividend growth is quite good to keep up with inflation. Anything below 2% dividend growth would be considered slow.
  • For REITs, I can tolerate a growing dividend of 2-3% as long as the starting yield is over 5%.

By law, REITs have to distribute 90% of their taxable profits to shareholders in the form of dividends. This makes their dividends substantially higher compared to other types of stocks. Their high yield is the reason why REITs are so popular among dividend investors.

Once again, using our example of Boeing Company's stock, we see that dividend is growing at a very fast rate of double digits. Last year the dividend was increased by 30% and this year it is expected to increase by at least 10%.

We can see in the Boeing Company's stock dividend graph below, the dividend has been increasing at a very fast rate since 2014 and hasn't slowed down. It definitely makes it a darling of dividend growth investors.


Has the profit exceeded 20 years of dividends?

It can be very compelling to sell a stock if it has appreciated in price substantially. I own several stocks that have appreciated more than 50% and even few that are making me over 100% pure profit.

When this happens, I compare the unrealized profit to the number of years of future dividends. If the total expected profit from the potential sale is larger than 20 years worth of future dividends than per this rule, the stock position is a prime candidate for a sale.

As the saying goes, a bird in hand is worth two in the bushes. Who wouldn't want to take the 20 years worth of dividends now than wait for 20 years on uncertainty?

This is one of the most compelling reasons for me to sell an overvalued position. However, there are a few caveats to consider before going ahead with the sale as I will discuss in the next two questions.

What is the Tax Implication?

A profit as big as 20 years worth of dividends would likely be a hefty amount, resulting in a big tax bill.

In the US, if you have held the shares for at least one year, you would likely be paying a reduced 15-20% capital gain tax depending on your tax bracket. The only time you don't pay any federal taxes on capital gains is if you fall under a 15% tax bracket.

For shares held less than one year, the profits are treated as ordinary income and taxed at your normal income tax rate which can be much higher as they are not caped at 20%.

And it's not just the federal tax, you may also have to pay state or local taxes on your investment profits. I live in Oregon and we have one of the highest state income taxes in the country, so that would be an additional 9-10% in state taxes for me, on top of federal tax.

We are talking nearly 30% of profits gone in taxes. That's a large chunk of money that is gone from my total profit from the sale of the high performing stock. Therefore, it is very important to understand tax implications before selling any stocks.

Now, of course if I had held these shares in a tax sheltered account such as an IRA, Roth-IRA, or a HSA, I wouldn't have to worry about taxes, at least not at the time of sale.

What is the Opportunity Cost?

By selling the shares now, I would be giving up any future growth opportunity in the stock. This means, if I were to take my 20 years worth of dividends now, I would lose on any future growth in the stock price as well as compounding of any future dividend increases.

A company like Boeing that grows its dividends in double digits year after year has an annualized Total Rate-of-Return of 9.1% over the past 20 years. In comparison, S&P 500 has only returned about 6% annually for the same period.

Assuming, BA and S&P 500 maintain their respective returns for the next 20 years, keeping BA shares would seems like a better decision.

Also, given the Boeing company's dominant position and having a larger moat than its competitors, there is a high probability that it will continue to perform well into the future and may even provide bigger returns than in the past.

From a risk/reward perspective, I consider the opportunity cost of selling BA stock now as high while the future risk as low. Therefore, I would not be selling the Boeing Company's stock even though it seems overvalued at its current price.

Conclusion

These are some of the ways I make a decision about selling a high performing stock. This is by no means the only method of determining when to sell or not to sell. The process of making a decision can be as elaborate or as simple as one chooses, at the end it all depends on their risk/reward profile.

What is your method? How do you decide when to sell a high performer stock?

Disclaimer: Author of this article is not a licensed/registered financial or investment adviser and does not provide investment advice. Any mention of stock names/tickers in this article or website is not a recommendation to buy or sell. This article is for informational and entertainment purposes only. Full disclaimer can be read here: Full Disclaimer


2 comments:

  1. Honestly for me, I look to see if the company has cut dividends. While I can say that's not the be all end all strategy, it's at least the beginning of the look to see if I really want to sell my shares. This at least makes logical sense since I'm invested for income. This is why i choose companies that have survived through recessions, etc, and came out stronger.

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    Replies
    1. Yes, makes sense and why I also look at dividend history. A dividend cut or freeze would be a good reason to sell.

      Thanks for sharing!

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