What is the right time to exit an investment?

While it is good to focus on the long term, investors need to follow processes to minimise the impact of potential drawdowns.

As is evident from the graph, in the 2020s, barring the short span of correction around the covid years, we haven’t seen a material drawdown for many years. The absence of a negative return period during a new investor’s investment career could make one believe a material correction is a low-probability event. While it is difficult to predict the market's trajectory, one needs to be mindful of warning signs to protect your holdings from a sharp correction. There are two prominent warning signs that could help investors gauge the drawdown risk.

Too good to be true stories

The 2007 annual report of a prominent infrastructure company has the following excerpt: “Sustaining economical growth, reforming the agricultural sector, improving education and healthcare, opening the economy to the benefits of globalisation and emerging as a true world power are but utopian dreams in the absence of adequate infrastructure development. Fortunately India has, since recent years, aptly recognized the importance of the same. Something that has resulted in a remarkable growth story… Another noteworthy development in the recent years has been the expansion of the role of the private sector to achieve infrastructure development in both rural and urban areas.”

See here: Stockology: No need to rush in or panic exit markets

The stock was a multi-bagger when this was put out, but just a year later, it was a different story altogether, showing that for this company, its plight was no different from the sectoral performance.  As shown in the graph below, drawdowns witnessed by the sector took more than a decade to nullify. The story jibes with many others in recent times. Certain names are trading at triple-digit PE or price to earnings multiples, building in a lot of optimism. It is always advisable to see if the story has credence.

In the example above, high hopes built on the sector's growth was eventually proven wrong, leading to negative returns for a prolonged period.

Stock price appreciation far exceeding earnings growth

When the price of a company's share appreciates far ahead of what its earnings warrant, it would lead to an expansion in valuation metrics like the PE multiple. Once this happens, a material price correction is inevitable. While it may not always be always feasible to pinpoint the reason for a correction in valuation multiples, every enterprise would face enough challenges in its life cycle, leading to a reality check. The following graph shows the stock price performance of a leading paint company that was believed to have unrivalled moats. However, despite what was believed to be a ring-fenced market share, the entry of a new rival with deep pockets led to muted stock price performance despite reasonable earnings growth. In today’s market, there are many names trading near peak valuations built on the hopes of a flawless future.

Clearly, unreasonable valuation multiples could make the stock vulnerable to even a slight disappointment in earnings or news flow.

'Sell' discipline is critical for long-term success

Identifying exit points are as critical as finding new ideas. Every investor should have a robust process to trigger the exit from an investment. This could be based on valuations or simple heuristics to identify the market expectations from the stock. At Quantum, we follow strict Sell limits based on our fair value estimate of the stock. As the stock crosses Sell limits, we start trimming our position. A disciplined process would go a long way in managing downside risk, especially in volatile markets.  While it is important to remain invested for the long run, it is equally important to see if you are invested in the right companies that have room for long-term stock price appreciation.

See here: Top mid-cap stocks that fund houses sold ahead of volatility