Wednesday, January 31, 2007

Fundamentals key to sustain share price

Retailers are tempted to lock in their gains following the recent run-up in stock prices. They should not worry that higher prices would mean the stocks are due for a fall. It is the fundamentals of a company that determine the sustainability of its share price, writes Ooi Kok Hwa of MRR Consulting.

I have made very good returns on certain stocks. Should I lock in my gains now?

When to sell is always the toughest decision to make in investing.

Over the past week, as a result of some pull-backs on Bursa Malaysia, investors have started to wonder whether this is the right time to lock in their gains, given that the market has surged by more than 30% since the low in the middle of June 2006.

Most investors will have a sense of regret when the price of a stock that they have just sold goes up further.

To an investor who has sold Genting Bhd at around the RM25.00-level versus his original purchase price of only RM15.00, a return of 67% is supposed to be considered as a very handsome one. However, instead of feeling good about it, he may feel the other way around if the stock is currently selling at the RM38.00-level.

To him, he has missed an opportunity gain of 52% if he compares the current price of RM38.00 with his disposal price of only RM25.00. He would have earned an extra 52% if he had continued to hold the stock.

Do not sell just because the stock price has gone up

In his letters to Berkshire Hathaway shareholders, Warren Buffett said: “We need to emphasise, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time”.

He would only recommend a sell if the stock’s quality deteriorates or if the price rises far above the demonstrable value, or when a better opportunity arises. Except for the above three reasons, he would never sell a business whose intrinsic value continues to increase at a satisfactory rate and the current price is only temporarily above intrinsic value.

According to Buffett, the maxim that “you can’t go broke taking a profit” is a foolish premise on which to sell a good company’s stock.

Investors may miss out on the potential of greater gains if they do not have the patience to hold on to their winners for a longer period of time, as a good stock can sometimes increase 10- or 20-fold in value.

Investors get worried when there is a drop in the stock market. As they follow closely their winners’ stock prices, the chances are high that they will regret selling the stocks too early.

Sometimes, certain investors who seldom follow stock prices can sell at a better price than active investors who closely monitor the market's movements.

Hence, we should always remember that “just because a stock price has increased, does not mean it is due for a fall – the fundamentals are the determining factor, not stock price history”. (Peter Lynch)

Need to know the intrinsic value of the company

Nevertheless, it is always not easy to determine the intrinsic value of a stock.

Normal investors with limited financial training will find it difficult to determine the point at which a stock becomes fairly valued.

John Neff in his book entitled John Neff on Investing said: “Successful stocks don’t tell you when it’s time to sell them”.

In order to judge the intrinsic value of a company, investors need to know the earning power and the sustainable earnings of the company. We need to check whether the current market price has gone far beyond the company's fundamentals.

Some investors have tried to predict short-term price movements. They sell a good stock when the price appears to be too high with the expectation of buying it back at a cheaper price later.

Instead, the stock price goes up even higher after the disposal. If the fundamentals of the stock remain intact and promising, they should buy back the stock.

Unfortunately, in most instances, investors seldom buy back at a higher price when they realise that their prediction did not come true.

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