It is said that entering a stock is a science but exiting the stock is an art. How do you develop the art of exiting the wrong stock at the right time. There could be many reasons for exiting like overvaluation, unfavourable markets, company specific negative inputs, rich valuations, industry level factors etc. But the big challenge is to identify the triggers for a sell in the specific stocks. How do you go about it?
Triggers to sell a stock can be fundamental, technical or even purely news driven. The irony is that most traders and investors understand buy signals quite well but they falter in identifying the sell signals. The next big debate is whether you should predicate the decision on fundamental factors or on technical / chart factors. Ideally, you should first consider the fundamental factors that induce to sell the stock and then ratify it with technical signals. At times, it can also be the other way round wherein the technical charts give you the first signals. Here are 7 important signals that can help you exit the stock at the right time.
In a market like India, always sell when yields on bonds are rising
This is an important trigger that equity investors need to be wary of. Higher bond yields are normally an outcome of rising inflation. We saw that trend in India between June 2018 and November 2018 when the RBI also hiked the repo rates by 50 bps and yields got as high as 8.3% on the 10 year benchmark. Why do higher bond yields matter to equities? That is because, it is an indication of rising cost of funds and that can have negative implications for companies. Rising yields also mean that future cash flows will be discounted at a higher cost of capital thereby depressing current valuations.
It is time to exit when the liquidity in the system is getting tight
If yields are one side of the “sell equity” signal, the other is liquidity. Indian equity markets love abundant liquidity. When liquidity tightens, yields on the short term instruments also start to go up. These include the CPs, CDs, call money etc. When the short term bond yields rise faster than the long term bond yields due to liquidity tightening, the yield curve takes an inverted shape. This indicates pessimism over the longer term and is a clear bearish signal.
Is the company making a mess of its working capital management
Negative working capital is when the current liabilities are more than the current assets. That is when the company has to rely on long term assets to meet the current liabilities. That is a clear case for a maturity mismatch between assets and liabilities. Apart from just looking at the net working capital, the investor must also look at the quick ratio. This considers current assets excluding inventories. The advantage is that you get a clearer picture of liquidity. In the past, we have seen in cases like Arvind Mills where negative working capital was a major signal of downturn.
Is the company paying more to service its debt?
This problem can be clearly seen from the trend of the interest coverage ratio. You can also look at the overall debt service coverage ratio rather than just the interest coverage. If falling interest coverage is accompanied by falling net and operating profit margins, it is a signal of deteriorating financial health of the company. It is clearly a time to sell out of the stock and look at other options.
At a macro level, do you see the trend in rise in credit downgrades?
This can capture the industry trend quite precisely. Do we see consistent rating downgrades on the debt paper of a specific industry? This is an example of strained financials and limited capacity to service the debt. This can be an extension of the previous point but at a sectoral level this can be an important exit signal.
Is the index or the sectoral index falling with rising volumes?
If you look at the market peaks of 2000, 2008 and 2010; they were all followed by prolonged periods of market correction. Normally, a correction of 8-10% can be seen as a normal halt in the up-trend. A correction of more than 15% supported by higher volumes and price damage in front line stocks is a clear indication that all is not well. It is time to sell out in a larger context.
When P/E ratios are closer to historic peaks and way above average P/E
The best way to deploy this measure is to use peer group benchmarks. If the company valuations are out of line with peer group valuations and if financials are also deteriorating; then it means that the margin of safety is negative. Such stocks are best sold out of.
Interestingly, every big correction has had enough advance indicators. It is just that you need to keep a watch out for the same.