Five years ago, Jim Slater published an article on when to sell. In view of the current market turbulence and uncertainty, we thought it would be a good idea to invite him to edit and update his article. We consider this an all time classic and we are sure it will be of great interest to all our subscribers.

Jim Slater - When to sell

Most of the questions at investment conferences are from private investors who want to know when to sell. There is no simple formula. The answer is complex, individual and according to one's personal circumstances and temperament.

There are really two problems. The firt is whether or not to reduce the general level of your portfolio and the second is when to sell particular shares. If you are unhappy about the percentage of your money invested in the market and about the performance of particular shares then the obvious remedy is to sell the shares. However, if you are happy with the overall level of your portfolio but worried about particular shares that is a very different matter.

The general problem of the percentage you invest needs to be considered first.

Patient money

The key point is to invest only 'patient money' that can be locked up for the longer term and will not be needed suddenly. Shares should be bought systematically and selected with the greatest of care and attention to detail.

Signs of a bear market approaching

Cash is usually a very undesirable asset. As a result, cash balances of institutional and private investors will typically be at very low levels at the start of a bear market. American investors describe the mood well: 'cash is trash'.

As you can see, very few of these factors are in place today. In many cases, the opposite is true. For example, interest rates are more likely to fall than rise, the consensus is more bearish than bullish and new issues are at a low ebb. However, the bear is a wily animal and each bear market seems to have a few different characteristics from the last one. As always with personal investment, you have to make the final decision.

Sell down to your sleep level

When there is too much uncertainty in the air, it is tempting to become more liquid. Even then, I would advise active investors to leave about 75% of their patient money invested. The main reason for this is that they could easily be wrong. Also, it is almost impossible to judge the top of the market to sell and the bottom when it comes to re-enter. Also, costs and capital gains tax have to be taken into account. For most investors, therefore, it pays to weather the storms that lie ahead with their patient money.

Everyone's temperament is different so, in a very bearish climate, some investors may prefer to tune down their investments to 50% of their patient money. If your investments are keeping you awake at night, it obviously makes sense to reduce the percentage invested down to your sleep level.

Warren Buffett's approach to selling particular shares

Now we come to the problem of when to sell particular shares. Let us first examine how Buffett manages his own portfolio. You would be forgiven for thinking that he never deals, as he is often credited with being the kind of investor who ignores the market and likes to hold shares forever. Investors studying his very successful methods should distinguish between his core holdings (quasi-partnerships) and more general investments. Of course, if a company is doing well and its shares are going from strength to strength, it pays to run profits.

The oldest and best axiom in investment is to run profits and cut losses. That way the profits are likely to be large and losses are bound to be small.

In the 1987 report of Berkshire Hathaway, Buffett spells out his approach to selling. He first makes it clear that he judges his holdings not by their market price but by their operating results. As Benjamin Graham said: 'In the short run the market is a voting machine but, in the long run, it is a weighing machine.' His point was that eventually the market will recognise superior operating results and increased value and he does not worry unduly if this takes a few years to happen. Buffett is completely confident both of his ability to judge the value of a company and that, in the end, the market will recognise that he is right. He goes on to explain that his monitoring of operating results is to ensure that 'the company's intrinsic value is increasing at a satisfactory rate'. The implication is that if this is not the case he sells, as indeed he did with his first British investment, Guinness.

Buffett draws attention to two other reasons that would prompt him to make a sale: first, when the market judges a company (other than a quasi-partnership holding) to be more valuable than the underlying facts would indicate and, second, when funds are required to invest in a security that is even more under-valued.

Buffett further qualifies his approach by saying that he does not sell holdings simply because they have risen in price or because they have been held for a long time. He scorns the Wall Street axiom 'You cannot go broke taking a profit' and is happy to remain a holder indefinitely provided the return on capital is satisfactory, management is both competent and honest and the market does not over-value the business. As you can see, these are heavy provisos.

Another reason put forward by Buffett for holding on to such exceptional growth shares is that they are very hard to find. Dealing in shares costs money as well as sometimes crystallising a capital gains tax liability. When a share that is not held in a PEP, ISA, or a personal pension plan has a really good run in the market, the potential capital gains tax liability can be many times the original cost. Provided you continue to hold shares that are not sheltered from tax, the government, in effect, makes you an interest-free loan of the tax that will eventually have to be paid. This loan helps to increase the capital appreciation on the investment very substantially because there are no interest charges and your investment is geared without the usual worry of how the loan will be repaid.

