Do You Have An Exit Strategy?

Do You Have An Exit Strategy?

Investors are always faced with the frustrating dilemma of whether to buy and hold or to exit taking profits off the table. Geyatee Deshpande explains why having an exit strategy before taking any position is quintessential if one wants to win in market conditions such as now 

No matter what the market conditions are, investors are always faced with this peculiar dilemma of whether to adopt a buy and hold (forever) strategy or to exit stocks at regular intervals. Most so called longterm investors adopt a buy and hold strategy and never sell shares even when the stocks have either multiplied or have fallen by more than 50 to 80 per cent. This is because the buy and hold temperament does not allow such investors to book early profit or loss. Thus, the perennial question is always about which option provides more returns. In other words, which strategy proves to be better in the long term: buy and hold or exit?

The answer to this question may not be objective. However, when we have a look at historical data and study how several investors have been stuck with underperforming stocks even after holding them for more than five years, we can say that there is a serious case for investors to consider adopting an exit strategy, either at the stock or the portfolio level.

Assuming a long-term investor adopts a buy and hold strategy and focuses on BSE 500 stocks as an investment basket, there is a good chance that he or she may have been stuck (negative returns) with at least 19 stocks (which made all-time highs in 2010) out of BSE 500 stocks even after remaining invested since 2010 till now i.e. April 2020. In other words, at least 19 stocks which were trending in 2010 and were bought by long-term investors adopting a buy and hold strategy did not manage to generate positive returns in spite of holding them for more than nine years!

In fact, the average returns of these 19 stocks that made all time highs in 2010 is negative 81 per cent in a duration of more than nine years. That is what the buy and hold strategy would have yielded in case of investors getting stuck with wrong stocks. Clearly enough, here the long-term investment horizon is not guaranteeing positive returns. Investors often tend to believe everything will be alright and stocks will recover in the long term. Rather, we have seen marquee names such as IDBI Bank, Canara Bank, Bank of India, Suzlon, JSW Energy, NMDC, Vedanta, ONGC, Just Dial, DHFL, Yes Bank, Oil India, etc. disappointing investors, especially those who have adopted the buy and hold strategy.

Stop loss is like a life jacket; it will save you from drowning! 

Thus, an exit strategy can be extremely handy in minimising the damage caused due to under-performers. Having a pre-defined exit strategy can prove to be advantageous rather than having no exit strategy at all. The bitter truth of participating in markets is that you will find dozens of advisors telling you when to enter the markets and what to buy but you will hardly find anyone who will assist you in exiting the stocks or markets in general. Very few seasoned investors have learnt the art of exiting stocks and markets even as the majority focus on sharpening their skills to identify entry setups and attractive valuations to buy stocks. 

Defining Exit Strategies

A predefined exit strategy can help investors from being overwhelmed when the markets either crash or jump higher than expected. Following are some of the ways in which an exit strategy can be implemented:

☛Stop Loss : The most popular exit strategy adopted usually by traders rather than long-term investors is stop loss. A majority of investors believe stop loss is not effective for value investors. That may not be correct. Stop losses are especially effective for those investors who have less conviction on stock picks and have bought stocks on somebody else’s recommendation. As the investor himself has not generated the stock idea and may not be aware of the detailed financials and fundamentals of the company, chances are the investor will not be able to estimate the negative changes in the fundamentals and the extent of price damage that may follow.

Usually a stop loss is placed as a fixed percentage, as for example, 10 per cent or 20 per cent below the purchase price. Stop losses are essential in choppy market conditions and can save huge amount of losses during market crashes. Few investors also place stop loss at the portfolio level. For example, due to market crash if the portfolio value comes down by 25 per cent and a stop loss is triggered at 25 per cent for the portfolio, the entire portfolio will be liquidated.

