Exit Underperforming Stocks Before They Sink Your Portfolio

'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"?

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.

A stock is said to underperform if it gives a return that is worse than an index (benchmark) or the overall stock market

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?

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

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 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.

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 Rs 100 per share and expects the stock to reach Rs 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.

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 thUnderperforming stocks during broader market uptrend are generally not good bets for long positions. Investors who are holding such stocks
need to look a bit closely as to why these are underperforming and take a call on whether they should exit the stock.e 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 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.

For investors with a long-term investment horizon, preserving capital is of utmost importance. One of the best ways to limit the downside potential is to adopt a trailing stop-loss strategy.

Most investors do not use stop losses and think that stop losses are meant for short-term and intra-day trades. Placing stop loss even on long term trades can prove to be extremely useful when it comes to managing risk. While placing stop loss, the beta of the stocks should not be ignored. High beta stocks would require deeper stop losses when compared to low beta scrips.

DETERMINING THE STOP LOSS LEVELS 

First and foremost, in order to decide at what level the investor should put his stop loss, he/she should assess one's risk appetite. Risk appetite is what the trader or investor is willing to lose on a trade without losing his/her sleep. One trader/ investor may be willing to lose Rs 1,000 on a single trade, while another may not bat an eyelid even if he/she loses Rs 10,000 on one trade. The risk appetite is determined by the trader's/investor's income level and the financial daring that the trader/ investor can muster, the latter being a part of personality trait.

Secondly, the stop loss should take into account the average true range (ATR) of the stock over a specified time period. The time period could be daily (DATR), weekly (WATR) or even monthly (MATR), depending on the investment time frame. Determining the true trading range of the stock may help prevent the investor/trader from getting stopped out of the trade prematurely. Of course, it must be said that the stock may not always remain within the true range and may violate the range occasionally when there is some good or bad news about the company or the markets become highly volatile due to some social, political or economic upheaval at the national or international level. Therefore, since the true range of a stock is essentially the average price range within the specified time period, it should be used with caution in determining the stop loss level.

MARKET OUTLOOK 

Markets currently are trading at record high levels and Nifty looks to be settling above the magical figure of 10,000 comfortably. Will the Nifty sustain at the current level is something that investors would watch out for in the coming days. Says Rakesh Tarway - Head Research, Reliance Securities, "Nifty finally touched the psychologically important mark of 10,000 on the back of strong domestic liquidity, rally in global equity markets and reasonable earnings performance from domestic companies. Valuations are now discounting good earnings growth for the next year and any disappointment on the same might lead to sell-off in equity markets. Retail investors should prefer regular periodic investments in equity markets, rather than bulk one-time investment, to spread out the risk".

Underperforming stocks during broader market uptrend are generally not good bets for long positions. Investors who are holding such stocks need to look a bit closely as to why these are underperforming and take a call on whether they should exit the stock.


Three important questions an investor needs to ask while deciding exit strategy

1)Has the stock achieved its pre-defined 'sell' price?
2)Could the capital be better utilised elsewhere?
3)Would you buy the stock now?

With a predefined exit strategy, an investor should be able to face any contingent market correction and also participate and re-enter markets again without loss of both capital and confidence.

CONCLUSION 

Markets are trading at record highs and it is but obvious that investors remain wary of the market levels, even as they wonder if the rally will sustain. The million dollar question is whether to book profit now at these levels and wait for a correction to re-enter. It is no secret that the timing markets is not something one can rely upon. In such a situation, it makes tremendous sense to have an exit strategy in place which will not only ensure profits from investments but also limit the riskiness of the adventure.

An exit strategy will bring in the muchneeded discipline which will ensure selling near the top in the market. Investors should not worry if some money is left on the table. Selling near the top will ensure an investor does not get caught in the midst of a market correction and will also have enough cash and confidence to re-enter the markets.

For most investors, the definition of long-term itself is blurred and investor confuse long-term investing with 'buy and forget' strategy. Periodical reviews of companies are integral part of the long-term investment strategy, which involves putting money behind a theme that you think will take a year or more to play out.

