Sunday, 22 June 2014

When to Buy, Hold and Sell a Stock - Contrarian Approach

Contrarian Investment Strategies – David Dreman

Finished reading a book last week titled "Contrarian Investment Strategies" by David Dreman. While the book contains over 400 pages, the author had summarized it into 41 rules. I will publish the rules in my next post. For now, instead we will discuss key strategies to buy and sell a stock directly taken from the Contrarian Approach. 

When to Buy?

Contrarian Main Strategies
  • Low Price to Earnings (bottom 40% stocks)
  • Low Price to Book
  • Low Price to Cash Flow
  • Low Price to Dividend yield
  • Diversify. Hold at least 20-30 different stocks from different industries.

Financial Analysis

  • Strong financial position. current ratio, cash etc
  • As many favourable operating and financial ratios as possible. ROA ROE ROC
  • Higher earnings growth than S&P (STI) in immediate past, and likelihood that it will not plummet in the near future 
  • Earning estimate should always be conservative
  • An above average yield which company can sustain and increase
Sometimes the stock will experience a plunge due to over-reaction in the market resulted from a temporary political or financial crisis. How should we react? – to buy right after the plunge or wait till dusk clear? Contrarian approach suggests that we do not be a hero and charge into the initial panic. It pays to sit on the side-line for a while. In all probability, you will get plenty of chances to buy it cheaper in the next 90 days. When there is negative surprise, the poorer the results, even first rate companies are sure to fall for a while.

Financial Analysis does not work - When?

Prime growth company
Financial Analysis forecast build base on past earnings, and not necessary on growth trends! Normally prime growth company has high debts and that is when Financial Analysis dislike.

What is the proper PE? 
Especially for growth company! Initially in 1997 when you say Tech stocks PE 20 is high, but how can you imagine that it can grow to 50-60 or even 100 later.

Changing PE
A rapid growth company can trade at PE of 40/50 then drop to 25/15/10 as investors change their mind on value. 

Unnoticed Stock
A stock may be highly undervalued, but there is no guarantee that market will recognize or spot it. May linger in the dumps for years.

When to Sell?

Consider following situation: You buy a stock at $1.00 and pre-set a sell price at $1.50 (50% increase.) When the stock price reaches $1.50 and in its rise, it is accompanied by even more good news. You start to ponder should I sell now, because you may think that it is likely that the stock may go higher to $2, then to $2.50 then to $3.00. Yet, sometimes the reverse can be true! It is very common to see Investors riding the stocks all the way to its high and ride it all the way down again. 

Therefore it is critical to know when to sell a stock. Since human beings are run by emotions, very often, selling a stock can be one of the most difficult decision. 

Pick a sell point, do not be greedy
Before you purchase a stock, it is good to set a sell point. In the above example, if your pre-set price is $1.50 after buying it at $1.00 once it reaches $1.50, you should sell the stock immediately. Do not be greedy. Grit your teeth, brace yourself and get rid of the stock. You are probably unhappy when later it goes up, but you should not be bothered. Remember that you already reap your profit, unless there are other reasons you are 100% sure that the stock price will rise later. 

Imagine you bought a stock at PE 10 compare to the industry average of 15. With earnings unchanged, PE rises to 20 after announcement of some good news. Contrarian approach suggests even with the impending bright prospects, we should sell the overvalued stocks and replaced it by another low PE stock. 

Do not fall in love with your stocks
2.5 to 3yrs is adequate waiting period. For a cyclical stock with fall in earnings now, it may take 3 to 3.5yrs before its right time to sell. But you still need to have a plan and stick to your time frame. Do not be stubborn to hold forever.

Long term fundamentals deteriorate
Do not sell your stock just because it has a poor Quarter of results, due to one-off temporary reason and PE becomes large. On the contrary, if the fundamentals of the company are affected such that the outlook is bleak, sell the stock no matter how painful it is!

Sell to rebalance portfolio

Try to have fix number of stocks and buy and sell to rebalance your portfolio! While doing so, please avoid dangers of overtrading and incur on hefty trading charges. 

When to Hold?

Relevant to Book value

There are times when you do not sell your stock even when it reaches the pre-set sell point. This kind of situation is when book value of the stock also increases with the stock price rise, such that stock is still selling below its PB ratio. In this situation you may consider to hold the stock. 

Hold Forever

Warren Buffett once said “Our favourite holding period is forever”

I think it probably relates to specific stocks and situations and how you design your portfolio. For instance, you may classify your stock portfolio, into long term (>5 years), mid-term (3-5 years) and short-term (1-2 years). The long term group normally belongs to “blue chips” with very strong fundamentals with slow and steady growth yoy, that you consider holding it as long as you can. The mid-term ones are probably cyclical stocks or stocks with a mid-term aggressive growth outlook. The short-term stocks probably inject adrenaline and make your investments livelier. 

As a matter of fact, whether to buy, sell or hold, it depends a lot on your portfolio and strategies. There are no hard and fast rules. 

Rolf’s View

I tend to agree with the Contrarian "Buy" approach of low PE, PB, PCF, High dividend approach. However it is definitely not easy to find a stock with all the four characteristics. A combination of 3 with solid fundamentals and growth opportunity may well justify the buy call.

Diversification is important but make sure your portfolio is sizeable to diversify and not to incur high trading fees. Probably it is wise to ensure your trading fees incurred at 1 or 2% or less of the trade cost. I try always to keep my trading cost at 0.5% and below. 

Over-reaction is a good time to buy, but do not jump into the plunge. Probably 90 days suggested by Contrarian approach is way too long. For me, as long as the price plummet to a level that justify a low PE, PB, PCF, High Dividend over its peers, it is fine to take the buy position. 

Before you buy a stock, always have a plan for it - different for different stocks. Sell the stock as long as pre-set objectives are met. Similarly, when market over-value the stock and the fundamental of the business deteriorate, let go of the stocks with no emotions attach. 

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  1. I’m now not sure the place you are getting your information, but good topic. I must spend a while finding out more or understanding more. Thank you for fantastic information I used to be searching for this info for my mission.

  2. Hi Buy Sell Signals,

    Thanks for the comments and compliments.

    My info was via wide range of reading and my own personal thoughts and experiences. If there is any similarity, I can assure it is pure coincidence.