Investors are always being advised by investment gurus in the financial media to "cut the losers and hold the winners" in our stock portfolios. Rightly so, I might add. Of course, this statement is so general that its certain truth is of absolutely no help to us in practice.
I think the first problem I have with the old "cut the losers" adage is that most people assume that when we are talking about losers, we are talking about stock performance. It is perfectly possible for a company with great business prospects to go from $10 a share to $7 a share on no news, or even good news. That's because in the short term, there are all kinds of forces that can move a stock's price.
You have to keep in mind that the stock market is an auction ï¿½ if there are more sellers than buyers on a given day, the stock will go down. If there are more buyers than sellers, the stock will go up. And market participants have reasons to sell a stock that have no relation to the fundamental value of the company that the stock represents. Therefore, it is important to use some measure other than stock price when determining which stocks are the "winners" and which are the "losers."
There is a second level of complexity to the equation, that being that winners don't stay winners forever. Trees don't grow to the sky. There are times when we have to cut the winners before they become losers. So, how do you know when that wonderful stock that has gone up five times in value in the past three years is about to take a 50% haircut? This is the true topic I'd like to address today, and I find it to be one of the toughest decisions in the investing game. Honesty compels me to say up front that I don't always get the answer right, but nevertheless, I'd like to present my thoughts on the subject.
Stick to the fundamentals
My first suggestion will be, not surprisingly, that you should avoid using the stock price as the sole arbiter of your buy-and-sell decisions. I've never known a successful investor who follows ironclad rules such as "sell when it's up 50%," or "sell when it's down 20%." You have to look at the stock price in relation to the business.
Here's a great excerpt from investing legend Peter Lynch, from his wonderful book One Up on Wall Street:
Some people automatically sell the "winners" -- stocks that go up -- and hold on to their "losers" -- stocks that go down -- which is about as sensible as pulling out the flowers and watering the weeds. Others automatically sell their losers and hold on to their winners, which doesn't work out much better. Both strategies fail because they're tied to the current movement of the stock price as an indicator of the company's fundamental value. The current stock price tells us absolutely nothing about the future prospects of a company, and it occasionally moves in the opposite direction of the fundamentals.
Let's look at a couple of examples. Let's say you bought Stock A because you have studied the business and you think the stock is undervalued. It's a small-cap stock, and the company makes building products. It's solid but offers little potential for growth, but you think it's dirt cheap. You buy the company at $5 a share, and figure it's worth at least $8. Within six months, three of the company's competitors have been bought out at nice premiums to their quoted stock prices by bigger companies, and your stock is now riding high at $9 a share. Should you sell?
I believe that you should -- your initial analysis that the stock was cheap has proven correct, and there isn't much more to expect from it. The "catalyst" that many small-cap stocks need to boost their visibility has arrived -- take advantage of it. The longer you hang on, absent real fundamental improvements in the business, the better the chances that the stock will eventually sink back into obscurity.
Let's take a look at a second example, Stock B. This company has a market cap of $150 million, and is a fast-growing retailer. Being the small company aficionado that you are, you discovered this one real early -- the company only has 20 stores, and you believe that the company has a real chance for long-term growth. The stock is $20 when you buy it, and is trading at 20 times earnings. Two years later, you are still holding, and the stock has moved up strongly to $55. The company now has 36 stores, is planning on adding 10 more in the coming year, and some small mutual funds have begun to buy the stock.
Additionally, the company has been getting some mentions in the popular business press and is ranked as one of the top 200 small companies by one of the big business magazines. In evaluating the business, you note that profits have doubled, accounts receivable and inventories are under control, and profit margins are rising. The stock is now trading at 27 times earnings. Should you sell?
I believe the answer is no -- even though the price has more than doubled and the P/E ratio has gotten a little higher, the price is still reasonable and the growth story is still intact. If this concept has the legs to get to even 100 stores, you are still looking at a triple from here. If the company has a concept that can get to 400 stores over ten years, you are looking at a ten-bagger if the management can execute. There just aren't that many legitimate opportunities to find those great stocks that go up 10 or 20 or even 40 times in value over a decade or two, and you don't want to lose one because you sold too soon.
Cutting the Winners
So, when should you cut the flowers? There are two primary reasons to sell winning stocks. Reason number one is when the valuation has gotten to a point that leaves you vulnerable to a huge percentage loss in the event of a disappointment. In our second example, if Stock B had been at $80 instead of $55 and was trading at 40 times earnings instead of 27, I believe that you may want to consider selling the stock, which has quadrupled in value, has clearly gotten way ahead of the business, which has only approximately doubled in value. Those relationships have a way of evening out, so if it works dramatically in your favor over the short term, you might want to take advantage of it.
The second reason is when a winning stock has appreciated to the point where it threatens to take over your portfolio. For example, if your biggest winner has grown to represent 40% or 50% of your portfolio, you might want to consider paring back, especially if the valuation is starting to get stretched. I used to think that having 50% of one's portfolio in a single stock wasn't necessarily bad if the stock was really undervalued, but experience has taught me that it's just too risky for most people (including myself).
Personally, I begin to consider cutting the position when a stock has grown to be more than 20-25% of the portfolio. I use valuation to determine how much to cut back. If I think the stock is still undervalued, I may cut back only slightly. If the stock is pushing the red zone, on the other hand, I may sell half or even all of the position. Your threshold may vary, of course, depending upon your age, risk tolerance, and portfolio size. One thing I will definitely recommend: If you find yourself worrying about one stock's possible effect on your portfolio, cut the position down. It's not worth the anxiety.
Zeke Ashton doesn't own Stock A or Stock B. He wouldn't know a flower from a weed, so it's best if he stays away from your garden. The Motley Fool is investors writing for investors.