The Biggest Mistake Most Investors Make (and How to Avoid It)
Welcome back to your Extreme Small-Cap Profits email course.
This is Day 8 of your 12-day email course.
If you missed yesterday’s email, we took a closer look at the business behind the stock. Specifically, we had a look at how a business uses cash to fund operations.
What did we learn? Cash is king, even for small-caps.
Today, we’re going to look at something a little different. We’re going to look at when you should sell your small-caps stocks.
It’s not always an easy decision to make.
But it’s an important part of investing. If done wrong, it could significantly reduce your returns. But if done right, you could lock in profits and minimise your risk at the same time.
So let’s take a look at when we should sell those suckers.
To sell or not to sell
How do you get your hands on a 10-bagger?
Make sure you don’t sell stocks that go up 500%.
If you keep selling stocks for 100%, 200%, and 500%, you’ll never have the chance to be on the other end of a 1,000% return.
That doesn’t mean you should just hold on forever until your investments go up. But if you’ve already made 500% and still believe the stock has potential, why not keep holding on?
Of course, there are plenty of good reasons to sell.
Maybe you’ve put far too much money into the market to begin with. Remember, you should only invest an amount you won’t miss for months.
Or maybe you’ve put your money into a company you no longer fully understand. From time to time, businesses can change their activities. They might jump into an industry which you don’t fully understand.
If you find yourself in this position, it’s probably a good time to think about selling.
Conversely, there are also many good reasons not to sell.
One is volatility. For example, if your position drops 30% in a market-wide sell off, you probably should hold on, waiting for the market to rebound.
Inactivity also isn’t a good enough reason to sell. So if a stock you’ve bought hasn’t done much in the past month, continue to hold on.
Just like a decision to buy, your decision to sell should be a well thought out beforehand.
Of course, the decision to sell is completely up to you. Everyone has their own personal reasons for investing in stocks. And that could dictate your decision to sell.
Yet there are times when selling absolutely makes sense if you want to lock in profits and reduce your risk.
Don’t go down with the ship
One of the most memorable scenes in Titanic was when Captain Edward J Smith locks the doors behind him. Edward tells everyone to evacuate, but stays behind.
Even if you haven’t seen the movie, you’re probably familiar with this idiom. It symbolises a Captain’s ultimate responsibility for both the ship and everyone on it.
As small-cap investors, we want to do the exact opposite. Instead of going down with the business, we want to get off as quick as possible.
This is the first good reason to sell — when a business is in decline.
But how can you tell when a business is sinking?
Declining sales is a good start. If a business is losing money and cannot grow sales, it’s a pretty good sign for worse things to come.
It’s not always easy to identify this early on. But sometimes you can tell earnings will decline simply by looking at inventories and accounts receivable.
A perfect example is Aussie icon, Billabong International Ltd [ASX:BBG].
From 2008–11, receivables and inventories grew much faster than sales.
If receivables are growing faster than sales, it usually means the business is accepting more credit and less cash.
With more receivables, there’s also the chance more debtors won’t pay, leaving Billabong to take what they can get.
If inventories are growing faster than sales it’s usually a sign of eroding demand. Billabong thought they needed X amount of clothing. Yet it turns out their assumption of demand was optimistic.
Thus, inventories piled up on the balance sheet.
This is very dangerous in the fashion industry, as trends can change on a dime. Like piling up receivables, inventories can become worth a whole lot less in a short space of time.
Had you seen this trend early, you might have been able to get out before Billabong’s decade long decline.
Since 2008, Billabong share price is down more than 92%. Had you put $10,000 into the stock in 2008, you’d now have $800.
Source: Google Finance
What’s the lesson here? Don’t go down with the ship!
Minimise your risk by taking profits
The small-cap world is unpredictable. One moment you might be up 100%. The next, you could be down 30%.
It pays to know when you should take profits off the table.
Let’s say you bought Animoca Brands Corp [ASX:AB1] at the start of this year. The mobile game developer has already climbed 476% this year, quadrupling your money.
Source: Google Finance
To ensure you don’t lose your original investment, you might think about selling a fourth of your position.
That way, you still have exposure to Animoca and lose nothing even if the stock hits zero.
This is the second reason you should sell a small-cap investment.
But how do you know when a stock climbs high enough?
Like I said, these aren’t hard and fast rules. Think of them as guidelines. A lot of it really comes down to what you’re comfortable with.
If you’re not comfortable leaving a 300% return untouched, maybe it’s a good idea to take some profit off the table. That way you won’t toss and turn at night, thinking about potentially losing money.
But I suggest not to realise profits too quickly, as it will limit your returns in the long-run.
For example, say you netted a 300% return on $1,000. Meaning your total position is now $4,000. To prevent losing your original investment ($1,000), you could sell a fourth of your position.
If the stock runs up another 300%, your profit would be $9,000.
But had you left that $1,000 in the stock, your total profit would be $12,000.
Sell when it makes sense
Alternatively, you might sell when your position becomes overvalued. Meaning the stock price has climbed above the business’s potential true worth.
This is the third reason for selling your small-cap investments.
I’m not going to lie, it’s hard to stick to this one. And that’s because a business’s value is so subjective.
What I think Animoca Brands is worth could be different to what you think it’s worth.
A lot of variables might go into valuing a company like Animoca Brands.
For example, you might estimate how much cash the business will generate over its life time. You could value Animoca compared to its peers. You might even try to guestimate the market share Animoca will carve out of its industry.
As you can see, there are a lot of reasonable values you could come up with.
So if Animoca Brands rises to a dollar and you believe it’s only worth 10 cents, it’s probably time to think about selling.
That’s it for Day 8.
Tomorrow we’re going to take a step back and look at the economy and how it affects small-cap stocks.
Keep an eye on your inbox for that.
Editor, Money Morning