How to decide whether to take profits or run a winner

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This week’s episode examines the dilemma of whether to run a winner or take some profits from an investment that’s performed well.

Joining Kyle to offer his expert insight is Richard Hunter, head of markets at interactive investor. The duo discuss fear of missing out (FOMO), top slicing, position sizing, and much more.

The idea for this episode came from a listener email. Have you got a topic or question you’d like answered? We love to hear from you, and you can get in touch by emailing OTM@ii.co.uk

In this episode, Kyle refers to a previous podcast called ‘The reasons to sell a fund and how to judge performance’. You can find the episode here or by searching through the back catalogue on your preferred podcasting app.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly look at how to get the best out of your savings and investments.

In this episode, we’re going to cover the investment dilemma of whether to run a winner or take some profits from an investment that’s performed well.

Joining me to help tackle this topic is Richard Hunter, head of markets at interactive investor. Richard, great to have you back on the podcast.

Richard Hunter, head of markets at interactive investor: Glad to be here, Kyle.

Kyle Caldwell: So, Richard, the idea for this episode came from a listener. We love it when listeners get in touch, and if you’ve got an idea for a future episode or you’ve got a question that you’d like myself or one of the team to tackle, then please do email otm@ii.co.uk.

So, let’s now kick off this week’s topic. I won’t read the email in full, but in short, the question is, how can investors decide whether to take profits or run a winner?

The person who got in touch said, “I’ve been investing for 35 years. I’m not a day trader. I normally invest in funds, investment trusts and exchange-traded funds (ETFs). Some of my holdings are for income and the rest for growth. The trouble that’s bugged me since I started investing is when to sell and take profits.

“I don’t have problems when to buy. I am a contrarian investor, and I like to buy when markets tank or there are dips in the market. I’ve often read in fund manager reports that they have sold up and taken profits when a certain investment has done well and then invested the money in something else. Selling out of an investment when it’s doing well is difficult because of the fear of missing out (FOMO). So, how do the professionals go about this?”

So, Richard, for me, it’s in deciding whether a company share price has reached the limits of its potential or has further to run. It’s an art rather than an exact science.

Having said that, what would you say, Richard, how should an investor approach it when they own a company that’s performed really well for them? How should they decide whether to run the winner, take some profits, or sell out entirely?

Richard Hunter: I think we need to go back to square one and accept the fact that a lot of people think that it’s much easier to make a decision to buy a share than to sell it. And if you imagine that you spot a company you might like the look of, you like its prospects, you’ve done your own research, you’ve looked at some of the metrics surrounding the company and you’ve decided to take the plunge, so you’re now in there.

After that, of course, you’ve got money committed to that share. I’ll just say share rather than portfolio for simplicity. If the share price goes down, this is when human psychology starts to kick in. Share price has gone down. There’s a lot of investors who are reticent to admit defeat and take the loss, even if that’s the right course of action because the company’s fortunes have changed.

If on the other hand, the share price has gone in the correct direction upwards, as the investor had hoped, then, of course, you do absolutely get that fear of missing out, had it got further to run, etcetera.

I think you’ve only got to look as far as the amount of market sayings and additives that there are around this very topic. It’s one of those questions that’s coming to some investors’ mind with a lot of our main market indices on both sides of the pond at or near record highs.

Kyle Caldwell: In terms of taking a step back, for me, it’s examining whether the current share price justifies the potential future growth.

So, in terms of valuations, Richard, are there any measures you pick out more than others that investors should drill into to ascertain whether a company’s looking reasonably valued or has now become overvalued?

Richard Hunter: It’s a difficult question in as much as each metric has its own value, and it’s normally best to look at a combination of metrics, certainly not one in isolation.

In terms of the very word ‘valuation’, most people are going to be thinking about the price/earnings ratio and what sort of multiple that share’s on, and whether, given its share price increase, that’s now starting to look a bit frothy.

However, it could be that all boats have been lifted in that sector, and on a relative basis, although it’s more highly valued than it was, it is overvalued compared to its peers.

Then, of course, you get other metrics, such as return on capital, the capital cushion for the banks in particular, the amount of money they are putting aside for any potential global downwinds. There’s any number of key metrics that an investor should be bearing in mind before making the plunge in the first place.

And at these new higher levels, it’s probably worth revisiting why you bought the share in the first place and whether those things are still intact.

