It is said that in the stock markets you make money only by selling. Notional profits are notional, period! The best of stock market buy decisions are pointless if you are not able to get out of the stock at the right time. That brings us to the fundamental question; when to sell a stock in the market? That is a fairly complicated question and you need to look at this issue in a much nuanced way. Let us look at some of the nuances that are implicit.

How do you decide on exit if you are a trader?

Traders are basically in the stock market for the very short term. They try to buy a momentum stock at a reasonable price and exit the stock when there is an opportunity. For such traders there are 2 critical levels that could trigger a sell decision. First, is the stop loss level! As a trader, you must never trade without a stop loss. It is the level at which you book loss and exit the position and is normally the technical support level of the stock. Your basic rule should be that the moment the stop loss is triggered you must simply exit your position. The second level is the profit booking level. As a trader, you must respect your stop loss levels and your profit booking levels. A smart trader is one who buys on expectations and sells on announcements.

What should be your approach to selling stocks when interest rates are headed upwards?

You may wonder how interest rate movements could impact the value of your equity holdings. It is one of the key factors impacting equities. You will find equities gaining value when interest rates are cut and typically losing value when interest rates are hiked. If the RBI is indicating that interest rates are headed upwards, then it is better to exit equities. A rise in interest rates will mean greater strain on borrowers and also future cash flows get discounted at a higher rate. In terms of priority, the worst hit in the event of a rate hike will be rate sensitive sectors like banks, automobiles, NBFCs and real estate companies. There are also other aspects to this argument. When rates go up, the cost of borrowing of companies also goes up. For example, in the last one year when bond yields have gone up Indian companies have seen a 120-150 bps increase in their borrowing costs. This impacts their cost structures and also puts them under pressure on the solvency front. The immediate impact will be visible on a worsening interest coverage ratio.

How should I approach the sock when FIIs are selling?

Not every FII selling is a signal to sell. They also have their own allocation constraints. But if you see consistent selling by FIIs, then it can be a solid reason for you to start selling out. Focus on the word “consistently”. In any month, there are going to be days when FIIs sell. That is more likely to be routine profit booking and you need not be worried about that. But look at situation like 2008, 2011 and 2015 when FIIs turned consistent sellers and the markets corrected sharply from these levels. FIIs will sell on a consistent basis only when they have changed their view of the Indian market for a period of time. Since these FIIs are the largest contributors to cash delivery volumes, they will have an oversized impact on markets. FIIs impact the Indian market in two ways. Firstly, they depress the prices in the market by selling. The second impact is on the rupee since FII selling is a signal of converting rupees back to dollars. This dollar demand weakens the rupee and makes profits smaller and losses wider.

What should you do when the rupee is likely to weaken over a period of time?

This argument can actually work both ways and hence requires some clarity in understanding. Remember, a weak rupee is likely to help export-oriented sectors like software, pharma and textiles. What we are referring about here is the weakness in the rupee due to macroeconomic concerns. For example, in mid-2013 there were concerns because the current account deficit (CAD) had touched a high of 4.5% of GDP (currently the CAD is 1.8% of GDP). This led to a run on the rupee and the INR fell from 54/$ to 68/$. This also resulted in a large scale sell-off in equities as a weak rupee wipes away the dollar gains of FIIs. When the INR gets wobbly, it is best to sell equities and exit markets.

When the industry in which the company operates is fundamentally shifting or disrupting

In most cases, equities get badly impacted when the industry they are operating in undergoes a fundamental shift. At an extreme level, there are cases like the years 2000, when IT companies lost over 90% value and 2009 when real estate companies lost over 90%. These were the obvious combinations of unreasonable valuations and poor cash flow visibility. But the less obvious is of sectors going out of favour for a length of time. Capital goods went into a down cycle post 2011 and it impacted capital goods substantially. Similarly, the NPA problem has brought PSU banks into perpetual pressure zone. Telecom stocks became underperformers when the ROI just could not keep pace with the cost of debt and equity. More recently, take the case of pharma which has lost heavily as Indian pharma companies struggle to move towards an IP based model. These are all classic case studies for investors to exit stocks in that particular sector.

Bad governance standards is always an important trigger to sell out

We suggest that investors should exit companies the moment there are obvious governance issues. Companies like Satyam, Kingfisher, Deccan Chronicle and Financial Technologies had serious and obvious governance issues long before the stocks went into a tailspin. This should be an early warning signal. When you see governance issues in the company you are invested in, just think with your feet. Remember, institutional investors are extremely touchy about governance issues and this can have a deep impact on the stock price. In the last one year we saw cases like Dewan Housing, Infibeam, and PC Jewellers which crashed on corporate governance issues. For example, Infibeam did not disclose inter group transactions, most NBFCs were caught being opaque on their exposure to the IL&FS group while other companies had seen auditor resignations due to inadequate disclosures.

Finally, give it a skip if the valuations are just not justified by the growth factor

Last, but not the least, apply the valuation rule. Don’t go by P/E ratios and P/BV ratios alone. The question is whether the P/E ratio is justified by growth. Both IT and pharma would have failed this test a year ago. Earnings and revenues were almost flattening but valuations still remained at premium levels in case of pharma. Over the next 1 year, frontline pharma companies lost over 40% of their value. The same is happening to IT. If the numbers indicate that growth is much lower than the P/E and the ROE is less than bond yields, it is time to exit the company. There is no hard and fast rule on when you must sell out of equities. But the above Guidelines will give you a quick guide book. These rules if applied diligently will help you identify most, if not all, of the equity warnings. When it comes to selling, it does make sense to err on the side of caution. Remember, you make a lot more money in the markets by exiting bad stocks early than by holding good stocks long enough.