Top News

Five reasons why selling big winners can be a big mistake for investors

The average Canadian net worth dropped by $7,594 or 1.1 per cent to $678,792 last year.
The average Canadian net worth dropped by $7,594 or 1.1 per cent to $678,792 last year.

Here are five solid reasons why you should not sell your big winners, and should perhaps instead let them ride to enjoy more giant gains. You’re welcome.

A higher market cap is positive for many reasons

Let’s look at a few reasons why a larger market cap can be very good for a stock. First, many stock market indices are market-cap weighted. In other words, the bigger a company, the greater its position in an index. Ironically, index funds often need to buy more of a company after the share price has already risen. A greater impact though can happen on index transitions: Once a company hits a certain size, the likelihood of it being added to a stock index increases greatly. So, as a stock rises, market cap grows, it gets added to an index and voila: More investors need to buy it, or at least are more likely to notice it once it is in the index. Next, let’s look at fund managers’ compensation. Most managers are compensated on how they do in comparison to a peer group of funds. Suppose your fund peers own lots of shares in XYZ Corp., and it does nothing but rise in value. You don’t own XYZ. Guess what? That stock’s outperformance is going to cost you your bonus, if it keeps going higher and your peer group’s performance leaves your own fund performance in the dust. More often than not, you are going to buy some XYZ shares, even just as ‘insurance’ against falling further behind your peers and potentially losing your big year-end bonus.

Higher valuations lower a company’s cost of capital

If a company has a high valuation, it can more effectively use its high-priced stock to make accretive acquisitions. Or, if it prefers, it can sell new shares to raise money, but will not have to dilute shareholders as much as it would if its shares were worth less. Thus, a company with a high valuation has a competitive advantage in terms of its cost of capital, which often means it can grow faster than peers within the same industry. Its fast growth increases its value further, and the cycle continues.

A rising stock attracts lots of attention

Many investors, like me, scan the new high lists every day, looking for new potential stock ideas. New highs mean a few things, but one in particular cannot be denied: Other investors are buying, and paying more than ever before. Now, your job is to find out why, and whether those reasons for buying are justified, and sustainable. New highs are like a giant advertisement for a company, attracting potential new investors.

Reliability and gains can improve a stock’s valuation further

Ask yourself this simple question: If you own two stocks, which one do you ‘like’ more, the one up 100 per cent in the past year or the one down 50 per cent. While there are some investment masochists out there, most will admire the gaining stock much more than the loser stock. Generally, the winner: (a) is growing fast, (b) beats analysts’ estimates, (c) makes good acquisitions, and so on. All this adds up to greater reliability and investor confidence. These factors tend to result in a higher valuation on the winning stock. In other words, a stock that has done well can get an even higher valuation in the market, as investors buy into its continued consistency and growth.

Great performing stocks make it easier for companies to hire and keep employees

Stock options can form a big part of an employee’s total compensation package these days. A surging stock makes for happy employees, and also helps attract new talent. While stock-based compensation expenses impact earnings, it is a non-cash expense and most analysts ignore it when looking at a company’s financial numbers. So, with a rising stock, your company has better employee retention, is able to recruit new talent easier, and likely has lower cash compensation charges. It’s a virtuous cycle.

Peter Hodson, CFA, is Founder and Head of Research of 5i Research Inc., an independent research network providing conflict-free advice to individual investors ( http://www.5iresearch.ca ).

Copyright Postmedia Network Inc., 2019

Recent Stories