Deciding when to sell

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The Independent Online
Usually, you buy a share for a reason. A high-yielder when the yield is well above average; a cyclical when the company is near the bottom of the cycle; an asset situation when the assets are worth substantially more than the market price; and a growth share because you hope the company will grow faster than most, and the price does not yet seem to reflect the expectation.

It is easy to decide when to sell most of these different types of investment.

The high-yielder is sold if the company passes or reduces a dividend, or if the share price rises to such an extent that the yield nears the market average.

The cyclical is sold when there is an upturn in the cycle and the fortunes of the company. (A sure selling signal is when analysts begin to describe it as a growth stock).

The asset situation is sold when there is a bid or the shares rise to over the underlying asset value.

Growth shares are much more difficult. When you find a superb one, you would probably be best advised never to sell, unless there is a change in the story - a change in the essential reason you bought the shares in the first place.

For example, I have recommended Amersham International because, during the next few years, I expect the company to grow at an exceptional rate and I admire the commercial approach of the managing director, Bill Castell. If the growth rate were to falter or if he were to leave the company, I would have to review the situation. The story would have changed to such an extent that I would want to sell my shares.

The classic investment advice is to run profits and cut losses. That way you always have big profits and small losses. There is also a tax inducement to run profits - you continue to enjoy an interest-free loan from the Inland Revenue. When you make a sale, you crystallise the capital gains tax liability, which then has to be paid.

In spite of these arguments, running profits and cutting losses can test the strongest nerves. Warren Buffett, the legendary American investor, has an excellent and simple way of illustrating the merits of this approach.

He asks you to imagine that you could buy the earnings for life of 20 classmates on the day you graduated from school or university. It does not matter how much you paid, the point of the exercise arises 15 years later when you have the opportunity to review their progress.

One has died, one has become a drug addict, one has Aids, four are unemployed and among the rest there are a detective, a priest, a vet, a doctor, a dentist, two accountants, two solicitors and a barrister.

The remaining three are really in the money; one is well-established as a captain of industry, another a leading financier and the last one has just become chief executive of a large multinational.

If you had the opportunity to make a few sales, albeit at differing prices, you would obviously cut your losses on the less fortunate and run your profits on the high-fliers.

When you bought your classmates' life-earnings, they all had varying prospects.

The one who contracted Aids could easily have been the most promising. The important point to grasp is that when you came to review the situation, his story had changed.

The story of a share can change in just the same way. The chairman's statement could become cautious, the balance sheet might show an alarming increase in debt, there could be significant troubles with a new product, or a strong new competitor might enter the industry. The story might change to such an extent that the reasons you purchased your shares no longer apply.

In that event, you should sell immediately.

Of course, there can sometimes come a point when even a great growth stock should be sold. For example, if the price/earnings ratio rose to over 1.7 times the growth rate (less for a smaller company), I would regard this as adulation, which would make me feel nervous - especially if I felt uneasy about the general level of the market or I noticed executive directors selling a significant number of their shares.

Another difficult and testing point is when the price of a share shows poor relative strength or drops for no apparent reason.

If you cannot obtain a satisfactory explanation, you should either use an automatic stop-loss after, say, a 25 per cent fall, or, if you prefer, try to get a feel for the situation and exercise your own judgement. I favour the latter course, as I like, wherever possible, to give great growth shares the benefit of the doubt. They usually win through in the end.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. He has agreed not to deal in a share within six weeks before and after any mention in this column.