When to Sell a Stock? And What to Buy Instead?

What are some signs that you should sell a stock, plus a cheaper alternative to Tesla and Nvidia for you to buy right now.

Ruth Saldanha 24 August, 2023 | 4:08AM
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Ruth Saldanha: At Morningstar, we say that there are some definite indicators on when you should buy a stock. For example, if a stock has an economic moat or a competitive advantage and is also undervalued, meaning it has a higher margin of safety, you should probably consider buying it. But when should you sell a stock? Are there any specific indicators for that? Adam Fleck, who is the Director of Research, Ratings and ESG from Morningstar Research Services, recently did some research around this and is here today to discuss what he found.

Adam, thank you so much for being here today.

Adam Fleck: Thank you so much for having me.

How Important is Price When Considering Whether to Sell a Stock?

Saldanha: Well, I'd be lying if I say I don't consider price the main indicator of whether I should buy or even sell the stock. So, how important is price to this process?

Fleck: Yeah, price is a key determinant, no doubt, but there are a few other important considerations I think investors need to make when they're considering selling a stock. The first, just to cover quickly, is tax and income considerations. Those are ultimately personal choices that are going to differ, of course, for each individual investor, but selling a strong and steady dividend payer that might provide regular income may not be an option for those investors who need that income, even if the shares have become a bit overvalued. But there are a couple of other important considerations.

  1. First is risk. Sometimes owning a stock with a lower expected rate of return but also less uncertainty and lower volatility may be more palatable to investors who have a lower risk tolerance.
  2. Second, once personal finance and risk considerations are satisfied, I think perhaps the most overlooked aspect of selling shares is the need to find alternatives.

Finding new stocks to buy in place of ones you sell goes beyond price versus valuation. It also involves considering a portfolio's overall diversification, including trying to find as closely as possible new names that are in the same industry, geography, or market size.

When to Ignore Price While Making a Decision to Sell a Stock?

Saldanha: Considering the astronomical rise in some tech stock prices, investors who would have sold as soon as these stocks crossed their fair value estimates would have probably given up significant gains. So, in what case should investors adjust or even ignore price in making a sell decision?

Fleck: Absolutely. I think it's a really important point. The stock reaching a fair value estimate is really more of a chance for investors to reassess and look at some of the important considerations that we've discussed beyond just price. Now, a stock with a price trading right in line with its fair value estimate, I want to highlight, doesn't necessarily mean we expect the price to stop rising, just that we expect the return going forward to be fair given the amount of risk being taken. And for that reason, just like we look for a margin of safety when we're buying stocks on the undervalued side, we want the same margin of safety on the overvalued side when we're selling them. Now, typically, this means looking at selling a name when it's 1 or 2 Stars, indicating the stock looks substantially overvalued on that risk-adjusted basis. But you're absolutely right. I think looking at a stock when it hits fair value is a great time to reassess and take the next step.

How to Decide Which Stocks to Sell Right Now?

Saldanha: With the recent run up in the markets in 2023, albeit in a highly concentrated run up led primarily by tech stocks, how should a relatively inexperienced investor navigate selling stocks right now?

Fleck: Yeah. I think first going back to my earlier comments about tax and income, those are really important. Look, they're individual, of course, decisions that need to be made and the laws are going to be different depending on what country you're in. I'm sitting in the U.S. There are different capital gains rules for Canada, for instance. But investors really need to think about how to cover those taxes come tax time and ultimately consult the tax professional or a financial advisor for any personal advice that's needed. But one more general point I'd note. It can be really tempting to adjust expectations after a stock's price has moved up. After all, you might know so much about the stock, you might have fallen in love with the story. But as you're going about then and making new assumptions, so you can avoid selling it and boosting your valuation and ultimately making too aggressive of assumptions in doing that, I think investors need to be aware that they might end up holding too long.

If I Sell Tesla, or Nvidia, What Should I Buy Instead?

Saldanha: You mentioned finding substitutes as a key factor in considering whether to sell the stock. Now, among the names that have performed best this year, are there any other stocks that investors could look to put their money to work for them instead?

Fleck: I think looking at Morningstar's 4 and 5-Star list of stocks is always a great starting point. I've got a couple of interesting ones that I think are worth investigating. Admittedly U.S.-focused, but two of the best-performing stocks this year have been NVIDIA (NVDA) and Tesla (TSLA), but they're now screening as overvalued. The first substitute I might point to is Alphabet (GOOGL), Google's parent in lieu of another tech name. Recently, accelerating growth in the company's core Search business has demonstrated that the segment's network effect is still intact despite threats from AI like OpenAI and Microsoft and growth in cloud plus what seems to be a turnaround in YouTube is leading to an attractive valuation. And then, as I mentioned earlier, finding stocks in the same sector can be really important. And so, with Tesla, we might be able to look to General Motors, GM. Now, there's obviously concerns right now with the Union, with the UAW and talks there continue to keep this name in the penalty box. But nonetheless, GM continues to enjoy strong pricing power and their own potential upside from upcoming electric vehicles, so perhaps another one to take a look at too.

Saldanha: Great. Thank you so much for joining us today, Adam.

Fleck: Thanks for having me.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Alphabet Inc Class C138.75 USD-4.50Rating
General Motors Co39.79 USD0.40Rating
NVIDIA Corp790.92 USD0.35Rating
Tesla Inc199.40 USD3.87Rating

About Author

Ruth Saldanha

Ruth Saldanha  is Editorial Manager at Morningstar.ca. Follow her on Twitter @KarishmaRuth.

 
 
 

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