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Kyle Caldwell: It’s also wise to consider the wider macroeconomic backdrop as well. For example, we’ve been in a period where interest rates rose from rock-bottom levels to peak at 5.25% in the UK. Interest rates are now starting to fall, and they’re currently 4%.

As they rose from rock-bottom levels to 5.25%, there were certain types of investments and sectors that performed well, and now that we’re in a different interest rate environment, there’ll be a new set of winners.

Richard Hunter: Yes, there will. Just leading on from your example around interest rates, the housebuilders have had a really rocky time over the last year, 18 months, mainly because, of course, quite apart from the fact we’ve got a domestic economy with cloudy prospects. Those higher interest rates have put off a number of first-time buyers, new buyers, while house prices have still been on the increase.

You can still see that longer term, the housebuilders have been doing what they can, given the fact they’re in a very cyclical sector. They’ve been continuing to buy up land at inverted commas bargain prices, which obviously they will sell on for a decent margin in due course.

But like anything else, they’re going to kind of step back a bit on building houses if the demand isn’t there. And that’s quite apart from the fact that in terms of the long term, there’s no question that there’s a chronic undersupply of houses in the UK.

So, that’s one of the major planks which should remain in place for the housebuilders. But at this particular moment in time, investors are looking elsewhere for more immediate growth prospects.

Kyle Caldwell: You touched on the fear of missing out, or FOMO. So, when a company does well, there can also be a strong emotional attachment to a company. Some investors can potentially fall in love with a stock because they love the returns they’ve had, and they’re hoping they’re going to get more in the future.

How can investors detach themselves from this risk?

Richard Hunter: There’s a couple of things, quite apart from recommending you don’t fall in love with your investment, is to treat it with the same cold eyes that you did when you bought it.

But one of the things we’ve already mentioned is to revisit whether it still fits into your investment strategy, into your growth objectives, and so on. And whether you think that maybe it has run its course and even within the same sector, there’s other opportunities coming through and perhaps you can see echoes of Company B as compared to Company A that you’ve been invested in.

There’s a couple of other things as well in investment jargon, something called top slicing. Let’s imagine you bought £10,000 worth of shares and you absolutely got it right and the share price went so high that your investment is now worth £20,000, so you’ve doubled your money.

Top slicing would involve selling £10,000 worth of those shares, so your original investment is covered. You’ve now broken even. The remaining £10,000, a) leaves you with skin in the game, and b) is pure profit.

So, that’s one of the things that you can do. It probably won’t be a 100% usually, but on those percentages, you can see the point that top slicing could actually keep you involved.

Kyle Caldwell: I do often hear that from fund managers when I interview them that they top slice stocks. Sometimes it’s because they think the valuation has become a bit too rich, but other times it’s because of the fund’s mandate. The stock has become too large a percentage in the fund relative to the risk level of the fund. So, it sort of forces their hand. It’s the fund manager’s decision ultimately, but for a risk-management reason, they also need to sell.

For example, some funds invest in a particular area of the market. So, some UK funds will invest in UK smaller companies and if the stock becomes much more successful in share price terms and the overall business, then that stock can go from the FTSE Small Cap index right up into the FTSE 100.

An example that I can think of is Games Workshop Group (LSE:GAW), and if you run a UK smaller company fund mandate, Games Workshop is no longer a UK smaller company share, so they have to sell. Even though I’m sure many of them would like to continue running it as a winner because it’s become a more successful and more profitable business.

Richard Hunter: In some ways, that’s a nice problem to have, but there is no reason why you can’t also apply that thinking to an individual portfolio.

If you’ve got 10 stocks in your portfolio, 10% in each, and one of them really does go off to the races, and it’s now worth 20% of the overall value, in terms of rebalancing, you might want to consider getting back to the equal level you had previously.

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Kyle Caldwell: In terms of individual stock positions, it’s very rare to see a fund have more than 10% in a single stock. [This] is for regulatory reasons, so the fund is sufficiently diversified.

So, there’s a rule called the 5/10/40 rule. Under this rule, funds can’t have more than 10% invested in a single company, and holdings that account for 5% each cannot exceed 40% of a fund’s assets.

However, with investment trusts, they don’t have the same sort of rule in place, but in practice, it’s very rare to see an investment trust have more than 10% in a single stock, and it’s very rare to see it around 15% or higher.

So, fund managers and indeed private investors, Richard, they also often have price targets for a stock, and that can help you have discipline. Obviously, when it hits that price target, then that’s a sign to then sell.