Placing stop losses, using technical analysis, looking at historical valuations (P/E) and unwarranted diversification by companies and keeping a tab on corporate governance issues affecting the companies negatively are some of the important things an investor should keep in mind while deciding on an exit strategy.

Pankaj Karde
Head- Institutional Sales & Sales Trading
Systematix shares

''In this market, not all underperforming stocks are bad''

Most retail investors tend to stick with underperforming stocks and book profits in outperforming stocks. In your experience, what is the right exit strategy when it comes to underperforming stocks?
In terms of underperforming stocks, one should first find out reasons for underperformance. If the company has issues within and there are issues with growth in the company, it is best to book your losses and look at investing in companies with high growth and better financials. But if you think that the company is a slow-moving stock with good fundamentals, hold on. The stock will give stable long term returns.

What is the best way to deal with underperforming stocks in current market environment?
As mentioned above, good companies, although underperformers, should be held on to. In this market, not all underperforming stocks are bad.

Why do investors in general find it difficult to book losses and move on?
Greed and fear. Investors in general find it difficult to book profits as well as losses. There is lack of discipline among investors and hence they find it difficult to move out. If you follow a principle of strict stop loss, exit would be easier.

What is your outlook on the markets in general and where do you see (sectors) underperformance in the market?
I feel that the market is flush with liquidity. The domestic as well as foreign institutions are very bullish on India. In such a scenario, we will see short term corrections in stocks and indices, which would be used as buying opportunities. Domestic consumption theme would continue to do well, irrespective of their high valuations. Sectors with high export dependence such as IT and pharma would underperform. Although pharma may see some value buying, in broader market range, it would underperform.

Viraj Mehta
Head - PMS & Fund Manager
Equirus Capital

''We should not let short-term mis-pricing affect our long term wealth creation''

As a fund manager, how do you know when to exit a stock?
We let the business performance rather that stock price performance dictate our decision. Our average expected holding period is more than four years. We believe as investors it is our duty to give businesses some time and space, especially in a situation when on the ground challenges are for long term benefit. We think about exit in a scenario when business is grossly underperforming our expectation for more than six quarters. We also think about immediate exit in case of any gross corporate governance issues previously unknown to us.

What is your call to action when you realise the stock you have bought is underperforming?
We are not unduly worried about temporary underperformance of a stock in a scenario when business is performing as per our expectation. As Buffett rightly said that 'market is a weighing machine in long term'. There could be short-term mis-pricing of securities based on market moods. We should not let that affect our long term wealth creation process.

Have you booked loss at anytime in your career as a fund manager? Which factors did you consider while booking loss? Was it difficult to book loss and do you think in hindsight it was a good decision?
We have booked losses for sure in the last decade. We have booked losses in situations when business is grossly underperforming our expectation and on gross corporate governance issues. It is important not to keep rationalising the purchase of the stock, but think objectively about the businesses today. Another important factor to consider is not to keep averaging down when business environment is changing at a pace much faster that your anticipation. So the losers in the portfolio remain a finite allocation. Moving on from businesses where you were wrong to begin with is always a good idea.

Nilesh Shetty
Associate Fund Manager
Quantum Mutual Fund

''Market valuations suggest there is greater downside risk at the moment''

As a fund manager, how do you know when to exit a stock?
We have a predetermined 'buy' and 'sell' limit for each stock actively covered by our research team. The limits are decided based on sustainable cash flow generating ability of a company and its long term valuation bands. Once a stock hits our buy limit, it finds its way into our portfolio and once it hits our sell limit it exits our portfolio.

What is your call to action when you realise the stock you have bought is underperforming?
The research team will keep rechecking the original investment thesis and if there is any change. If there is no change, then we will continue to hold the stock.

Have you booked loss at any time in your career as a fund manager? Which factors did you consider while booking loss? Was it difficult to book loss and do you think in hindsight it was a good decision?
Yes, we have. The company had made too many acquisitions which it could not manage, putting strain on the balance sheet. The management kept telling us how they planned to improve the balance sheet, but we realised it would be not be easy and we sold out of the stock at a large loss. The stock is even lower today from the price we sold it as the balance sheet has gotten worse.

