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Should Investors Sell Losing Stocks to Prevent Further Damage?

Tuesday, October 25th, 2017

At Wilsey Asset Management we employ a disciplined approach to buying and selling equities. Selling equities has always been more difficult for investors because emotions can get the best of you. At our firm there are four questions we ask ourselves when we invest in equities. First, has the stock reached the target sell price? If it has, then 99% of the time we sell.

Question two through four are more important, if the equity declines in value should we sell? We also ask ourselves why we bought the equity. Third, what has changed? And fourth, does the change affect our reasons for investing in the company?

Some investors use stop losses, a selling limit of 10% or set a bottom of when to sell the stock. In our portfolio there are numerous times when had we used this strategy we would have missed out on large returns a year or two later. However, this strategy works fine if you don't know the reason why you bought the stock, perhaps it was a hot tip from your brother-in-law and once again it did not work out. If this is your stock buying strategy, then I highly recommend you use this approach because you are more or less gambling. The same holds true if your broker does not have a disciplined investment strategy. I heard a joke many years ago about brokers who know the price of everything and the value of nothing.

At my firm, we spend many hours understanding the worth of a business. Does this mean everything we buy automatically goes up? The obvious answer is no. So, what do we do when a stock we have invested in declines 20%, 30% or maybe 50% or more? We go back to rule number two and ask why did we buy the stock? A good example is retail, some retail companies are getting beaten up badly as if the only retailer in the future is going to be Amazon.

When a stock declines many people think it was the wrong decision to invest in that equity and therefore one should sell and take the loss. The problem is they are not looking at the current value of what they own. Let's take a look at XYZ retailer, you bought the stock at $60 a share, it now trades at $20 a share, a 66% decline. You hate the stock and just want to get out. It is a tough pill to swallow but let's go back to the fundamentals of why we bought the stock. When we first bought the stock, it had a price to earnings ratio of 10, now that price to earnings ratio is 5.5. This is a positive and makes the stock a much stronger buy. We can also look at what we pay for the sales of a company, if we paid 0.50 for the sales and it now drops to 0.25. Price to tangible book value is one ratio used by value investors because even if the company currently has no earnings, this ratio can show future value. This ratio has also proven to generate some big gains for value investors, but patience is required, and the big returns could take two to four years. Another ratio used is price to cash flow, what are investors paying for the cash flow of the company. XYZ retailer may be generating tons of cash but because of the decline in the stock price investors may miss a retailer in rebuild mode that is still cash flow positive and using the cash to invest in other businesses and the business itself. Lastly, one can look at the estimated forward earnings and what an investor is paying for the forward earnings. Back to our example of XYZ retailer, before the stock price fell, investors were paying 10 times forward earnings and now they are paying 7.2. If you didn’t have the large loss in the equity, you would be thrilled with receiving such a great value but because of the large loss you are thinking emotionally, not rationally. This can cause an investor to realize a large loss because they could no longer stand the red ink on the investment.

As long as the company’s fundamentals remain attractive, holding on or investing more in this company can really enhance your portfolio returns over the long term. But you must overcome your emotional objections that the company is going broke solely because the stock price has fallen dramatically. Our motto at Wilsey Asset Management is “No Emotions Just Results”. There is no room for emotions in investing.

Do you have a question or a company you would like us to take a look at?
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