How to take a profit
Markets have been bountiful, but there's risk in overstaying your welcome
Buy low. It's the first step of the most famous investing cliche out there, and thanks to dirt-cheap prices in the wake of the financial crisis, it's never been easier to accomplish over the past year.
But with stock markets up more than 60% and hitting new recovery highs, now comes the tough part: selling high.
"An investor's biggest problem generally -- fund managers, retail investors, everyone -- is that they don't sell very well," said Joanne Hruska, a vice-president at Aston Hill Financial. "And there is nothing more frustrating than riding a stock up and riding it back down."
Deciding if, when and how to take profits is never clear-cut, and the dizzying rally that doesn't want to quit has left many investors unprepared to think about locking in gains. But smart investors who have a plan in place over what to do with their stocks tend to get burned far less often than those who don't.
George Athanassakos, a professor of finance at the Richard Ivey of School of Business, says investors should have an exit strategy even before buying a stock.
"More than that they need to be disciplined, consistent and patient," he said.
As a value investor, Mr. Athanassakos buys stocks that are trading at a discount of at least one-third intrinsic value. Generally, he likes to hold a stock for three to five years or longer, but when it hits full value, he exits.
Not without exception, of course. If a stock rises quickly in a very short period of time, the finance professor said it makes sense to get out even if it hasn't reached intrinsic value.
"If your target upside is 50% and the stock rises 30% in a week, get out and invest your money somewhere else that now offers better upside," he said.
That doesn't necessarily mean selling the whole position, but at a minimum Mr. Athanassakos said it is important to bring exposure back within preset positional limits. For diversification purposes, the typical weight of any one stock ranges from 3% or 5% of a total portfolio.
Additionally, he said it is prudent to lock in profits early when the business model of the company changes in a way you don't like.
He recalled the story of Shermag Inc., a Quebec-based furniture maker that earlier this decade stopped manufacturing its own product locally and decided to manufacture and distribute furniture made in China.
"Investors realized the stock was no longer the stock they bought and sold out in 2002 and 2003," he said. Sure enough, in 2008, Shermag filed for bankruptcy.
Robert Floyd, the lead manager at R.A. Floyd Capital Management Inc., admits to taking some knocks over his 30-year career because he didn't sell soon enough or didn't sell at all.
For him, knowing the right time to take profits is a matter of consistently reassessing the true worth of the underlying investment, whether it be a stock, bond, exchange-traded fund or commodity. At the same time, it is equally important knowing what to do with the proceeds of the sale.
"If you like a sector but the stock you own now trades at a premium value, look for another stock in the group that trades at a discount," Mr. Floyd said.
"In many respects, that is where we are in this market. There are some names that have gone wildly positive and others that are laggards that make more sense."
The other possibility, he said, is shifting out of the sector entirely into a cheaper sector that is trading at more attractive valuations.
As a total-return investor who views performance as a combination of capital gains and dividends, Mr. Floyd said people must never forget why they bought the stock in the first place. During the market collapse of 2008 and early 2009, he held on to Baytex Energy Trust, even though it got crushed.
"I didn't sell, because I thought it was a terrific cash machine. They did cut their distribution and it went from the mid-$30s to the teens, but I needed to generate income for my clients and it was still providing cash flow on a regular basis."
Valuing the worth of a stock to determine whether it trades at a discount or premium can be a complicated affair. It will depend largely on the company and sector being bought and sold, but also on the type of investment style being employed.
Managers who rely on fundamental analysis may look at earnings and revenue momentum as well as balance sheet strength, for instance, while technical analysts will rely on moving averages, resistance levels and seasonal indicators (Sell in May and Go Away).
Ms. Hruska, who runs an oil and gas fund, uses a combination of strategies, including cash flow multiples.
For example, she likes to buy companies that are trading at 3x cash flow, compared with 5x, which is the average for the group. Once it gets over 7x, she will consider selling it, but it is not always a hard and fast rule.
"We look at what the market is doing as well," she said. "If we see strength, we may extend for a few days. At the same time, we don't delay too long."
Colin Cieszynski, a market analyst at CMC Markets Canada, believes using fixed targets such as those utilized by Ms. Hruska makes for smart investing.
One method used by many of the short-term traders he advises is to sell once a stock either rises to a pre-determined price or falls to a pre-determined price.
"Generally, you would look for a stock where your return-to-risk ratio is at least two-to-one. In other words, a stock bought for $10 would be sold at $12 or more, or if it falls to $9.
"It is important to avoid marginal trades. If a stock could go up one dollar but down two, you don't want to make those trades."
Another method is to use a trailing stop. Using this strategy, investors stay invested as long as the trend is in their favour, Mr. Cieszynski said.
"You might start with a stop loss at 10% below the buy price. If the price goes up, you would keep moving the stop loss up in proportion. Therefore, you only sell when the stop loss is triggered," he said.
If the underlying stock is volatile, Mr. Cieszynski thinks a wider berth with your stop loss may be necessary so the trade does not get knocked out too early.
"If you are day trading, you probably go with some pretty tight stops. If it is weeks or months, there's probably more leeway," he added.
No matter what strategy one utilizes, Mr. Cieszynski cautions investors against becoming complacent.
"The market is dynamic and always changing, he said. "Be proactive, particularly in a consolidating market like we have today. You do not want to outstay your welcome."