Imagine this. 

Let’s say, I inherited your stock portfolio, comprising 20 stocks. 

Some stocks appreciated and some stocks depreciated. So, the main question is this. ‘Which of these stocks should I keep and which of these should I sell off?’. 

Well, for a start, I need to establish my investment objectives, which is basically, the direction for my inherited stock portfolio. So personally, I’m a stock investor who likes to accumulate shares of fundamentally strong stocks in the long run. I don’t trade stocks for short-term gains or glories. Simply put, I buy to keep. 

To invest efficiently, I assess each stock deal with the quadrant below:

There are 2 key components to this quadrant. 

The first component is on the stock’s fundamentals (F) which comprises 3 boxes in the quadrant. They are its business, financial and growth initiatives. Whereas the second component is on the stock’s valuation (V), which takes the final box. 

As F takes up 3 boxes, it is more important than V. 

Therefore, when it comes to choosing stocks to sell off first: 


Step 1: Identify Fundamentally Weak Stocks in the Portfolio

Back to the 20 stocks in my inherited portfolio. 

First, let’s assume that 10 of these stocks have fallen in stock prices. 

Of which, the first step is to reassess their fundamental strength at present and sift out the weak ones among the 10 stocks. The fastest method to reassess the fundamentals of these stocks is to plot a graph on its shareholders’ earnings for the last 10 years. 

This tells me if a stock could deliver consistent growth in earnings in the past 10 years. 

If it could, I would keep. If it failed to do so, why would I keep them? 

Consider the two stocks below: 

Which of the two stocks would I keep? 

Of course, it would be Stock A. Thus, to me, anything that does not look like the earnings growth of Stock A, I would sell them off first in the stock market. So if I found that among the 10 stocks that had fallen in prices, 7 of them have poorer financial results (nothing like Stock A), they shall be disposed of first. 


But you may ask, ‘What if they rebounded in stock prices?’. 

Well, think of it this way. If you are in a bad relationship, will you choose to stay on or move on?. Understandably, there is emotional attachment to it. You hope that by staying on, your relationship could turn around for the better. But is this highly possible?. If you are dating an alcoholic or a drug addict, is it practical for you to expect him to break free from his addictions anytime soon? 

In the context of stock investing, most fundamentally poor stocks stay poor. The ones that managed to turn around are quite few. 

Personally, I would prefer to exit a bad relationship and give myself a chance for a much better relationship. Obviously, it takes courage but it is worth it. It is the same with stocks. It is better to ditch bad businesses in exchange for strong and resilient businesses if I wish to build wealth sustainably for the long-term. 

So, step #1 is to get rid of bad businesses. 

If I do so, I would be left with 13 stocks in my inherited portfolio. 


Step #2: Reassess Stock Valuation

Now, let’s focus on my remaining 3 stocks that had fallen in price. After Step #1, I found that the 3 stocks are decent in their fundamentals. So does it mean that they are offered at discounted prices today? Or does it mean that I have bought these stocks when they were overvalued?

This is when we need to recalculate their stock valuation. 

First, I would take the purchase price of these stocks and calculate the P/E Ratio at that point in time. So, let’s say, we have Stock C, a fundamentally good stock. It was purchased 3 years ago at RM 10.00 per share when its latest earnings per share (EPS) was RM 0.20. This means Stock C was bought at a P/E Ratio of 50. In most cases, buying a stock at >30 in P/E Ratio could be overvalued, indicating to us that the investment made 3 years ago was overpriced. 


Above 30 = Potentially (but not necessarily) Overpriced. 


But what if Stock C’s P/E Ratio is <30, let’s say at 25? 

Well, I would then proceed by calculating its past historical P/E Ratio for the last 10 years. Here, let’s say its P/E Ratio ranges between 10-20 and its average is 15 in that 10-year period, then, it is overvalued. But if its P/E Ratio ranges between 22-40 and its average is 31, then, it is undervalued presently. 


If Stock C is overpriced, I may consider selling it. 

But if Stock C is undervalued, I may consider keeping or buying it.  


So back to the 3 stocks. If there is 1 stock that is really overpriced, I would sell it off in the stock market despite its fundamental strength. 

With that, I should be left with 12 stocks in my inherited portfolio. 


Step #3: Repeat Step 1&2 with Stocks that Had Appreciated

Step #1 and Step #2 place the priority on stocks that had fallen in prices. 

Here, Step #3 is a repeat of the 2 steps but on stocks that appreciated in prices. 

So back to my 10 stocks that had risen in stock prices. First, I would reassess the fundamental strengths of these stocks. If I find any stocks that failed to look like Stock A, but yet appreciated in stock prices, I would consider myself fortunate. I would realize their capital gains. 

Second, if there are stocks that deliver consistent growth in profits, but are now ridiculously overpriced, I may consider realizing their capital gains too. 

Third, if there are stocks that deliver consistent growth in profits in the long run and I find them to be undervalued, I may consider keeping or buying them. 


Conclusion: 

By following Step #1, #2, and #3, I would recover some fresh capital that can be reinvested into fundamentally solid stocks when they are undervalued. As such, my inherited portfolio will now comprise fundamentally solid stocks which have the ability to deliver consistent growth in earnings in the long-term.

Here, if you wish to learn more on the art of stock investing, here’s a free training you can attend:

Link: How to Build a Stock Portfolio that Pays Increasing Dividends?


Ian Tai
Ian Tai

Financial Content Machine. Dividend Investor. Produced 500+ Financial Articles featured in KCLau.com in Malaysia and the Fifth Person, Value Invest Asia, and Small Cap Asia in Singapore. Regular Host and Presenter of a Weekly Financial Webinar with KCLau.com. Co-Founded DividendVault.com, an online membership site that empowers retail investors to build a stock portfolio that pays rising dividends year after year in Malaysia and Singapore.

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