When is the right time to exit a stock?
Everything you need to know about the tenbagger opportunity and how to deal with book losses
This is the second part of a blog series in which I describe the basics of my stock-picking strategy. I strongly recommend that you read High-Growth Investing 101, Part 1 before reading this article.
Tenbagger with the right exit strategy
At least as important as a well-prepared buy decision is having a disciplined exit strategy.
When is the right time to exit a stock?
How do you achieve triple-digit gains on a regular basis?
And how do you keep the chance of a tenbagger in your portfolio?
Since the days of the great fund manager Peter Lynch, the term "tenbagger" has been used to describe stocks that increase in value tenfold over the years.
The following sections are intended to help you answer these difficult questions as simple as possible.
The crux of fair value
I could take the easy way out and just advocate the pure doctrine of value investing. This says that you should get out of a stock when it has reached its fair value and the company is no longer undervalued.
This is certainly true in theory, and in High-Growth Investing 101, Part 1 I have already explained a rule of thumb for estimating the fair value of a tech company based on its revenue mix.
But that's just the theory, which I used to put into practice in a very disciplined way in earlier years. However, from my 35 years of experience, I can say that for many years I made the mistake of getting out of a stock too early. As a result, I have missed out on many gains because I thought the stock was too expensive and overvalued after a sharp rise.
What went wrong?
In practice, there is always the problem that fair value cannot be calculated exactly, but must be estimated using a variety of methods.
In addition, when investing in growth companies, fair value is very dynamic over time and, in the best case, grows exponentially with long-term sustainable growth.
Any approximate formula for calculating the fair value of a company is fundamentally incomplete if it is only a snapshot in time and does not include a time component. However, the usual formulas that include a time component, such as the discounted cash flow (DCF) method, have two major disadvantages:
First, they are relatively complex and, second, they are based on assumptions about the future (such as future cash flows) that cannot be predicted with sufficient reliability in a dynamic environment.
Therefore, despite (or perhaps because of?) my education as a mathematical economist, I don't think much of using such models to calculate fair value and then pretending that the result is "THE" fair value par excellence.
Time works for you in High-Growth Investing
Much more important than the correct calculation of a DCF model is a fundamental understanding of the central importance of the time component. By investing in a true growth company, time works for the investor. That's why I love high-growth investing!
Here is a simple example:
Let's say a company generates 200 million USD in recurring revenue from software subscriptions and we assume (e.g. based on my rule of thumb for valuing tech companies) a fair Enterprise Value (EV) of 6 * 200 million USD = 1.2 billion euros.
At the time you bought the company stock, it was valued on the stock exchange at an EV of 800 million USD. And was therefore trading well below its fair value. You bought a position at this bargain price and within the next 6 months the share price actually rises by 50%. The company is now valued at 1.2 billion USD.
The stock would then no longer be worth buying, at least at first glance, but at most a holding position. Suddenly, the broad market discovers the stock and a few months later it is valued at an enterprise value of 1.6 billion USD - a 100% increase on your original entry price.
Should you sell after a 100 % price gain?
To answer this key question, you need to develop a sense of how the fair value of the company is likely to develop over the medium term. It is extremely helpful to understand the company and the market in which it operates as well as possible. That's why I never invest in a company whose business model and market I don't understand.
If the company in our example grows by 30% p.a. for 3 years, it will increase its revenue by around 120% during this period, from an initial 200 million USD to approx. 440 million USD.
This means that if the sales mix remains unchanged, the fair value of the company will also increase by around 120% to around 2.6 billion USD in 3 years. After 6 years, with organic growth of 30% p.a., it would already be around 5.8 billion USD.
This means that the potential increase in value of your original investment within 6 years would be a factor of 7. It would be a shame to walk away with only a 100% gain, wouldn't it?
An uncertain look into the future
But of course you don't have a magic crystal ball and you don't know for sure whether the growth can really be sustained for so long. You have to keep asking yourself: how realistic is it that the company can really grow so strongly for so many years and thus maintain its high valuation and grow beyond it?
Often you can't be sure. Then it is certainly not a bad idea to take some profits from time to time after steep price rises and sell a smaller part of the position. According to the motto:
"Nobody ever went bankrupt by taking profits."
