❛ Pre De­fined Exit Strat­egy ❜ A Pre­cur­sor To Sound Port­fo­lio Re­turns

Dalal Street Investment Journal - - CONTENTS -

In­vestors tend to fo­cus on En­try strate­gies and pay lit­tle at­ten­tion to Exit strate­gies. Yo­gesh Su­pekar along with Karan Bho­jwani ex­plain how im­por­tant Exit strat­egy is and how it can be used prof­itably

Rohan has been in­vest­ing in stock mar­ket since last 5 years. While the BSE bench­mark Sen­sex has dou­bled in the last five years, Rohan’s port­fo­lio has strug­gled to gen­er­ate pos­i­tive re­turns. In fact, Rohan’s port­fo­lio is down by 30-odd per­cent­age points even after stay­ing in­vested for the ‘long term’, i.e five years.

Even as mar­ket par­tic­i­pants are busy cel­e­brat­ing Nifty @ 10,000 land­mark, in­vestors such as Rohan are sulk­ing look­ing at their port­fo­lio re­turns. Why has Rohan’s port­fo­lio un­der­per­formed? What went wrong? The rea­son for the un­der­per­for­mance of Rohan’s port­fo­lio is sim­ple. He has, like many other in­vestors, stayed in­vested in ‘un­der­per­form­ing stock(s)’ for too long.

The plight of Rohan is shared by many re­tail in­vestors even in the cur­rent bull mar­ket. Of­ten, in­vestors keep think­ing “Why is my port­fo­lio not grow­ing when the mar­kets world over, in­clud­ing In­dian mar­kets, are touch­ing record highs”?

A stock is said to un­der­per­form if it gives a re­turn that is worse than an in­dex (bench­mark) or the over­all stock mar­ket

It is com­monly ob­served that many in­vestors pur­chase stocks which they think will pro­vide mar­ket-beat­ing re­turns, but even­tu­ally these stocks turn out to be 'un­der­per­form­ers'.

Once an in­vestor bets heav­ily on an un­der­per­form­ing stock by al­lo­cat­ing a higher per­cent­age of funds to the stock, he or she is bound to suf­fer lack of con­fi­dence when it comes to in­vest­ing fresh money into the stock mar­ket. But then, this is bound to hap­pen with the best of in­vestors. One of the com­mon mis­takes that re­tail in­vestors com­mit is hold­ing on to stocks that are not do­ing well and book­ing prof­its early on those stocks that have gen­er­ated good re­turns.

This pe­cu­liar trait of the in­vestors to

keep hold­ing on to un­der­per­form­ing stocks costs them dearly, as not only does it drag down the port­fo­lio re­turns, but they also lose out on op­por­tu­ni­ties to in­vest in other stocks that are do­ing well. So there is an op­por­tu­nity cost at­tached to un­pro­duc­tive in­vest­ments, and this cost could be very high.

While there is no sim­ple for­mula to solve the mys­tery of when to exit a stock prof­itably, there may be a pro­ces­sori­ented so­lu­tion that, if adopted by re­tail in­vestors, will help limit the dam­age caused by un­der­per­form­ing stocks. Hav­ing an exit strat­egy thus be­comes ex­tremely im­por­tant. With­out a proper exit strat­egy, the chances of win­ning the game of in­vest­ing are low in­deed.

While for­mu­lat­ing an exit strat­egy, three things need to be very clear in the minds of in­vestors and traders alike. In­vestor need to de­fine How long is he or she plan­ning to re­main in­vested in the trade. Once the ten­ure is de­fined, quan­ti­fy­ing the risk tol­er­ance will be cru­cial. In other words, one needs to ask one­self – How much risk am I will­ing to take? The third most im­por­tant as­pect on de­vel­op­ing exit strat­egy will be know­ing where, or at which point, should one get out of the in­vest­ment?

Sea­soned mar­ket par­tic­i­pants will agree that the 'sell' de­ci­sion is the most im­por­tant de­ci­sion that an in­vestor or trader makes in his in­vest­ment ca­reer. Hav­ing an exit strat­egy in place is the best risk man­age­ment tool and, if ex­e­cuted prop­erly, will help long-term in­vestors make money in the eq­uity mar­kets and, at the same time, limit the down­side. Hav­ing an exit strat­egy also brings in an el­e­ment of dis­ci­pline in trad­ing, which ul­ti­mately helps the

In­vestors must re­visit the long-term in­vest­ment the­sis and make sure it re­mains in­tact. If it doesn’t or if the in­vest­ment the­sis has been ful­filled, one should then sell the in­vest­ment and put the pro­ceeds to work else­where. That can hap­pen in less than a year

in­vestor in the long run.

When an in­vestor en­ters a stock, it is ad­vis­able that he or she keeps a tar­get price im­me­di­ately look­ing at the com­pany's earn­ings out­look.

