Do you have difficulties knowing when to sell a stock? It's probably the single hardest thing for an investor to do well. Sure, finding great companies with undervalued stocks is tough, but selling them is even tougher. You'll never achieve the 20- and 30-baggers of the next decade if you unload a great business at the wrong time.
Even great money managers get bit by the selling bug, sacrificing hundreds of millions in profit, even billions, in order to lock in gains. Selling a slow-growing mega cap such as Bank of America or Citigroup is one thing (and may have saved you some heavy losses during the financial crisis), but you could wipe out the next home run stock if you try that trick with a fast-growing small cap.
Do try this at home
In early March, one of the great small-cap fund managers, John Laporte, retired. Working for the T. Rowe Price New Horizons Fund for 22 years, Laporte turned in an impressive performance. An investor who deposited money when Laporte took over, according to The Wall Street Journal, would now have a return of 7.8 times his money, net of fees. A similar investment in the Russell 2000, an index of small caps, would have grown to just 5.2 times the initial outlay.
A key component of Laporte's success was his ability to hold on to his winners, although admittedly, even he sold some monster gainers way too early. Laporte held his stocks for four years on average. But that figure understates the truth: New Horizons has held two-thirds of its top 20 largest investments for at least five years. On the other hand, the average small-cap fund flipped its portfolio every nine months.
The insanity of the average fund's actions is stark: How could you ever invest in the next household name if you hold a stock for just nine months? Netflix (Nasdaq: NFLX ) under CEO Reed Hastings has returned more than 1,000%, but it's taken more than just nine months to get there. The flowering of Amazon.com (Nasdaq: AMZN ) under CEO Jeff Bezos took a decade. Now, Amazon has a key position in the online marketplace, while Netflix is the go-to website for online movies.
Getting a sense of the capability and genius of managers such as Hastings and Bezos takes time. As Laporte confided to the Journal, "It often takes me years to get confident in the business strategy and the management team."
Two errors of commission
But despite its emphasis on buy-and-hold investing, New Horizons has two notable sales that cost billions in total. It held a public stake in Starbucks from 1992 until 1994, when Laporte was convinced that a short-term move in coffee prices would hit the brewer's earnings. The fund manager took a profit on the shares … then watched them grow 10 times more. That move cost the fund $200 million and ownership in the most recognizable name in coffee, one that is still growing rapidly and just initiated a nice dividend.
Another sale was much more costly. Before Laporte's time, the New Horizons fund purchased shares of Wal-Mart during its IPO in 1970. As the company outgrew its status as a small cap, the fund sold in 1983. Today its stake would be valued at about $14 billion -- twice what the fund as a whole is worth. The fund lost out on owning the world's largest retailer and its dominant competitive advantages, which were such a huge attraction to superinvestor Warren Buffett that he bought shares.
That's the power of buying and holding small caps. In fact, finance gurus Eugene Fama and Kenneth French discovered that 1 in 8 small-cap growth stocks become large each year. According to the researchers, these soon-to-be-large companies return up to 62% on average annually. Those are the types of gains that can turn you into an accidental millionaire if you hold on for the ride.
Where to begin
For those kinds of gains, focus on small caps that have high returns on capital and equity, such as the following:
|
Company
|
Market Cap
|
P/E Ratio
|
Return on Capital (TTM)
|
Return on Equity (TTM)
|
| Yongye International |
$436 million |
16.8 |
27.1% |
20.6% |
| PetMed Express (Nasdaq: PETS ) |
$388 million |
16.4 |
24.8% |
25.2% |
| Hibbett Sports (Nasdaq: HIBB ) |
$777 million |
19.5 |
23.7% |
24% |
| Arbitron (NYSE: ARB ) |
$704 million |
17.5 |
31.2% |
106.2% |
Source: Capital IQ, a division of Standard & Poor's, as of Oct. 15.
Each of these stocks has had a bumpy ride over the last year, but the prospects for each are still very bright. PetMed Express is consolidating the market for animal prescriptions on the web, taking market share from traditional veterinarians. Hibbett continues a solid expansion of its sporting good stores, by focusing on smaller and midsize markets that have less competition. Arbitron estimates the size and composition of media audiences and their media usage. Yongye manufactures an organic fertilizer in China, and its business has been growing like it was sprayed with its own product.
Let's take a closer look at Yongye. The company is a new entrant to the stock market, and already its numbers are startling. Over the past two years, it has averaged sales growth of 119% annually, and earnings have clocked in 80% higher each year.
Of course, that type of growth has to slow. How could it not? But there's still a lot of opportunity here. The Chinese government is making a huge push (read: special treatment for ag companies) to use organic fertilizers in order to minimize environmental degradation and increase crop yields on its relatively small portion of arable land. Yongye sits right at this nexus of opportunity.
The financials at each of these three small caps, as measured by returns on capital and equity, continue to look strong. PetMed Express, Yongye and Hibbett are up in the last three months, a nice gain, but with such strong fundamentals, why should you sell any of these stocks now? "Locking in your gains" in this case could mean you'll never score a two-bagger , five-bagger, or more.
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