Do you have difficulties knowing when to sell a stock? It's probably the single hardest action 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, on average, four years. 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? The renaissance of Apple under Steve Jobs has taken years; the full flowering of Microsoft under Bill Gates took a couple of decades. Can you imagine the millions you would have lost selling Microsoft just nine months after its IPO in March 1986?
And to get a sense of the capability and genius of managers such as Gates and Jobs takes time. 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, and then watched as shares grew 10 times more. That move cost the fund $200 million.
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.
That's the power of buying and holding small caps. In fact, finance gurus Eugene Fama and Kenneth French discovered that one in eight small-cap growth stocks becomes 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. A company with high returns on capital need not tie up precious cash into its operations, meaning it can expand relatively quickly with less investment and leave more excess cash to shareholders. High returns on equity show how profitably a company uses the cash that shareholders entrust to it. Some of the best small caps have shown great marks in both areas before they went on to crush the market. Here a few future contenders today:
|
Company |
Market Cap |
P/E Ratio |
Return on Capital (TTM) |
Return on Equity (TTM) |
|---|---|---|---|---|
|
Fossil |
$2.5 billion |
17.6 |
15.1% |
15.8% |
|
Chipotle Mexican Grill |
$4.2 billion |
30.8 |
20.8% |
20.4% |
|
Female Health Co. |
$171 million |
41.5 |
41.7% |
39.9% |
|
Santarus |
$195 million |
6.5 |
56% |
114.2% |
|
rue21 |
$791 million |
35.3 |
45.9% |
51.3% |
Source: Capital IQ, a division of Standard & Poor's.
Fossil and Chipotle have had seriously good runs in the past year or so. Their financials continue to look strong, while Santarus has experienced a massive price decline recently. But with such strong fundamentals, why should you sell any of these stocks now? Sure, Chipotle is up 60% over the last year, but "locking in your gains" in this case could mean you'll never score a two-bagger, five-bagger, or more.
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Jim Royal, Ph.D. , owns shares of Bank of America and Microsoft. Microsoft and Wal-Mart are Inside Value picks. Chipotle is a Rule Breakers selection. Apple and Starbucks are Stock Advisor recommendations. Chipotle and Fossil are Motley Fool Hidden Gems choices. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Chipotle. The Fool has a disclosure policy.