Also, investors can put stop losses in place in which you automatically sell some of your holding when it reaches a certain level. Could you explain how stock losses suit certain investors?

Richard Hunter: It may well be that you’re a cautious investor. Perhaps it’s one of your earlier investments. Let’s say you buy the shares at a price of £1.20, and you decide that you don’t want to take losses with, say, 20p per share. So, you put a stop loss limit on of £1, and should the shares drop by 20p, they will automatically be sold.

That’s as opposed to looking at how your investments getting on six months later. I need to see that it’s now halved to 60p, and, obviously, you’ve lost a good percentage of your investment. So, it’s a question, really, of just putting a level in place which you could comfortably, although painfully, expect to accept.

Kyle Caldwell: As you’ve already touched on, Richard, the size the stock becomes in the portfolio is ultimately one of the most important things that you can consider.

You gave that example earlier, say an investment doubles from £10,000 to £20,000, by top slicing, as you described, that also rebalances your portfolio, and it brings it back down to the level of risk that it was in the first place.

Richard Hunter: Yes, it does. And it’s never a bad thing to spring clean your portfolio, because some of the things as you carry on through your investment life are going to change. It may be, for example, that you’re a forced seller at some point, either due to personal circumstances whereby you might have to raise some additional cash, or even if you’re pending retirement, and it may well be that you’re no longer particularly interested in growth stocks, and your requirements are now much more based towards income. So, you would sell out of your growth stocks into more stable income stocks.

So, around the whole question, as with so many types of investment, it’s going to tend to vary from individual to individual, Although, hopefully, we’ve covered some of the overarching themes, which is that knowing when to sell in the middle of the battle has been a conundrum for some considerable time.

Kyle Caldwell: In terms of funds, investment trusts, and ETFs, I’ll just provide a couple of pointers from myself regarding whether to run a winner or to take some profits.

Before I get to those, I wanted to mention that previously on the podcast we published an episode in which we talked through the reasons to sell a fund and how to judge performance. So, I’ll put a link to that episode in the description of the podcast.

So, that was more related to whether the fund or investment trust wasn’t performing well, or if the fund manager running the fund had left or retired. So, they were the main bits that we covered in that episode, but related to whether it’s been a top-performing fund, whether to take some profits or keep it as a winner.

It goes back to the points that we’ve made for individual companies. It goes back to the reason you bought the fund in the first place - does it still fit into your portfolio? Does it still fit into your objectives? And then also consider the wider backdrop.

Has the reason the fund’s performed well over the short- or medium-term time frame been down to its investment style? Has it done well because the macroeconomic conditions have been in the fund’s favour?

Particularly think about that regarding more adventurous funds, such as a fund that invests solely in India or solely in China. Has it been a strong backdrop for either of those stock markets? Because over time, it does ebb and flow, and specialist funds can go in and out of form pretty quickly.

So, ideally, you want to invest for the long term of at least five years, ideally 10 years or more. But if it has been a strong period of performance, I’d question why, and I would consider potentially taking some profits because it’s not going to be a strong run of short-term outperformance forever for a particular market.

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With investment trusts, one thing to watch out for is whether a trust trades on a premium or a discount. If you see an investment trust that’s trading on a premium of more than 5%, certainly more than 10%, I’d consider waiting until that premium cools. This is because history has shown us that investment trust premiums [aren’t sustainable] over the very long term because conditions change, and when conditions change, those premiums tend to erode.

One example of that is when interest rates were at rock-bottom levels, so, around four years ago, there was a lot of demand for renewable energy infrastructure investment trusts.

I think at the 2021, the average renewable energy infrastructure investment trust was trading on a premium of around 7% or 8%. Today, the whole sector’s on a discount of over 20% on average, and that’s because the environment’s changed. People were seeking out these investment trusts that were offering a good level of inflation-beating income when interest rates were at rock-bottom levels.

Today, they’re still offering that, but investors can get a decent level of income from bonds, and also money market funds, and that’s reduced the appeal for those alternative income areas like renewable energy infrastructure.

So, that’s all we’ve got time for today. My thanks to Richard and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app. And if you get a chance, leave us a review or a rating in your podcast app too.

We love to hear from you. You can get in touch by emailing OTM@ii.co.uk. In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website at ii.co.uk.

I’ll see you next week on your preferred podcast app or on video on YouTube. See you then.