(Unfortunately, I don't know which wise investor this quote comes from...)
In many cases, the best performing stocks - due to the rise in price - are usually among the largest positions in your portfolio. If you want to maintain a well-diversified portfolio, you will need to reduce these positions anyway to reduce the risk in the individual stocks. Because what has risen high can also fall low.
For my own portfolio management, I have imposed a rule that no position may account for more than 12-15% of the total portfolio value - no matter how strongly I believe that a stock will continue to rise in the long term.
When in doubt, take profits
If you are unsure whether a company can quickly grow into its valuation after doubling in price, it may not be a bad idea to sell 50% of the position. This leaves 100% of your original capital available for new investments and you still hold 50% of your position. You should only sell the remaining 50%, regardless of price, when you are no longer convinced that it will appreciate in value.
Time for the exit
This is where the final exit is made. But this should be done quickly. The time to get out is when you have serious doubts about whether the company will continue to grow dynamically. There can be many reasons and signs for this. It is important to recognise these signs in good time, preferably before they become apparent in the business figures. The fall of a high-growth stock can be quite dramatic if the company can no longer meet the market's high expectations and justify its own high valuation. If you fear this, you should get out of a company, no matter how much profit or loss you make.
Your purchase price should not be a factor in your decision to sell.
This is not easy psychologically, but it is one of the most important exercises on the road to becoming a successful investor in the long term.
The "Rule of 30" as an alternative to stop prices
I think it is important that, as a medium to long-term investor, you learn to think about the performance of the company in the real world outside the stock market.
In general, you should only buy a stock if you are convinced that the fair value of the company will be significantly higher than its current enterprise value in the medium term.
If the share price rises after you have bought it, you have done everything right and you just have to decide if and when to take profits without making the mistake of selling a potential tenbagger too early.
But even if you have done your research and analysis before buying a stock, there will always be a situation where a stock does not perform as expected and the price falls.
Then, when you look at your portfolio, red numbers jump out at you and you have to learn how to deal with them.
Dealing with book losses is probably one of the most difficult exercises on your way to becoming an above-average successful investor. And that's what this section is all about.
What should I think about stop prices?
Much of the stock market literature and countless trading courses say that strict observance of stop prices is a basic rule that must be followed at all costs.
In practice, this often means that a share is automatically sold at 15% to 20% below the purchase price and a trade is closed. This turns book losses into real losses, but they are limited to that 15% to 20%.
Stop prices are indeed essential for short-term speculative traders who do not really look at their stocks closely.
Beginners who are unsure of their own judgement about the real value of a stock can also use stop prices for extra security.
Above all, stop prices ensure that your portfolio does not accumulate zombies: Portfolio zombies are shares that have lost a large part of their value and are spread throughout the portfolio with no real prospect of recovery. These have no place in a portfolio and must be removed.
Therefore, at least for certain groups of investors, stop prices have a right to exist. But for medium- and long-term investors, who are already a little more experienced, stop prices act as a brake on performance.
It is all too often the case that shortly after a position has been “stopped out”, the price of a stock turns up and moves in the right direction. The stop price has then triggered a sale at the bottom of a much more valuable stock.
I would argue that for medium- to long-term investors, strict adherence to stop prices in high-growth investments means that a lot of outperformance potential is lost.
Personally, I have not used stop prices for many years. Instead, I have established a different rule for dealing with book losses in my strategy, which I have named the "Rule of 30".
The "Rule of 30"
Whenever book losses of 30% have accumulated on a portfolio position, I force myself to make a decision.
Either I take the opportunity to buy the stock at a cheaper price, or I sell the position completely and realise a maximum loss of 30% on the whole position.
I have deliberately set my tolerance level for book losses at 30%, as this is still a normal range for volatile high-growth stocks.
Many of the best investments in my portfolio have gone through several consolidations in the order of 30% on their way to becoming multibaggers. This is part of the day-to-day business of investing in fast-growing companies and does not deserve special attention.
However, once losses of more than 30% have accumulated, it is indeed time for some very serious and sometimes uncomfortable thinking. It is time to question whether the investment case is as coherent as originally thought.
