What to do if a stock skyrockets?

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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Since the start of 2023, several stocks, especially in the US, have skyrocketed to the moon. In such times, many investors are unsure on whether they should sell to profit from the rally, or if they should continue holding on to the stock to make bigger profits.

When faced with such a situation, investors have several choices which they could make moving forward. In this blog, I will be covering some potential decisions which investors can make when a stock they own has skyrocketed, as well as the pros and cons of each decision.

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Overview 

Before deciding whether to sell, hold, or even to buy more of the stock, investors should first ask themselves this key question: "is the stock overvalued?"

The answer will vary across individuals, and it is the due diligence of each individual to research about the company and its financials before coming to a conclusion on whether the company is overvalued or not.

There are four potential answers to this question:

1) Overvalued

2) Fairly valued

3) Undervalued

4) Unknown / Unsure

Some common methods to determine a stock's intrinsic value (IV) are as follows:

a) Discounted Cash Flow

b) Net Book Value

c) Dividend Yield

d) P/E Ratio

e) PEG Ratio

f) Gearing Ratios

g) Residual Income

h) Historical Prices / Yields

Do note that the list is non-exhaustive, and there are many other useful methods to calculate a stock's intrinsic value. Oftentimes, one method alone is insufficient to have a complete and accurate picture of a stock's IV.

As such, it is usually recommended to use a combination of methods to get a more accurate and complete analysis of a stock's IV.

Please note that I will not be covering the method of calculating IV in this blog. I might cover it in a future blog.

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Fear Of Missing Out (FOMO)

If a stock is overvalued, the clearest step moving forward is to simply sell it. However, in cases where overvalued stocks have suddenly skyrocketed, investors are usually hesitant to sell because of the fear of missing out (FOMO) on the rally.

In such situations, investors are often making their investment decisions based on their emotions instead of sound logic and reasoning. If a stock is overvalued, the most logical decision is to sell it. Yet, many investors do not, and continue holding on to the stock through the rally, despite knowing that it is overvalued, and only selling out of fear once the bubble bursts.

I believe that one mindset investors can adopt to overcome this situation and FOMO is this:

Instead of worrying about how much higher the stock can go or trying to sell the stock at its peak, investors should stick with the fundamentals — if a stock is clearly overvalued or hyped-up, the best decision you can make now as an investor is to immediately cash-out and move on, looking ahead for other better investment opportunities.

It is not a matter of how high you sell the stock at but whether you sell when it is overvalued or not.

If overvalued, sell. If it isn't, hold.

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For example, let's say you bought a stock at $100, and now the stock is trading at $200. After doing your research, you have determined that the stock's IV is $150. As such, the stock is currently 33% overvalued, ($200-$150)/$150 = 33.3%. Meanwhile, financial experts and the media have raised their target prices of the stock to $250.

In such a situation, you might be tempted to continue holding on to the stock, and selling only at $250 or higher. If you are convicted of your own valuation of the stock of $150 (instead of the $250 target price hyped up by the media and financial experts), then the best decision you can make for yourself is to sell off your position and move on.

Although it may be initially difficult to sell the stock when everyone out there is hyping up the stock, the margin of safety of 33% provided by the stock's valuation of $150 helps cushion any potential "loss in profit" if the stock continues to go higher.

Do note that there is a big difference between "loss in profit" and "losses". Loss in profit denotes that you are still making a profit but only less than what it could have potentially been, whereas "losses" simply mean negative profits, or in layman terms, "lose money", in contrast with "loss in profits" which means that "you made less money than you could have".

Since the stock is trading at a 33% premium to the IV of the stock you have determined, this provides a reasonably large margin of safety when selling. Although you will probably not be able to sell at the peak of the hype, at least you have sold it at a 33% premium to its fair value. 

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Margin of Safety 

The purpose of the margin of safety is to ensure that in the event your valuation of the stock is overly conservative (e.g., the stock's IV is actually $170 instead of the $150 IV you underestimated), you would still have profited from the overvalued stock, compared if you were to sell the stock at only a 10% margin of safety ($165).

