When Investing, Forget Conviction, Follow the Rules

We admire people with the courage of their convictions, those who know their own minds and don't waver.  We think of the stick-to-it spirit as a sign of character, and it's a good thing to be called tenacious, persistent, tough, steady or steadfast.

A good thing, that is, if you're not a growth stock investor.

The rules say that growth investors should stick with a winning stock for as long as it continues to rise.  The problem arises when a stock starts to lose value but the investor has faith in the stock and demonstrates that conviction by holding it all the way to financial disaster.

Let's consider at the action of one amazing stock that had a long, profitable run and is now being dragged through the weeds.

Starbucks (SBUX) came public at about 70 cents a share (adjusted for many, many stock splits) back in mid-1992.  Investors who bought it then and held it through its eventual high at 40 in November 2006 would have scored a 98 bagger, earning 98 times their original investment!  It looks like the perfect example of the benefits of conviction.

There are a couple of problems with this rosy scenario.  During SBUX's climb to legendary status, it suffered several corrections and consolidations, some of them substantial.

For example, in the 15 months that began in January 1993 and ended in April 1995, SBUX roared from 1.3 to 1.5.  Not really very hot.  Similarly, you could have bought the stock at the end of January 2001 at 12.8 and sold it in July 2003 (29 months later!) at 12.4.  This is deep in the Nothin' Happenin' Zone.  If you had needed an income tax loss, you also could have sold Starbucks during that period for as little as 6.7 immediately following the September 11 attack.

The positive run that everyone remembers from SBUX actually began during that period in August 2002, when the stock bounced from its July correction, beginning at 9 and winding up at the end of 2004 at 32 handing the lucky investor a 256% gain!  That remarkable stretch of 28 months included only five months in which the stock actually declined, and only once did it decline for two months in a row.

But the fact remains that you would have to be crazy to hold Starbucks straight through from its IPO to yesterday.  In addition to some sickening corrections, you would have had to endure the double top at 40 in May and November 2006 and the subsequent long slide to 14. 

Conviction or Stubbornness?

There is a truism in law that applies to stock investing as well.  It's that "Good cases make bad laws."  It means that making the right decision in a particular case may yield a legal principle that's really harmful. 

It happens in stock investing, too.  Just think about the last person you talked to who bought a penny stock for, say, $0.18 and then sold it three days later for $4.00.  This kind of thing happens all the time, but if you try to make it your investing principle, you'll lose your shirt, pants, skivvies, accessories and the gold crown your dentist gave you back in the '80s. 

Buying stocks that you believe in and holding them essentially forever is a valid strategy if you either pick a stable dividend-paying blue chip or grab a hugely undervalued fallen angel that's selling at a discount.

But if you're trying to play in the growth stock league, you need to temper your conviction with humility.  My main example here is the case of a friend who was convinced that Crocs (CROX) was oversold.  Just last Halloween the stock was trading at 75 and everything was right with the world.  Then the wheels came off, and by last Thursday the stock was trading at about 10, having recovered from as low as 7.  This friend decided that the move from 7 to 10 was the first leg of a big recovery, and he had conviction that the health of the company and the continuing appeal of its plastic sandals was enough to warrant a renewed position. 

Last Thursday evening, however, company management warned that second quarter revenue and earnings would be substantially lower than previously expected.  On Friday the stock opened at 5 and has since plowed a little deeper into the mud on the bottom of the lake. 

Moral: Forget conviction.  Follow the rules.  Look for stocks in sustained uptrends and limit losses to 20%--max!  As the killjoy lifeguard at the pool used to say, these rules are for your protection.

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Wrestling With the Olympics

The Beijing Olympics are looming on the horizon and I'm looking forward to them, as usual.  Sports commentators have already laid out the major challenge of the games (bad air quality) and other reporters are working hard on the human-interest stories that will give the game their unique texture.  My favorite so far is the extensive coverage of China's efforts to teach its citizens how to cheer politely. 

NPR has reported that the government wants to avoid a repetition of the embarrassing response to the presence of the Japanese team at an Asian Cup football (soccer) match in Beijing in 2004.  The booing and whistling from Chinese crowds directed at the Japanese team may not seem like much to sports fans in the U.S.  But for the Chinese government, which wants a perfectly polite Olympic games overflowing with sportsmanship and joy, it was intolerable. 

That's why the government is training a volunteer force of 300,000 cheerleaders who will smile and loudly chant the approved encouragement (sample: "Go China! Go Olympics!") to the athletes and teams on every field.  They will also, not incidentally, fill any empty seats that might give the impression that any sport or country was being ignored. 

China's leaders are going all out to be sure that everything goes perfectly.  Personally, I wouldn't want to be standing in their way.

Where I would like to be standing is in line to watch just about every freestyle wrestling match of the entire games.  Wrestling was my only varsity sport (for one season in junior high school), and I coached a high school wrestling team when I was in the Army.  I've always loved the sport, despite the matches in which the opponents keep hanging back and looking for weaknesses that never show up and the matches where one wrestler gets a one-point lead and tries to ride out the match. 

My only regret is that the only matches I usually get to see are the ones in which U.S. wrestlers win, and even then only in the semis and finals.  Maybe this will be the year when streaming coverage of every sport finally shows up online.  If it is, I'll get a great workout as I twist myself into a pretzel on the sofa telling the wrestlers what to do. 

But I probably won't be cheering "Go Wrestling! Go Olympics!"


My investing idea today is a little odd, perhaps.  It's a Chinese stock whose chart is underwhelming and whose reputation is strangely bland.  Yet it's a leading marketer of over-the-counter, plant-based pharmaceuticals of the sort that millions of Chinese buy every day for common problems like rhinitis, respiratory diseases and "female complaints."

The company, American Oriental Bioengineering (AOB), was founded in 1970 in Los Angeles and is registered in Nevada.  Despite this occidental origin, the company's exclusive focus is on the Chinese domestic market.  To implement this focus, AOB has built its brand identity and pursued a program of acquisitions to gain new products and existing sales networks.

The most impressive aspect of the company is its consistent profitability.  Earnings have grown every year since 2002, and both revenues and earnings have risen every quarter dating back to mid-2004.  Despite significant cash outlays on acquisitions, EPS rose 20% in Q1 on a 51% rise in revenues, with a 24.3% after tax profit margin.  An all-time high of 65 institutional investors have positions.

The chart is the stumbling block for AOB.  After two big runs--one from 2 to 8 in 2005 and one from 5 to 14 in 2006--the stock has settled in under resistance at 14, trading in a slightly tightening range with support around 7.  Investors may just prefer stocks with more movement, or they may be waiting for earnings on August 11 to deliver the advance that seems likely to eventually happen. 

American Oriental Bioengineering is a well-run company with strong brands, and it represents a chance to play the increasing buying power of the Chinese consumer.  I wouldn't buy it yet, but it's one to watch. 


Editor's Note: Paul Goodwin is the editor of Cabot China & Emerging Markets Report, the #1 ranked newsletter for 2006 and 2007, according to Hulbert Financial Digest. If you'd like to follow some emerging markets stocks that are making good on their potential, you should consider a no-risk trial subscription to the report.  Click the link below to get started.



Paul Goodwin
For Cabot Wealth Advisory


Paul Goodwin can be found on Google Plus.

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