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A tough call: when to cash in a winning stock

Taxes, company valuation and other metrics can help investors make a difficult decision


Date: December 3, 2015

Buy and hold, they say. But when do you sell? It has become an afterthought in an industry preoccupied with building wealth.

“It’s often more tricky than choosing a stock to buy,” says Tony Demarin, a Winnipeg-based portfolio manager and president of BCV Asset Management.

Investors are often reluctant to sell what has done well because it could do even better. Yet if you hold on too long, today’s winner can become tomorrow’s loser.

So just when is the best time to sell a winner? First you have to decide what to sell. Chances are you have more than one winner. You could clip them all back a little, or sell one or more entirely.

Taxes are a consideration if the stock is held in a non-registered account, Mr. Demarin says.

When selling out of taxable accounts, it’s often best to sell a winner in tandem with a loser so that you can counter the gains with the losses and reduce your overall tax bill. “Or you may have past losses from other years to help reduce the tax burden,” he says.

In tax-free savings accounts (TFSAs), registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs), taxation is not a concern, so the focus is on selling winners that could end up going in the other direction.

Certainty is impossible, but many investors sell companies with stock prices higher than their true worth.

“I would say valuation is the single most important point to consider,” says senior portfolio manager Paul Johnson, vice-president and senior portfolio manager for RBC Global Asset Management.

Stock analysts use metrics to assess whether a stock’s price has grown beyond the company’s underlying value. The most popular is the price-to-earnings ratio (P/E), which measures what investors are willing to pay to own a company’s stock for every dollar of profit.

For example, a stock with a P/E of 15 indicates the market is willing to pay $15 for every $1 the company earns.

Yet this metric alone cannot establish whether a stock is overvalued. It must be compared with other stocks in its industry, the broader market and its own price history.

“Does the stock look overvalued relative to a number of things: its peer group in the same sector, for example?” Mr. Johnson asks.

In addition, companies in different sectors have different P/Es. “Canadian banks, for example, trade from about nine times earnings on the depressed side to about 12 or 13 on the more euphoric side,” Mr. Demarin says.

Yet the broader market – the S&P/TSX Composite – trades at about 17 times earnings on average.

“If a Canadian bank ever started trading at 18 to 20 times earnings, most managers would say that’s well outside the historic norm, and it doesn’t make sense to continue to own it from a valuation perspective alone,” he says.

But no one metric is sufficient. Analysts also examine return on equity, free cash flow generation and return on investor capital, Mr. Johnson says. “These are often important in determining when to buy, but they’re equally important in determining when to sell.”

On the sell side, metrics mainly help mitigate the hazards of holding on to highly overvalued stocks, says Barry Schwartz, a portfolio manager and chief investment officer at Baskin Wealth Management in Toronto.

“What people unfortunately learn time and time again is what goes up to the moon can come back down,” he says. “Look what happened with Valeant: Everybody got giddy thinking it is the greatest thing since sliced bread, and it becomes the biggest stock on the TSX, and now it’s dropped 60 per cent.”

Moreover, valuation metrics do not tell the entire story, Mr. Johnson says. “It’s important to consider other factors: What has changed since you bought the stock? Has the management changed?”

Conditions that made a stock a good buy can shift in the other direction even before metrics reflect the changes. The business “is no longer what you thought it was,” Mr. Demarin says.

Investors must also face the fact that, once sold, a stock’s value may keep increasing. That’s why they need clarity and comfort with their reasons for selling, Mr. Schwartz says.

“This is more of an art form than a science,” he says. “Nobody’s way is the right way.”

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