Thus, having a reasonably large margin of safety will help to compensate for any errors or overly conservative estimates in your valuation of the stock.

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As a rule of thumb, a stock trading at over a 20% premium to its IV is usually considered a reasonably large margin of safety. However, this may vary greatly across stocks.

By having a reasonably large margin of safety, you will be able to sell the stock not just when it is overvalued but also when it is trading at a relatively highly overvalued price. While you will probably not be able to sell at the peak (based on probability), as long as you sell the stock when it is overvalued, you are on the right track moving forward.

In the long term, as long as you stick with your investment plans and decisions, it will be almost impossible to lose money in the long run. If you win more times than you lose, you will make money, regardless of the amount.

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The Market Trap

In the markets, investors often fall for the trap of news and financial experts. After being swayed by the hype surrounding a stock, investors choose to hold on to the stock in spite knowing that the stock is clearly overvalued. Many times, it is only after the hype has died down and once the stock bubble has burst that many investors start selling their positions in the company.

By then, the stock will likely only be fairly valued or possibly even undervalued, which is why many retail investors lose money in the markets despite the markets always going up in the long term — they buy on the bubble or hype and sell on the crash or dip.

Such has happened before in the past, and will continue to happen in the future, as the unfortunate truth is that many investors buy out of greed and sell out of fear.

As such, in order to buy low and sell high, it is important for investors to stick to their investment plans and follow logic and reasoning instead of the news surrounding them and the emotions bubbling inside them.

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How much to sell?

Once you have decided that you plan to sell the stock because it is currently overvalued, the next important question to ask is this: "how much to sell?"

Similar to "how much to buy", the purpose of "how much to sell?" is to mitigate the volatility risk when investors sell stocks, especially those of overvalued companies.

However, in cases where the stock is highly overvalued (e.g. trading at a >50% premium to its IV), the question of "how much to sell?" may not be so relevant, as selling your entire position is probably the wisest thing you can do for such companies.

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In cases where the stock is overvalued but not highly overvalued, you may want to consider the following 3 options:

a) Sell half of your position and hold the other half

b) Sell off shares equal to the amount you invested in the stock

c) Sell in tranches

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A cost-free investment

Option (b) is usually only applicable in cases where you have profited a lot from the stock. For example, if you bought 1,000 shares at $10 each, and it has now quadrupled to $40. Your initial investment of $10,000 is now worth $40,000. If you follow option (b), you should sell off 250 shares at $40 each to get back your principal amount of $10,000. The remaining 750 shares you hold now are essentially cost-free as you have gotten back your principal.

The purpose of option (b) is to ensure that your principal amount is preserved (as you will have gotten it back by selling), while continuing to hold on to shares of the company cost-free.

Option (b) is also useful for companies which are fundamentally sound, as you will only want to continue holding the shares of companies which are fundamentally sound. If the company is hyped-up, or a company with much uncertainty, it may be wise to sell your entire position and avoid holding such companies in your portfolio. 

However, if your stock has grown a lot, then option (b) may be not so meaningful. For example, if you bought 1,000 shares at $10 each, and the stock is $11 now, you would have to sell off 909 shares at $15 each in order to cover your principal amount of $10,000. In such situations, option (b) may not be so meaningful, as it is almost as good as selling off your entire position, especially if your overall gains are less than 50%. Option (b) is usually more meaningful for stocks you own which have doubled or more in value.

In cases where option (b) is not so appropriate, you may want to consider option (a), which is to simply sell half of your position and keep the other half. 

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Winning Both Ways

Similar to option (b), for option (a) to apply, the company you are holding needs to be fundamentally sound. If it isn't, then you will be better off selling your entire position, and reinvesting the funds in a fundamentally sound company.

Using the same example, if you bought 1,000 shares at $10 each, and the stock is now $15, you would have made a 50% gain on your investment. Assuming that your valuation of the company is $13 a share, then selling half of your entire position to reinvest in other undervalued stocks could be a wise decision. This will allow you to continue benefiting from the future growth of the company, while having the flexibility of deploying your funds to other undervalued stocks.