In the current market environment, with markets at record highs, how do you deal with stocks generating negative returns?
We continue to focus on our investment thesis and whether the research has missed anything in the stock. If there is no change in the research team's opinion about the stock, then we may increase our exposure if the stock price has fallen from our original purchase price.

Mahesh Patil ,
Co-CIO,  
Aditya Birla Sun Life Asset Management Company Ltd

''For a fund manager loss is both absolute and relative''

As a fund manager, how do you know when to exit a stock?
There are primarily two reasons to exit the stock. One is, when there is a change in business fundamentals of the company which may not augur well for the stock price. Two is, when valuations become stretched and discount all the positives that the company can do. It is in many cases the former than the latter.

What is your call to action when you realise the stock you have bought is underperforming?
 When a stock underperforms, one would have to revisit the thesis with which the investment was made. The fund manager has to analyse the company and industry looking all the aspects once again. This has to be done using primary and secondary research, working with the internal team and industry experts.Even after this, if the stock looks good, there is case to add more. Else hold on to it or exit it.

Have you booked loss at any time in your career as a fund manager? Which factors did you consider while booking loss?
For a fund manager, loss is both absolute and relative. It is absolute when the purchase price is lower than the current price. It is relative when the same is measured adjusted with the benchmark return. In either case, the fund manager has to revisit the thesis of investment. He or she may have to cut the position if the analysis no longer supports holding the position. Apart from the fundamental reason, impact price at the time of exit and profitable replacement idea have to be considered. It is difficult to do the same, but it is the right thing to do for the portfolio. It would also add to the experience so as to not repeat again.

Hemang Jani
Head - Advisory
Sharekhan

Investor should invest based on investment philosophy one is able to relate to

How does an investor identify when to sell/exit a stock? What are the signals one should look at?
There are no sure shot ways of finding the perfect exit or sell signals. However, there are few fundamental and technical indicators one could use. If management quality is not up to the mark, it is advisable to exit the stock even though business potential is promising. Fundamentally, if the valuations of the company is excessively high (P/E, price-to-book, EV/EBIDITA, etc.) and actual performance is lacking, it is better to exit. Investors should track performance for few quarters; it should be reviewed, and if there is no improvement, it is better to exit and move into better stock rather than hoping for revival.

Based on technical studies, investor should look at things like stock is forming lower top lower bottom, bearish crossover, trendline break down or moving average break down. These studies could assist investor in selling or exiting stocks.

Why is it difficult for retail investors to book loss and minimize the overall portfolio losses?
Investors generally get emotionally attached to stocks and are not willing to take losses on certain positions, and in spite of knowing that fundamentals have changed, they are not ready to exit. Many times, investors convert their trading stocks into delivery, so discipline is not maintained resulting into losses.

Nagaraj Shetti
Technical Research Analyst
HDFC Securities

''Retail investors often mix the concept of low value with good buys''

How does an investor/trader identify when to exit a stock? What are the crucial technical parameters one should look at when it comes to exit strategy?
Technically, there are many ways to find out reversal in the uptrend of the stocks, mainly these are candlestick reversal patterns at the swing highs, presence of strong resistances/ change in polarity, price extension levels, indications of momentum oscillators, volumes decelerating and the formation of distribution patterns at the highs.

How should one deal with the underperforming stocks in current market environment?
Underperforming stocks during broader market uptrend are generally not good bets for long positions. Investors who are holding such stocks need to look a bit closely as to why these are underperforming and take a call on whether they should exit the stock. However, in case the company is not overleveraged and is not de-growing in terms of topline and bottom line, then one can take a chance and keep holding on to the stock as its trigger point/turnaround point may not fall during market up-runs.

