Selling into strength

For a little while I’ve been meaning to write a post on selling into strength i.e. selling when a share is rising in price. A couple of things have prompted me to consider whether I should sell into strength more often. The first is some of my experience last year, where I gave back most of the gains on a few profitable positions, when the market became a bit choppy. The second is reading a couple of books published by momentum investors (O’Neill and Minervini) who seem to swear by it.

The hardest decision?

I’ve very often read that when to sell can be the hardest decision in investing. This may be superficially true if you make investments without a plan and try to decide when to sell based solely on judgment. However, it is a problem easily addressed with some simple and sensible rules to avoid you making emotionally charged decisions. For example, a ‘buy and hold’ investor of quality growth stocks may decide to sell ‘only if the story changes’. A momentum investor may use stop losses to sell whenever shares lose momentum. If you have sensible rules, I think when to sell should really be one of the easiest decisions in investing.

I have clear rules for when to sell, as set out in my investing strategy page. Broadly, these are to sell on profit warnings, reversals in momentum, to trim back a holding that has got too large or if there is a better opportunity that I need to raise funds for immediately. I’m happy with these rules, but I’m considering whether I can define a 5th situation in which I should sell – when a share price is still rising, but I’d be better off taking profits to raise cash (and invest in a better opportunity at a later point).

Selling into strength

The main reason I haven’t considered selling into strength previously is that I wanted to capitalise on the momentum factor as much as possible. This implied doggedly holding a share until it stops rising in price so that is what I did. As a strategy it has worked quite well. But I’ve thought of a couple of reasons why selling into strength on occasion may do even better, if applied well…

When markets are choppy

As I’ve often said, the bane of any momentum strategy is choppy markets, as these can induce you to sell out on the lows and buy back again on the highs. A general policy of sometimes taking profits when the share price is rising, rather than waiting for it to start falling again, can mitigate this effect.

However, you don’t want to sell too often when the price rises, as snatching at profits reduces the benefit of following a momentum strategy in the first place. You need to make sure that the ‘trading maths’ still works, in other words that the probability of a successful trade and the relative size of profits and losses mean you maximise your performance overall. In general this means taking profits at a multiple of cutting losses. For example, if I use stop losses at 10%, I might want to aim to get at least 20% profit before selling into strength (given under 50% of my trades are successful).

Opportunity cost and the time factor

A second important reason to sell into strength is that holding a share carries the ‘opportunity cost’ of what you might otherwise do with the money. The implication of this opportunity cost is that the ‘time factor’ (or portfolio turnover) is a key component of total returns. I’ve explained this previously here – broadly the idea is that you can benefit very significantly from reallocating your funds from the worse to the better opportunities more quickly.

Selling into strength can help with this. Even without selling into strength, I do occasionally allow myself to sell out of my worse-performing positions when an excellent opportunity presents itself. However, judging when to do this can be tricky as there is a balance to be struck between under and over trading. Occasionally taking profits when prices are rising can provide a more mechanical and reliable way of ensuring there is enough churn in the portfolio to take advantage of the best opportunities available at any given time, without having to make tricky judgments.

Selling into strength presupposes that you can identify better opportunities than the candidate you are thinking of selling, even though its price is still rising. This is difficult, so I think means the tactic should be employed sparingly. You shouldn’t sell out of one of your best opportunities that you’re likely to want to buy back into fairly shortly.

The reason that momentum investors like Minervini and O’Neill advocate selling into strength is that their strategy focuses on short term catalysts (‘breakouts’) – basically they believe a share that has just broken out after a period of consolidation is likely to offer a better risk reward than one that has been rising in price for some time and is ‘extended’. Because of this it makes sense to them to take profits when they have made sufficient profit and the price is still rising to quickly take advantage of the next breakout opportunity. I think there may be something in this type of ‘technical’ trading but it’s a tricky subject – one for a further post. More importantly, the high level principle applies more broadly to other catalysts (such as positive news) and to other factors such as the relative valuation i.e. the things I keep track of in ranking my watch list.

New string to the bow

I’m going to add selling into strength to my list of rules of when to sell. I’m going to implement it by reviewing holdings when they are 25% in profit, even if they are still rising in price. I’ll then sell in situations where I would be unlikely to reinvest again soon in the same holding, either because there are significantly better opportunities in my watch list or because the market is looking negative and I’d be better off holding more cash.

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