As Sensex hits new high, when is right time to bid goodbye to your stock?

Having an exit strategy will help maximise your profits and limit the downside

As stock markets scale new highs, many investors are wondering if the rally will sustain. And, whether they should book profits and wait for a correction to re-enter. While timing the markets is not possible, having an exit strategy for stocks in your portfolio can ensure you make profits, irrespective of where the markets go from here.

“The sell decision is the most important decision you can make in investing,” says Arun Kejriwal, founder, Kejriwal Research & Investment Services. “It’s the best risk management tool which ensures traders and long-term investors make money, and the downside is capped.” Sticking to an exit strategy also ensures you stay disciplined and don’t get swayed by emotions.

Fix a target: Before buying a stock, keep a target sale price, based on the company’s earnings outlook and its potential to grow its business. Then, stick to it. Don’t feel sorry about selling a stock if it climbs further after you have sold it. 

Sometimes, your stock won’t hit the desired target or might achieve it much before you anticipated. In such cases, the exit decision should depend on the price and on time. Say, you invest in the shares of a company trading at Rs 1,000. You expect it to touch Rs 1,200 in three quarters. Different scenarios can play out. The stock could move faster than you anticipated and almost reach your target price, say Rs 1,175, in two months. The best strategy in such a case is to exit. Do the same if the stock crosses the target price.

What if the three quarters pass and you don’t achieve the target? Say, the stock languishes at Rs 1,050. In that case, too, one should exit it. Admit you were wrong and move on.

If you have a longer investment horizon — two years or more — and are betting on a stock that has shown high growth, look at the historical valuation range in which it has traded. You may decide to exit when the company reaches close to its historically high valuations. For example, a company in the consumer staples business might have traded at a low price to earnings (P/E) of 30 and a high of 60. You may decide to exit when the P/E is close to 60. “The drawback of this strategy is that sometimes companies, as well as the entire sector, can get re-rated. In such a case, the investor won’t be able to determine the exit point,” says G Chokkalingam, founder, Equinomics Research & Advisory. He cites the example of tyre companies. These companies traded historically at a P/E below eight. They have been re-rated recently and trade at a P/E of 15-18 times at present. In view of this, you should pull the trigger only after evaluating the stock afresh. Would you buy the stock, given its current outlook and valuation? If the answer is yes, don’t sell. 

Exit when the rationale changes: Investors need to be clear about why they bought a stock and need to review their rationale periodically. If the reasons for which a stock was bought change, consider exiting it. After the dynamics of the information technology sector started changing and companies started witnessing a slowdown in earnings, Chokkalingam recommended mid-tier companies to his clients, as he believed there would be consolidation in the industry, and smaller companies would get acquired. Some of his bets came correct and he exited the others.

Company diversifies into an unrelated business: Fund managers and investment advisors are unanimous in the view that it’s a sign that the investor should exit the business. Whenever a sector catches the market’s fancy, a few companies start diversifying into it, though it is completely unrelated to their current business. Peter Lynch famously dubs this phenomenon “diworsefication”. In early 2000, many got into software. In 2007, it was real estate. “Only a few companies can move away from their core competencies and build an entirely unrelated business. There’s a strong case to exit, especially if a mid- and small-cap company gets into an unrelated business,” says Abhimanyu Sofat, vice-president, research, IIFL.

Bad news that impacts earnings: This is a tough call for investors. Many pharmaceutical companies receive notices from the US Food and Drug Administration if it finds violations at their manufacturing plants. Usually, pharma stocks correct whenever such an event takes place. “One has to weigh if the management can tide over such setbacks and then decide whether to exit. Usually, by the time investors can act, the stock has already corrected, factoring the event into the stock price,” says Atul Bhole, vice-president and fund manager, DSP BlackRock Mutual Fund.

Stop-loss is the best exit tool: A stock can start falling right after you purchased it for various reasons. It could be due to a broad market correction or a wrong call by an investor. According to William J O’Neil, the author of How to Make Money in Stocks, one should always exit a stock if it falls seven-eight per cent below cost price. According to his research, if a stock reaches this threshold, there are high chances it will fall further, and it means there was something wrong with the entry point. You need not stick to the seven-eight per cent stop-loss but can change it, depending on risk appetite. However, his advice of following the stop-loss discipline can help you cut losses and preserve capital.

Hold stocks without an exit strategy: This strategy is well suited for the long-term, buy-and-hold investor. According to DSP BlackRock’s Bhole, for a small investor, the best strategy is to invest in a few good consumer facing businesses, which are growing consistently and hold these without worrying about the market noise. He says a longer holding period can help small investors make much higher returns than buying and selling stocks periodically. He suggests investors should wait patiently for a good entry point into companies that are growing at 15-20 per cent or more every year. Others agree. “I have been holding Bharat Electronics since 1996 and will continue to hold it in the future,” says Kejriwal. But, you cannot buy and forget, he adds. You must review your investment periodically – at least once a quarter – to see if the earnings outlook remains positive. 

Whenever you sell, ensure it’s done in a staggered manner. Just as one should average out the buying, one also needs to average out the selling.