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Many analysts and experts talk about buying stocks and forget talking about exiting them. Selling and exiting from stock is very important decision and it must be taken with great care.

When I started investing professionally, the first question I asked myself or tried to figure out was, why
sell?
It is one of the toughest jobs to identify good stocks to invest and stay long then why sell. Also in some way or the other we get emotionally attached to our holdings. To detach myself from the claws of these emotions, it was very urgent for me to identify valid reasons for selling any stocks.

Professionally, if you ask me, then there are five reasons I look for to sell any stocks. They are as follows:

  1. 1.Business performance is at decline
  2. 2.Business value is in decline
  3. 3.Share prices rise well above its value
  4. 4.Future growth is less promising
  5. 5.A superior other investment is found

I have divided this very important topic in two parts. In today’s blog, I will explain you my first two reasons.

  1. 1.Business performance is at decline

In my opinion there are four things that can affect the performance of any business.

Businesses are dynamic in nature

Businesses are dynamic in nature and they change all the time. Their profits change, composition of capital changes and also many times their products changes. Let me give you example of how dynamics of Bharti Airtel had changed in last 4 years. Last financial year Bharti Airtel made profits of around two thousand Crore, that has dropped down from Nine thousand Crore not too long!!

When you buy or sell any shares, what you are doing is buying or selling part of that business. Because you have bought that business, I cannot stress enough but you are tied 100% to how that business performs… if a business had performed well in the past, whilst not always true, it should continue to do well in future. If you don’t look at the past, you may get caught holding poor performing businesses that are declining from its peak performance.

This is what happening with Bharti Airtel today. Bharti Airtel performance is at decline and to explain my first reason, I will be sharing our investment rationale in regards to this business in more detail.

Economic environments change and impact business model

We talk and listen a lot in the media about FDI in retail, insurance, pensions etc. we are listening and reading a lot about paralysis of reforms by GOI. These reforms and government policies can change the whole economic environment and can impact businesses in positive as well as negatively. The reforms in the gutka packaging had a very diverse impact on Ester industries business model is one of the example.

Consumer’s sentiment changes

Who would understand this better than us? The life of human being changes all the time and that changes its taste and priorities. When he is young and single and not burden with any family responsibilities, he prefers buying clothes from expensive retail outlets, eat in branded outlets and spend all his earnings. But as he gets into serious relationships and gets mature, his priorities to spend changes. Suddenly the wave of foreign brands like Dominos, KFC and Mc Donald’s changed business conditions of our local idly dosa and wada pav and sandwich eateries. You would love to go and eat at your local eateries but maybe not your kids!

Businesses that fail to adapt can be left behind

Which brand do you like most? Just think about it and compare their old advertisements with their new ones. As a big fan of sweets and chocolates, I use to love watching old ads of Dairy Milk. If you compare them with today’s ads, product is same but pitching of their products (consumers) has changed. You will notice that they have adapted themselves to their surroundings.

Businesses that are struggling to update their websites, not getting connected to their consumers by social media and adapting to E-commerce will find them left behind in the race. I do not want to get involved in the name and shame of businesses which are lazy to even update their websites. A home work for you all, go and look at your invested businesses website and rate them on how easy they are to browse for information.

  1. 2.Business value is in decline

Valuing any business is more of art than science these days. To keep it simple, if you are expecting a 10% return every year on your bond investments. Then a business with return on equity of 20% will attract bond investor to value that business twice to its book value (20/10 = 2).

In the second year if the same business reports return on equity of 12% then that bond investor will be happy to pay 1.2 times of its book value (12/10 = 1.2). And if it falls to 6% then he will be willing to pay only 0.6 times of its book value. Bharti Airtel book value per share as per March 2012 is Rs 133!!

As business starts to fade its competitive advantage their return on equity starts falling down. Same
time looking at the past performance and its future expected earnings can help you understand the behaviour of business performance and its cycle.

Coming back to Bharti Airtel and our reasons to sell stocks, I cannot stop emphasising how vital it is to understand return on equity ratio to understand any business performance. Many people talk about return on asset is the real ratio to look at performance. But if you are investing with companies that have little or no debt then return on equity is same as return on assets.

Bharti Airtel return on equity has dropped down from 31% to 5% for the year end 2012.

Bharti Airtel

Bharti Airtel value had grounded badly for the year end 2012. It could take another 3 – 4 years for Bharti to match its ROE of 2011 (As of 3rd October 2012). These estimates change when businesses update their earning guidance, report profits, liquidate capital etc.

Investors who had invested in this business five years back and have not exited from this business in 2011 are sitting on massive losses. It is important to understand that preservation of capital is always our first priority and same should be yours too. Last but not least, we don’t change our views on stock looking at price!! You should also not!!

Stay tuned for the part two post to read in the weekend. If you liked this post or want to share your valuable experience in investments with us then you are most welcome.