Another most popular method adopted is the trailing stop loss. Here, let’s say an investor has purchased NBCC at Rs 18 per share and the share has jumped to Rs 22 per share in one week’s time. The investor can continue to hold the stock and place a trailing stop loss, say at Rs 21 per share. This way the investor can protect his profits and if he or she is lucky can ride the stock as much as possible. However, trailing stop loss may not be practical in choppy markets as the price movement in individual shares can be as high as 20 per cent in either direction on an intraday basis.

Exits are least understood part of investing!

PE-Based Exit Strategy : It makes tremendous sense to look at valuations and decide when to exit the stock. For example, it is possible that a stock has jumped by about 20 per cent while the valuation (PE) has expanded by 30 per cent. This may happen due to earnings growth being muted. Investors can take a decision to book out of the stock in such a scenario where the fundamentals are not supporting the stock prices. When the fundamentals are deteriorating and the stock prices are not falling, consider it a trigger to exit the stock.

Also, on the index level, investors can take a call to liquidate the portfolio when the PE ratio is in an extremely high zone. For example, a diversified portfolio is constructed with a beta of let’s say 1.2 when the benchmark index is trading at a price multiple of 15. After some years the markets inch up and trade at a price multiple of 25. An investor can take an exit decision taking reference of the price multiple of benchmark index as well. In this case, a portfolio with beta 1.2 is expected to beat the benchmark index returns. It is important while tracking the PE multiple that we keep an eye on earnings growth peaking out. Investors can exit the stock the moment it is felt that the earnings growth may slow down for a sustainable period.

Holding a stock for long term is not a guarantee for returns.

☛Technical Analysis Methods : Technical analysis is most commonly used to identify important stock levels, entry and exit. Supports and resistance levels are predetermined and can be used to exit stocks or portfolios. Various trend reversal patterns can be used to exit stocks as well. The only problem in adopting this method is that the investor should be able to interpret charts and be able to take quick decisions.

☛Corporate Governance : If the year 2018 has taught us anything, it is to not ignore the corporate governance issues faced by any listed company. Investors must exit the stock the very moment there is a corporate governance issue out in the public domain. The stock is more likely to fall rapidly than recover when such issues are faced by any listed company. We have seen what happened with Yes Bank and DHFL. Both these stocks were once the favourite of investors but crashed on account of corporate governance issues. One must exit these kinds of stocks with no second thoughts.

☛ Using Fixed Percentage : Many investors simply use fixed percentages above the buy price to exit the stock. This strategy can be useful in trending markets and can be extremely handy when markets reflect huge swings. Using a fixed percentage strategy, an investor simply can exit the stock if it jumps 20 per cent, 40 per cent or whatever percentage returns the investor finds satisfactory. In the current crisis we have seen stocks jump voraciously, at times delivering annual returns in a single trading session. It makes tremendous sense to book profit in such cases. For example, Tesla’s stock prices jumped nearly 60 per cent in just a week. For any investor adopting a fixed percentage strategy, the exit decision is easy to make. 

"An exit strategy can be extremely handy in minimising the damage caused due to under-performers. Having a pre-defined exit strategy can prove to be advantageous rather than having no exit strategy at all."

Conclusion

These indeed are unprecedented times to invest in. Experts believe the stock markets are not necessarily reflecting the pain felt in the industry. Investors however must understand that the markets are forward looking and hence a jump in prices suggests that there will be some sort of recovery. That said, the fundamentals of several companies have been damaged. Some of such companies may not even survive the onslaught of the pandemic. In such uncertain times it is very important that investors keep a predefined exit strategy in place. After a vertical fall we have witnessed a vertical jump in stock prices even as the fight continues between hope and fear.

Stocks are jumping anywhere between 5 to 50 per cent in a matter of days – something not witnessed usually. It is true that this may be an opportune time to enter the markets but have a planned exit strategy as it could be the differentiating factor between winning and losing. The era we are in is disruptive in nature. When uncertainty is sky-high, adopting a plain vanilla buy and hold strategy without an exit strategy will be like entering a war zone without a roadmap to come back home safely.

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