At this point, you need to do even more research and analysis and make a well informed decision about whether or not to make a bold anti-cyclical buy of additional shares.
If you are really convinced and have the courage to swim against the tide, then you should ideally buy in increasing quantities to reduce the average purchase price of the stock as much as possible.
Example:
Let's say you originally invested 4,200 USD in a company and bought 42 shares at 100 USD. If the share price has fallen by 30% to 70 USD and you then invest another 4,200 USD, you will receive 60 shares and own 102 shares at an average purchase price of 82.35 USD. This means that the share price 'only' has to rise by just under 21% to make up for your book losses.
Diversification comes first
Every rule has its exceptions - unfortunately, this also applies to the Rule of 30:
Perhaps the most important characteristic of a well-positioned individual stock portfolio is sufficient diversification. Under no circumstances should you invest in just a few different stocks.
In other words, even after a subsequent purchase at lower prices, the weighting of your increased position should not exceed the maximum weighting you have chosen (in my portfolio this is 12% of the total portfolio).
This is not a problem in normal market times, as the weight of the problematic position is reduced by the book losses before the possible additional purchase. However, this is not necessarily true in a crash or general bear market, when many stocks in your portfolio decline in price at the same time and, in extreme cases, the relative weighting remains almost the same.
In such a case, I sometimes stop buying - at least temporarily - and temporarily accept the high book losses in the portfolio. However, a basic prerequisite for this is that the weighting is still relevant, i.e. sufficiently high, in the context of the overall portfolio. A position that has slipped into insignificance due to high book losses has no place in your portfolio and must be adjusted.
But be careful: Under no circumstances should you fall in love with a stock and ignore negative developments in the company before buying more of it. You need to be pretty sure about the true value of your company's stock in order to apply the Rule of 30 systematically and successfully over the long term.
Ideally, you should be able to identify a clear reason for the 30% fall in the share price that has nothing to do with the real value of the company. Only then will the "safety margin ", i.e. the discrepancy between your purchase price and the fair value, have increased further as a result of the fall in the share price.
If the share price has fallen by 30%, you must always ask yourself whether there have been any changes in the company's position in the market BEFORE you buy additional shares. Changes that justify the fact that the company will not reach the value you had in mind in the medium term.
Such changes could be, for example: The market is not as large as originally thought. New competitors have emerged with better technology or the management isn’t executing well.
Take the time to make your decision
In order to make the difficult "kill or buy" decisions that the Rule of 30 requires you to make with confidence, you need to have the best possible judgment about the stock in question.
"Know what you own and why you own it."
This is one of my favorite Peter Lynch quotes. If you follow this old stock market wisdom, it will be easier for you to make the tough "kill or buy" decisions.
You want to make those decisions calmly. I advise you not to sell on emotion, especially after sudden book losses, but to sleep on it and analyze it calmly. It is perfectly fine if you want to wait for the next quarterly report, for example, so that you can calmly decide how to deal with the loss position after studying it.
When in doubt, better to take losses
If you are not sure whether a fall in the share price is unjustified, you should sell. Sitting on losing positions and hoping for better times is not a good solution.
You need to force yourself to make a decision and take action. When in doubt, it's better to liquidate a position at a loss than to throw more good money after bad.
In order to make the difficult "kill or buy" decision required by the Rule of 30, you need to be able to make the best possible judgement about the stock in question.
Even with 35 years' experience in the stock markets, I still sometimes make mistakes when assessing the valuation of individual companies. This is normal and not a problem. You don't always have to be right to achieve above-average returns with your shares.
Many roads lead to success
In this article I introduced you to my "Rule of 30", which I discovered years ago as a superior alternative to stop prices.
On this Substack I will publish more articles around my stock picking strategy as well as concrete investment cases. So stay tuned…
There are certainly several other promising ways to deal with book losses.
The most important thing is to have a risk management strategy and to follow it consistently.
My tip: Take a close look at your portfolio now to see if there are any big loosers that you have been successfully suppressing for years. The first step in dealing sensibly with book losses is to get rid of these stocks. This is incredibly freeing.
The second step is to think about how you want to deal with book losses in the future. Are you confident enough to try my Rule of 30, or would you rather use stop prices?