DE­TER­MIN­ING THE TAR­GET LEV­ELS

The tar­get level should be ide­ally put at the near­est op­po­site level of de­mand (sup­port level) in the case of short po­si­tion or the near­est op­po­site level of sup­ply (re­sis­tance level) in the case of long po­si­tion. There can be mul­ti­ple lev­els of sup­port or re­sis­tance for a stock, but ide­ally the near­est level of sup­port or re­sis­tance from the en­try price should be the tar­get price to exit. Hence, if a trader has gone short on a stock, he should put his tar­get price at the near­est price level where the scrip is ex­pected to find strong sup­port. On the other hand, if the trader/ in­vestor has gone long on a scrip, his tar­get price should be at a price level where the scrip is likely to face stiff re­sis­tance. This is be­cause the scrip is likely to re­verse its up­ward or down­ward move­ment from the near­est price level where it finds strong sup­port or re­sis­tance. Of course, some­times the sup­port or re­sis­tance level can be breached due to strong down­ward or up­ward mo­men­tum in the stock, in which case the tar­get level will be reached be­fore the stock runs out of steam and

If an in­vestor buys a stock. There are two pos­si­ble sce­nar­ios, ei­ther the stock won’t achieve the de­sired tar­get or might achieve the tar­get be­fore the pre-de­fined in­vest­ment ten­ure. Both the cases war­rant ex­it­ing from the counter. Let’s say an in­vestor has in­vested in a share of a com­pany at ₹100 per share and ex­pects the stock to reach ₹140 per share in 9-12 months. The stock achieves the tar­get price in three months. The best way to man­age such a sit­u­a­tion is to exit even if the stock crosses the tar­get price. In a dif­fer­ent sit­u­a­tion, where the stock price drops by, say, 15-odd per cent in 9-12 months and fails to achieve its tar­get price, it is still ad­vis­able to exit the stock. It is wise to ad­mit that you chose a wrong stock and move on to your next in­vest­ment bet.

re­verses its di­rec­tion.

It is com­mon to find that many in­vestors get emo­tion­ally at­tached to their hold­ings and hold the in­vest­ment even when the fun­da­men­tals have changed. With chang­ing fun­da­men­tals, the stock can get re-rated and its price can drop fur­ther. On the other hand, it is seen that in­vestors, in gen­eral, tend to book profit in those hold­ings where the fun­da­men­tals have ei­ther im­proved or have re­mained un­changed.

Of­ten in­vestors re­gret sell­ing a stock if it climbs fur­ther after sell­ing. One should avoid such feel­ing, how­ever dif­fi­cult it may sound.

One of the bet­ter ways of iden­ti­fy­ing exit lev­els for long term in­vestors is iden­ti­fy­ing the his­tor­i­cal val­u­a­tion range. For ex­am­ple, if a stock has traded at a PE mul­ti­ple of 28 his­tor­i­cally at its peak, and

has traded at a PE mul­ti­ple of 10 at its low­est, in­vestor can use this data in­tel­li­gently and exit the stock when­ever it trades at close to its peak PE mul­ti­ple.

Of course, like with most of the other strate­gies, this strat­egy also has its own draw­backs as the in­di­vid­ual stock un­der con­sid­er­a­tion may get re-rated and it may trade com­fort­ably at PE mul­ti­ples higher than its his­tor­i­cal peak. It may hap­pen that the set of stocks in the spe­cific sec­tor may get re-rated and start trad­ing at PE mul­ti­ples much higher than pre­vi­ously ob­served. Point in case are the fer­tiliser and com­mod­ity chem­i­cal stocks. Same can be said of the tyre stocks. Stocks from these sec­tors are trad­ing at much higher mul­ti­ples than pre­vi­ously ob­served.

One would ar­gue that, in such a case, how does one book multi­bag­ger re­turns.

Here, for the long term in­vestors, the trick is to re­view the stock en­core and ask your­self this ques­tion – “Would you buy this stock afresh, given its present out­look and valu­a­tions”? In case of a stock where the present out­look and val­u­a­tion re­main at­trac­tive, in­vestor should not sell the stock even if it has achieved its set tar­get.

IDEN­TI­FY­ING EXIT LEVEL

Of­ten smart in­vestors, in­clud­ing fund man­agers, are seen ex­it­ing the stocks once the rea­son for buy­ing the stock has changed. Also, smart in­vestors exit stocks when com­pa­nies, in search of growth, sud­denly di­ver­sify into un­re­lated busi­nesses. In­vestors should es­pe­cially show small-cap and mid-cap com­pa­nies a red flag when these com­pa­nies di­ver­sify into un­re­lated busi­nesses that have caught mar­ket fancy.

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