By David G. Wilson, Jr.
Daily Record Newswire
One of the most difficult dilemmas high-net-worth investors face is how to deal with a concentrated stock position. If a company’s prospects are deteriorating, I believe the answer is simple: sell as fast as possible. But if a company’s prospects are bright, a different approach is required.
Ideally, no more than 15 percent of a portfolio should be in any one stock, but many investors with a concentrated stock position have upwards of 30, 40, 50 percent or more in one stock, which can potentially be very risky. The list of fallen stars is long. Deep down investors probably understand the risk, but a strong emotional attachment to the stock may keep them from taking action. This is understandable because the concentrated stock is often an investor’s primary source of wealth. Perhaps the investor has worked for the company or inherited the position from a family member. In order to help keep emotions at bay, consider taking a systematic approach to reduce a concentrated position.
First, determine the future value of the stock. Let’s assume an investor has a $3 million portfolio and a concentrated stock position worth $900,000 (15,000 shares of XYZ stock at $60 per share). In other words, this concentrated position represents approximately 30 percent of the portfolio. There are various ways to determine the future potential value of a company’s stock over the next 12 to 18 months. Consider using a multiple of cash flow, next year’s expected earnings multiplied by historical price divided by earnings ratio, or a combination of methods.
Second, apply a 15 percent discount. Once the future potential value has been determined, a haircut of 15 percent should be used to arrive at the initial price to begin to sell the stock. Let’s say the investor determined the future potential value over the next 12 to 18 months at $72 a share. A 15 percent haircut would mean shares should be sold starting at $61 a share.
Then, start selling. After evaluating the stock the investor decides to sell 1,475 shares at $61, which equals approximately $90,000. If the sale occurred at $61 a share, this would reduce the holdings to around $810,000 or 27 percent of assets.
Finally, establish and maintain a threshold. After the initial sale, the investor’s total stock position is now worth $810,000. This figure is the selling threshold. Do not sell any additional stock until it appreciates substantially above this level. For example, let’s say the stock reaches a value of $66.50 per share and a total value of $900,000. At this point, the investor would sell off another $90,000, which would reduce the position to the $810,000 threshold. Continue this process until the concentrated position represents no more than 15 percent of assets.
The above hypothetical examples are for illustration purposes only. But this strategy, if it is followed, can help investors sell at progressively higher prices. It also takes the emotion out of the equation and can help prevent investors from being too greedy. Each year investors will need to reevaluate the stock’s future potential value and make adjustments to the selling price, if necessary. Tax considerations are also important, but should not interfere with the basic premise of the strategy, which is to gradually reduce the risk of a concentrated stock position.
Time and patience are two of the keys to making this strategy work. I developed this strategy after witnessing the devastation caused by individuals who refused to sell their concentrated stock during the 2000 bubble. Unfortunately, these investors never did anything to reduce their risk, diversify and protect a once-in-a-lifetime asset.
Implementing this strategy can be simple, but sticking with it requires discipline. If an investor owns a large concentrated stock position, the psychological problem of selling at the appropriate time must be addressed. Investors don’t want to sell too soon and leave money on the table or hold too long. That is why it is so important to determine a stock’s company’s future potential value, establish a reasonable selling price, and create a selling threshold that helps keep emotions in check.
David G. Wilson Jr. is senior vice president of investments with Stifel, Nicolaus & Co. Inc., member SIPC and NYSE, in Portland. He can be reached at 503-499-6260 or wilsond@stifel.com.
