How And When To Break Up With A Stock
While Valentine's Day is a time to show some appreciation to those we love, and maybe even a chance to ignite a spark with that special someone you have known for some time, there is also a darker side to Valentine's Day. Maybe it is me, as I was never one to have a mailbox overflowing with Valentine's requests back in the day (believe it or not!), but this special day often seemed to be a day where many would also re-evaluate their relationships and benchmark them against their more popular peers. Many might conclude that “It’s not you; it’s me”, and decide that Valentine's Day (or at least after waiting a reasonable period after the day) is the time to break up and move on.
While hopefully, you don’t have to go through this turmoil in your personal relationships this Valentine’s Day, it might be a good time to go through the process with your unloved stocks. It is hard; you have been together for a long time. There were good times and bad, ups and downs, and maybe the relationship even paid dividends, but the love that was there is now gone. So, how and when do we decide to break up with a stock?
When looking to break up and sell a company out of your portfolio, it should be broken down into two types of selling decisions. The first is fundamental, where it is related to something going on at the company level. The stock isn’t the same as when you first started dating, and now you are questioning your relationship. The second reason is related to portfolio management. Typically, this will fall into more of a trimming type of decision. The stock has become too large a part of your portfolio and it is time to reduce that size.
Maybe there is a tax planning reason where you want to realize some gains or losses but will return to it. From a relationship perspective, this might be more akin to taking a break, needing a bit of time and space, or maybe your parents don’t approve of the partner (for now). Since we are talking about a full break-up, we are going to focus more on the fundamental side of the equation.
Time Is Up
The key is to think long-term in relationships and investing. As the saying goes, “It is about time in the market not timing the market”. However, at the same time, your investments need to start producing some level of acceptable results. Think of it as that partner who is never able or willing to commit. You can’t spend your whole life waiting and hoping for them to step up! It is the same with stocks. The timeframe might be different to different people (we try to think 3 years out, but of course prefer stocks to “work” sooner than that) and timeframes might even differ depending on the investment in question. We might expect a bit less from a bank stock, for example, versus a tech stock.
Regardless of the stock in question, though, investors need to keep an eye on things and give some of their investments a shelf life. Sometimes it does simply take time for the rubber to hit the road at a business, but there are also costs to waiting too long. There are opportunity costs from other investments that might be better contributors than the company in question. A long-term timeframe and long leash should still be given to these names, as patience and long-term thinking are so important with investing, but an investor should evaluate stocks over time and if they simply aren’t doing what you expect them to do, it might be time to move on.
You could evaluate it on an absolute basis, and if it simply has not provided a certain level of annual return over a timeframe, it is time to cut bait. However, to be fair to the company in question, it might make a bit more sense to compare that performance to the market or sector it operates in, or even to a few direct competitors, depending on how granular you want to get. If all the other companies in their space are also showing a lack of commitment, maybe it is just a sign of the times and not quite right to move on…yet.
The Stock Is No Longer What You Thought It Was
It happens, sometimes people change. Stocks and companies do, too. If that stock is floundering but it looks like there is good reason for it at the fundamental level, it is probably time to move on. To assess this, you will likely need to remember why you got into the relationship in the first place. Keeping some brief notes on your investment thesis when you first start into the “relationship” can be a good habit to get into. Maybe you first purchased it for a strong balance sheet, but they have now gone out and taken on a bunch of debt. Or maybe it was a high-growth company, and the growth story has run its course, or the growth was never quite what they initially sold you on. This is probably another good reason to move on. Whatever the reason is, the key is that something at the fundamental level, or a characteristic that made up the core investment thesis in the beginning has now changed and is no longer the same.
There’s Someone Else
This might be the hardest for the stock. It didn’t really do anything “wrong”. You just found someone else who is a better fit, and that’s okay! This scenario typically applies to a portfolio that is fully invested and there is only so much capital to go around. As you continue to evaluate the opportunities that are out there, you come across a great potential investment, but need the space to be able to add it. Alternatively, to needing the actual capital, some investors might have a bit of a cap on the number of companies they are willing to own. Once they hit that limit, to add a new name, they need to boot another one out.
This is a healthy process as it ensures you are always looking for new ideas and opportunities, but it also helps to high-grade the entire portfolio a bit, as companies with less potential leave the portfolio and those with a better risk/reward setup enter the portfolio.
We might call this one the true “it’s not you; it’s me” excuse for knowing when it is time to sell a stock. Something better came along and everyone will be better off for it.
Maybe you have spent some time thinking through these reasons, but still don’t think the time is right, or you just aren’t sure yet. That’s ok, but one mistake we have all made in life and with investing is doubling down. A stock isn’t working, but hey, it is cheaper than when you first bought it, so you decide to add it to the name. We think this is one of the biggest mistakes investors make over time. They average down to losing names, when often they are losing for a reason. Adding to the position is not going to change what was wrong with the stock in the first place. It can work at times, don’t get us wrong, but just like buying a house or going on a big vacation isn’t going to solve your underlying relationship issues, averaging down on underperforming names is probably not going to solve a lot of problems. It is ok to give it time and see if they can shape up, but let the company show you they can improve before adding to the name!
We have taken the time, and now we know it is indeed time to break up with a stock. Now we need to look at how to go about doing it.
Consider Using Limits
When selling (and buying) you probably want to consider using limit prices. A limit order is an order to buy or sell a stock with a specific restriction that is set. In the case of a buy limit, it is the maximum price you are willing to pay for the stock. In the case of a sell limit, it is the minimum price you are willing to receive. Using these limits helps give you a bit more control of the situation and ensures you are getting what you expect, in case the stock runs away from you in one direction.
One thing to keep in mind on sell limits is to not get “too cute” when setting your limit price. You have done the work, you know you want out of it, and it is time to move on. Don’t try to get the perfect price that may never come. Waiting for that perfect price likely adds more costs, as it keeps you from moving on to better opportunities or maybe it goes even lower, increasing your losses.
Let The Stock Down Gently
In this case, you might know that your days with the stock are numbered, but maybe you want to take a bit of time to “set the table” for your departure. Averaging out of a name can make sense. Doing so might allow you to get better prices if the stock drifts higher as you sell (but this of course cuts both ways). Maybe it also gives you a bit of time to assess what your next steps are going to be with your newfound funds or find other ways to offset any tax impacts elsewhere in the portfolio. If it is a less liquid investment, going about it slowly might be your only option as well.
One thing to keep in mind with this approach is transaction costs. The more times you sell, the more costly the break-up is going to be.
Rip The Bandage Off
It is harsh, but this is often the best approach, and the one we prefer. The stock is underperforming for good reasons, and you have decided it is time to sell. Sitting and waiting only gives the company time to continue the bad habits it has been doing for the last few years! It has had its time and plenty of chances, but we find it is typically best just to move on and do it quickly. This also leaves you in a bit more of a position of power when you are thinking clearly. One of the worst outcomes could be when you are already thinking or planning to sell, then some bad news or a negative catalyst occurs in the meantime, and you end up being more of a forced seller at the bottom opposed to doing it on your own terms.
Perhaps the timing won’t be perfect and the stock rallies after you sell, but hopefully you have moved on to a bigger and better thing anyway and you and that stock are just too different. Realistically, it was never going to work out, right!?
Ryan Modesto, CFA - CEO, i2i Capital Management