Investing Knowledge

Having invested in a value share because it satisfied your purchase criteria, you should then switch immediately to a sell frame of mind regarding that particular play. 

The sale may be some time away because value requires lots of patience. If you are lucky it may be pretty soon, but either way your aim is now to dump the share as soon as it makes sense to do so according to your particular views. 

So as soon as you enter, start looking for the exit. The general idea is to have your cash at risk for as little time as possible.

The price paid is irrelevant

Note (Stockholm: NOTE.ST - news) that once you are in, the purchase price is virtually irrelevant. I know that you can't forget it, it's always there lurking in the recesses of your mind as well as in your records. But you must try not to let it affect your sell decision, because that decision needs to be based on a repeated appraisal of the share as it stands now, not as it did when you bought it or how much profit or loss it is making.

Emotionally, selling is naturally welcome if you are showing a nice profit but it can hurt if you are showing a big loss, making you possibly reluctant to take the hit. But if you are a regular value trader, as with any trading strategy, you will sometimes have to take the punches.

Sell when the value is outed

My idea is that you sell a value share when it no longer exhibits sufficient value. That can happen either when it is showing a profit or a loss. You bought the share on a certain price/earnings ratio, yield, price to book or whatever criteria you choose and should hold as long as it remains within a certain range of the levels you find attractive. Don't forget though that these ratios are relative to the market or sector. Here's what I mean.

Suppose a buy a value share on a P/E of 7 against a background sector comparison of 10. The price rises quickly to give a P/E of 11 on the same eps forecast, a decent gain of 57% in price but forget that. Should you now sell? 

Well, it depends what has happened to your comparison P/E. If the latter is still around 10, then value has evaporated in your share and it's probably a sell, based on that criterion in isolation. But suppose the sector has also risen strongly and now trades on a P/E of 15, what then? At 11, your share is still at a roughly similar P/E discount to the sector as when you bought it. In other words the relative value hasn't really been outed yet despite the strong rise. 

To do that, the P/E should go to around the sector mean. Then I'd sell. Yes, it may go even higher, but always leave something for the next guy, don't try to find the exact top, that's not for pure value players because a share that's dearer than its peers cannot really be described as value.

What happens when things go wrong

Now take the less than attractive situation where your play goes wrong because any or all of eps, dividends, assets, debts turn out to be not what were forecast when you bought. You find an ostensibly attractive share on a P/E discount to its peers and go in. The analysts' predictions go awry dramatically, so much so that the company makes no profits at all but delivers large losses, abandons dividends etc. and the share price dives. 

You're down 50% or more. What to do? Bin it I'd say, thereby releasing whatever cash you can salvage for your next play.

There is a huge emotional temptation in these losing cases to hang on, hoping for recovery. And if you are lucky that may work in time. But my point is that unless there is some highly redeeming feature in the share like serious asset cover, you are no longer holding a value play and being a value player means holding value shares and only value shares. 

Once the value has evaporated, even in a bad way by losing fundamental qualities in contrast to the good way by a rising price as in the earlier case above, it's time to say goodbye. In both cases though, the similarity is that it is the disappearing value that has made a sell desirable.

I've oversimplified the above by using P/E to make the point but in practice you need to look at all the criteria to make your judgement. For example, the P/E could go non-value but the share might still look good on price to book, yield or net cash or other combinations of various value measures.

Big bad banks

My most recent example of a hit like this is the big banks. 

There was a time last year at which they seemed ridiculously cheap. The disaster scenario that eventually happened just didn't seem that likely. It was always a possibility of course, even the biggest shares can go under, but I saw it on the balance of probabilities as having much more upside than down. 

Finally, it all went wrong and how, as we all know now. I got that one wrong and dumped at a large loss once it became clear just how bad things really were. 

I could have hung on and actually I do believe that shares like Lloyds Banking Group (LSE: LLOY.L - news) (LSE: LLOY) and Royal Bank of Scotland (LSE: RBS.L - news) (LSE: RBS) will in the long run recover handsomely. I would not advise eternity players like those who follow the High Yield Portfolio strategy to sell. But we're talking value trading here and my money in this strategy was, I believe, better off elsewhere, painful though it was.

Never look back

Whether you made a profit or loss on a value trade, never look back to see if you would have done better if you had stayed in. It doesn't matter, move on. The essential thing is that you did the right thing by selling when you did according to your rules. You bought what you saw as a good value share and you sold what was no longer such a good value share. 

This can mean that you might sell too soon, something I've done several times with a sharply rising share. By chance, someone actually said to me today about Inchcape (LSE: INCH.L - news) (LSE: INCH), one of my Fool value plays from years ago, that it went on to go many times higher after I sold. 

So be it, but it wasn't rising then as a value share. If the next guy made a lot out of it, good for him, he's not a value player. And incidentally it's since collapsed, I hope the next guy didn't hang in too long.