Your stocks have risen, should you sell?

Your stocks have risen, should you sell?

You've dug down, done extensive research, and ended up with stock that has made a handsome profit.

Congratulations! Not many people can claim to have done well in investing, so give yourself a pat on the back.

However, we are now faced with a different problem.

When stocks rise significantly above our buy price, we are faced with a happy problem.

Should we sell now to lock in our juicy gains, or should we hold out for even more gains in future?

Sometimes, we may sell out too early, only for the stock go on to double or more. This sets us up for regret, as your capital could have grown so much more had we simply stayed vested instead of taking a profit too early.

So, how should we know if it's the right time to sell our shares?

Let's look at two components to the increase in share price - the objective return and the speculative return.

THE OBJECTIVE RETURN

Share prices are actually a function of two components - the underlying increase in the earnings of the company, and the price-earnings ratio multiple (PER) that the company trades at.

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The former is simply the year-on-year growth in earnings as a result of improved business prospects, resulting in higher revenues and net profit. The latter, however, is a function of sentiment and others' expectations of how the company will perform in future years.

To give an example of objective return, let's take a fictional company called Company A.

The fictional company generated earnings per share (EPS) of $1.00 for 2018. In 2019, this figure grew to $1.10, meaning the underlying growth in earnings equates to 10 per cent.

Now, if we were all living in a rational, cold and logical world, all stock market returns would simply consist of the objective return. In other words, a 10 per cent increase in the earnings per share would result in a 10 per cent increase in the share price.

However, we know that this is not the case in real life.

If a company that reports a 10 per cent jump in earnings but sees a 50 per cent jump in share price, the gain is not from objective returns alone.

THE SPECULATIVE RETURN

With that, we now come to the second component of share price movements - the speculative return.

This return is determined by investors' perceptions of the PER that the share should trade at based on the company's characteristics, prospects and corporate strategies.

Using the previous example, Company A reported an EPS of $1.00 for 2018, and investors decided that based on its growth trajectory and prospects, it should trade at a PER multiple of 15x. Therefore, the shares were priced at $15 back then.

With the 10 per cent jump in earnings, and perhaps the company announced a new marketing strategy or new product launch that has great promise, investors now feel much more optimistic about the company's future sales and profit growth.

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Because of the optimism, investors may now feel that the shares should trade at a multiple of 20x, yielding a share price of $22 ($1.10 multiplied by 20).

If you do the math, the jump in the share price from $15 to $22 is around 46.7 per cent, but the only thing that has actually changed is that the company reported earnings growth of 10 per cent.

WATCH OUT FOR THAT BUBBLE!

You would probably figure out by now that speculative returns usually account for a much larger component of a company's share price gains than its objective returns.

Part of the reason is because human beings are generally optimistic.

When we see good results and performance, we tend to extrapolate recent trends into the future without considering the risks and challenges the company may face.

So, look at the performance of your own stocks and do a post-mortem. Have most of the share price gains been driven by the objective return (i.e. underlying rise in earnings) or the speculative return (i.e. an expansion in the multiple which the shares are trading at)?

If it is the latter, then it might be a good idea to consider selling as that may mean the shares are over-valued.

GET SMART: NEVER BLACK OR WHITE 

But before you go ahead and sell something that may continue rising, ask yourself this too: is the speculative return justified?

Are people correct in assuming that the company will continue to do well far into the future?

Or is this just a temporary surge and everything will settle back down to normal again?

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The reason to ask this is simple: in the stock market, it is never black or white.

In fact, they are often in shades of grey. As investors, we should also not think in terms of absolutes.

Speculative return is not always "bad" as it all depends on the situation.

If the company truly has climbed up the competitive ladder to be able to offer stronger future growth prospects, then maybe it does deserve to trade at a higher multiple.

Investors should then hold on their shares as the company goes on to earn higher and higher profits as the years go by. Its share price should also follow the same trajectory and also continue to make new all-time highs.

However, if the company's success is temporary and is not able to last, investors may be doing themselves a great favour by selling when everyone is feeling (unduly) optimistic, as this may signal that the shares are grossly over-valued.

So, the next time you are faced with the happy problem of a soaring share price, think through the above and decide for yourself if the rise is justified, and whether the shares should be sold, or kept.

This article was first published in The Smart Investor. All content is displayed for general information purposes only and does not constitute professional financial advice.

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