Around 205 companies out of BSE 500 companies have underperformed Sensex on a one year basis. In rising markets, does it make sense to identify investing opportunities in the underperforming stocks or should one stick with only those stocks touching 52-week highs or those which are in high momentum?
 The underperformance in a stock in a bull run could be due to not so encouraging fundamentals. Investing in stocks just because they have not run up in the current bull run may not be the best strategy. Similarly, investing in stocks that are making new highs cannot be adopted blindly. One needs to look into the reasons for the outperformance and whether the reasons are sustainable over the medium term. Only then investors should invest in such stocks. If one has the patience and the skill to do this due diligence, then one has a fair chance of succeeding.

Why is that most of the retail investors think that stock trading near to 52-week low is a good buy?
Retail investors often mix the concept of low value with good buys. While low prices or value offers higher margin of safety theoretically, this is true only for stocks where the investor has one sufficient study and feels that the current fall is temporary and likely to be reversed soon. Otherwise, the strong force in downside momentum could possibly lead to formation of new repetitive lows in the price and result in pain for the investor.

There is saying in the market "Ride your winners and exit losers", but retail investors do just the opposite. What would you advise them?
Riding the winners and exiting the losers is a good investment strategy with low risk. Retailers tend to do the opposite as they hate booking loss (and indirectly accepting mistakes by themselves) and are in perennial hope of the loss-making stocks likely to turn profitable soon. On the other hand, they get a kick out of booking small profits repeatedly (partly to boost their self-confidence in terms of percentage of plus trades and partly out of fear of the trend in the stock turning down). These mistakes can be avoided if the investors restrict their portfolio size and devote more time per stock in studying, gaining confidence about their prospects so that they don't get perturbed by short term fluctuations in the stock. If a stock behaves adversely despite their study, they may keep a mental stop-loss of absolute amount per stock so that their wealth can be protected from further erosion.

Haresh Mehta,
Chief Institutional Trader,
First Global

"At present there are two sets of views in the market amongst investors. One is that they feel the markets have topped out, hence they are taking out their money off the table, whereas the other set of people are those who regret not having participated in the rally, hence feeling missed out by looking at some stock prices which had gone up by 8-10 times in a year's time. They are still waiting for the market to correct 8-12% so that they can invest at lower levels. I personally disagree with both the views. I think that is not an accurate kind of hypothesis to go with, as I feel that neither the market has topped out nor will it give opportunity to buy by offering you cheap prices. You have to pay the premium in a bull market. My advice would be to probably look at BSE 200 stocks out of BSE 500 index which has under performed the rest. This, according to me, is the space where one should see some value".

Nishna Biyani
Portfolio Manager - PMS
Prabhudas Lilladher

Markets will always be excessive in the short term in both directions

As a fund manager, how do you know when to exit a stock?
The most difficult task for any fund manager has always been to time the exit for a stockholding. However, some of the parameters which help in deciding when to exit a holding is 1. Business growth dynamics changing due to rise in competition, 2. Pricing power in business deteriorating; margin pressure observed 3. Rise in regulatory risks hurting business potential and hence earnings growth, 4. Valuations of the stock getting in frothy territory, discounting too much of a future, 5. Capital allocation policy change and investing in unrelated business segments.

What is your call to action when you realise the stock you have bought is underperforming?
Markets will always be excessive in the short term in both directions. So seldom we expect a stock performance right after we invest. Also, we look for the reasons of underperformance and if we think it's a short term problem, we continue to hold the position.

Have you booked loss at anytime in your career as a fund manager? Which factors did you consider while booking loss? Was it difficult to book loss and do you think in hindsight it was a good decision?
Yes, we did book losses in pharma stocks when we thought that the regulatory environment is getting stricter and there was pricing pressure in the key US market. The call which one had to take was that profitability is expected to erode significantly and the FY16 earnings will come back again only in FY19. So, it was a long wait and valuations were still elevated as the earnings were deteriorating. It's always difficult to book loss, however, the decision has turned out to be good in hindsight.

In the current market environment, with markets at record highs, how do you deal with stocks generating negative returns?
Looking at the markets, it's not necessary that all segments of market continue to do well as far as stock price appreciation goes on a daily basis. There always is a lull after some rally and sector rotation happens at the large-cap level. We seldom look at near term stock performance and only re-evaluate our stock stance if something is changing in our investment thesis.