By selling half of your position, you are freeing up funds which you can use to invest in other businesses which are currently undervalued that could see stronger growth in the future. This will help diversify your portfolio and position it for stronger future growth over time.

Selling half of the stock and keeping half also mitigates the medium to long term risk if holding the stock. In the event the stock crashes, at least you have cashed out half. In the event the stock continues to rally up, at least you have half your position left in the company. Either way, you would benefit. As such, selling half and keeping the other half is a useful approach when deciding whether or not to sell off a stock that has skyrocketed.

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Dollar Cost Averaging

Thirdly, for option (c), it generally applies as long as the stock is not highly overvalued. Always buy and sell in tranches to mitigate stock price volatility risk. The stock may be trading at $105 today.but it may trade at $110 tomorrow. Therefore, it is important to always buy and sell in tranches (i.e., dollar cost averaging) to mitigate the risk of volatile price movements. This is especially so for US and HK stocks which can fluctuate over 10% to 20% in just a few days.

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High but still undervalued 

On the other hand, if the stock you own has recently skyrocketed but is currently undervalued based on your valuation, then it may be wise to either add more shares, or to simply hold on to the stock.

The decision on whether to add more shares depends on (a) whether you have sufficient funds available, and (b) whether you already have a relatively large position in the company. If the company already takes up a large position of your portfolio (e.g., 20%), then you may not want to add more shares. However, if your current position is small and you have sufficient funds, then you might want to add more shares despite the recent rally. 

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." — Warren Buffett

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Average Purchase Price

Another factor to consider is your average purchase price. If your current average purchase price is $6, and the company is currently trading at $8, with a fair value of $10, then you may want to consider whether you want to add shares, because buying now at $8 a share will raise your average purchase price. If your position is small and you have sufficient funds, then adding more shares at $8 may not be a bad idea, especially if you believe strongly in the company.

Similarly, if the company you hold is currently fairly valued despite the recent rally, then holding on to the company is probably the best way moving forward unless you require funds for your other investments or needs. 

Selling a company when it is fairly valued is not a bad idea, especially if you need the funds for an emergency or to invest in other undervalued stocks. Otherwise, it is usually best to hold on to fairly valued companies and only sell them when they are overvalued or when their business fundamentals have changed.

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What if I don't know the intrinsic value of a company?

Lastly, a common problem faced by many investors is not knowing the IV of the company they have invested in. If you find yourself in such a situation, then you should ask yourself this: "Why did I invest in the company?"

Whenever you are unsure on why you bought a stock, always go back to the fundamentals:

1) Did I buy it for growth/dividends?

2) Is it a fundamentally sound company or business?

If your answer to either (or both) the questions is no, then you might want to recollect and reflect on why you bought the company in the first place. Oftentimes, people buy a company out of greed or hearsay (e.g., buy on the hype or on the good news from the media, or buy because a friend, relative or stockbroker recommended you to buy it).

While it is not wrong to buy a company out of greed or hearsay, oftentimes investors get burnt because they bought into a company which they do not understand or know.

Instead of buying a company because of its strong fundamentals or business model, many investors buy to make money. While the purpose of buying stocks is to make money, if you buy only to make money, then you are unlikely to make money in the long run. However, if you buy with the mindset that you are owning a piece of a company or business that is making money for you, then you are more likely to outperform the average investor (or even the index) in the long term.

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Conclusion 

Remember, investing is not a one day, one month or even a one year affair. Investing is a journey that will last a lifetime. You plant a tree today because you believe that the tree will still be around and flourishing a 100 years later. You plant the tree not just for yourself, but for generations to come. Likewise, when it comes to investing, you invest not just for yourself, but you are investing in the future of the company, and in the future of those after you.

With this mindset to investing, you will not be so bothered by the short term movements in stock prices (no matter how volatile). Instead, you will be focused on looking out for companies which are fundamentally sound and undervalued. Through this, you will emerge as a better, stronger and wiser investor over time.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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