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