Has the story changed?

In The Zulu Principle, I suggest that the main reason to sell a share is if the story has changed. By this, I mean were there any changes in the key factors that attracted you to the shares in the first place? If, for example, profits are faltering, a major new competitor had entered the arena and begun a price war or the company had lost a major source of business then the shares should be sold immediately. In particular, if the company issues a profit warning it usually pays to sell at the first opportunity. The first profit warning is often followed by one or two more and there is no doubt that the story has changed for the worse.

In normal market conditions, with an exceptional growth share that is continuing to produce excellent year on year results, it pays to retain your holding even if the PEG rises to a slightly uncomfortable level. A PEG of 1.2, compared with a market average of, say, 1.5, is as high as I would personally allow, as the margin of safety would have shrunk to a level that would make me feel-ill-at-ease. However, I could well understand some investors deciding to hold their favourite investment, even if the PEG rose to the market average. Above that, I would recommend selling and bidding the shares a reluctant au revoir. If you keep an eye on them, there will almost certainly be another opportunity to buy them back at a much more favourable price. Meanwhile, your money could be better used in a share that is due for an upward status change, not a downward one.

Relative strength

The most difficult problem arises when a share suddenly begins to perform badly in the market for no apparent reason. After a substantial rise, great growth shares often encounter profit-taking so, from one month to another, their relative strength might be poor. If the trend persists, and they show poor relative strength over the previous three months, that is definitely a cause for concern.

If one of your shares performs badly for several weeks, you should ask your broker for an explanation. There may be a market story that accounts for it. For example, a key executive may be lanning to leave the company, there could be news of an impending major lawsuit or fresh competition entering the market. The other obvious source for this kind of information is press cuttings or the internet and a final option is to telephone the company and ask one of the directors or the company secretary if they know of any reason for the weakness in the share price.

If you can find an explanation, the key question then is whether or not the underlying story that persuaded you to buy the shares has changed. Re-examine the company in the light of all the available facts, including, in particular, the current brokers' consensus forecast and ask yourself if you would still buy the shares today. If the answer is yes, grit your teeth and hold on.

Some people believe in averaging down, which means buying more shares on hopefully short-term weakness to reduce the average cost of their investment. I recommend you resist this temptation. I prefer to buy more of a share that is doing well as reinforcing success seems to me to be a better approach than compounding failure.

Some investors will find that they cannot stand the worry of a share continuing to fall, particularly when no explanation can be found. Many commentators, especially those who specialise in highly speculative stock, recommend stop-loss systems and, if this is going to make you sleep better, by all means use one. You can for example set a stop-loss at 20% below your purchase price or a trailing stop-loss of say 20-25% below the highest price registered by the shares. The trailing stop-loss means that if the share does very well in the early stages you make sure of locking in some profit.

My preference is to hang in there until I can find the reason for the fall. A low PEG provides a margin of safety and buying shares in a systematic way is very different from speculating in, for example, bio-tech, internet and other concept shares, which often have no earnings or commercial products. With these kinds of shares, a trailing stop-loss is mandatory.

I have edited the above comments that were originally published as a paper five years ago. Since then, the market has experienced a great deal of volatility and turbulence, particularly in technology and internet shares. The basic principles have not really changed though. You should still invest your patient money in growth shares with a substantial margin of safety established by strong fundamentals such as higher than average growth rates, low PERs, a sound business model and a strong financial position.

If the companies' underlying businesses continue to perform well then hold on. If the story changes for the worse, sell immediately and re-invest in other, more promising situations. If you still own any internet shares, examine them on today's merits and remember that the price you paid is only relevant for tax purposes. It has nothing to do with today's fundamentals.

A final important caveat - in all except the most bullish of markets, do not forget that it pays to have a cash reserve. Cash is, after all, the most flexible of all financial assets with no downside and a certain yield. If the market goes up and you are 80% invested, you should be well pleased. If it goes down sharply, as the market's mood swings to excessive pessimism, your cash reserve of 20% will lessen your overall loss and be available to buy shares at bargain prices.

Jim Slater