Adding the How and Why to the What

 

Maxims are Helpful ...

... If You Know How to Use Them

Dependability is at a Premium

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If you’ve been reading our Wealth Advisories for a while, you probably know that I’m big on maxims. I think the reason has to do more with being a student of the market. After all, if you're a hedge fund operating some black-box trading system, or a value manager sticking just with your formulas, maxims don’t really help; you just stick to the numbers and do what the system tells you.

But for a growth stock investor like me with a sense of history, maxims actually help a lot; I often think of one when I'm in an investing rut, or when the market is a bit confusing. And you know the boss emeritus (Tim Lutts) likes them--his desk has more than 100 buttons with sayings we write about in every Weekend Digest!

However, my only beef with all of these maxims is that there's only so many times you can hear the basic ones like "cut your losses short" before your eyes glaze over.

So what I thought I would do today is add some “how” to the “why and the what” of those basic maxims; instead of just reciting some of the basic pieces of advice for growth investors, I’ll give you some ideas about how to actually implement them, reviewing a few different strategies to achieve your goals.

With any luck, you’ll be able to come up with a couple of methods that will improve your results.

So let’s get going, starting with the one mentioned above:

Cutting losses short

The most straightforward way to cut losses short is simply to make sure no stock ever shows you a loss of more a certain amount; we’ve used the 20% threshold in Cabot Market Letter for decades--although that is the absolute cut-off, our average loss in the 12% area. Generally speaking, I think 10% to 15% is more than enough room for most growth stocks.

Still, there are other ways to go about it. One thing to consider is by working backwards, so to speak. That is, figure on risking the same amount per trade (say, 1% of your portfolio or hopefully less), and then set your loss limit based on the volatility of the stock. It sounds complicated, but the basic principle is that you don’t need to give, say, Home Depot, as much rope as a fast-moving chip stock ... and if you’re giving something less rope, you can own more shares and still be risking the same amount of dollars.

If you’re uncomfortable giving a stock so much room on the downside before selling, you could do some partial selling--you could sell half your shares if you're down 8%, and the other half if the stock falls to 16% below your buy point. That way you'll never suffer more than a 12% loss in total (average of 8% and 16%), yet you’ll be able to give at least some of your shares extra rope before getting out.

Finally, the last thing to remember about cutting losses is to trail your mental stop if the stock gets going. Thus, if you buy a stock at 50 with a stop at 44, and the stock rises to 52, you might trail your mental stop up to 45 or 46. That way, if something does go awry, your loss will be smaller.

Letting winners run

Basically, the way most investors let winners run is to trail a stop, either by using a “percent off high” method (the stock will be held until it drops, say, 15% from any peak), by using a popular moving average (like the 50-day line), or by just doing some good old-fashioned chart reading, placing a stop below a logical support level.

But, honestly, my experience is that the method you use to hold on to your winners is far less important than your ability to adhere to it. Said another way, it’s one thing to say to yourself “I’m going to give this stock 20% on the downside” but it's quite another to sit tight when the stock has fallen 15% in 10 days on lots of bad news while the market sags!

Thus, it’s really important to know how much downside you have in any stock, and to be comfortable with it. If you're not, I guarantee you the stock will shake you out at some point.

Because of all this, I’ve always been a fan of booking some partial profits on the way up--selling one-quarter to one-half of your shares when you have a worthwhile profit and all the news is good. When you get profit like that in the bag, you’ll be able to give your remaining, smaller position enough rope to develop into a bigger winner.

Put all Your Eggs in a Few Baskets

Growth stock investors love to be concentrated in a few super-strong leaders, but doing so also increases your risk. If you’re taking 20% positions right off the bat and you get nailed for three or four straight losses, the damage is a lot greater than if you’re taking 8% or 10% positions.

So how do you have your cake and eat it, too? Through pyramiding methods, where you go into a stock with a plan to buy more on the way up. This way, you can build up to a large position in two, three or even four steps. And because you’re buying on the way up, you'll always have the most money invested in stocks that are your biggest winners; those that die on the vine will be relatively small.

I wrote about this topic in more depth in the Cabot Wealth Advisory titled “The Aggressive Aggressive Investor”.The key is to have a plan ahead of time; you might buy an 8% position to start, then buy 4% more if the stock rises 5% or 6%, and then top off another 2% if the stock keeps headed up. The exact formula isn’t as important as knowing what you want to do and how large you want to get, and then following the plan.

Let the market pull you into a heavily invested position

If your stockpicking is developed enough so that you’re buying institutional quality names, we've found that your own P&L can be your best indicator. If you’re struggling to make money, it’s likely because something isn’t right with the market or the group of stocks you focus on (growth stocks, in my case).

So how can you put this to use? One way is to put some restrictions on your overall exposure when you start a new buying spree. For example, say you’ve been heavily defensive for a few weeks or months as the market went south; you’re sitting on 75% or 80% cash. Then the market turns up and gives some new buy signals, telling you to put some money to work.

Well, one thing you might consider is a rule like this: You can't get more than 50% invested until your portfolio is up 2% from where you started. Then, once you’re up 2%, you can increase your exposure to 75% ... but you can’t go over that figure until you're portfolio is up another 2%. At that point, you’re free to get more heavily invested.

Those figures, by the way, are totally made up, so don't take them to heart. The point is that you’re letting the market (by delivering a new buy signal) and your own P&L (through actually making money) pull you into a more heavily invested position; you won't get completely burned by the occasional false buy signal by diving in with both feet, and you also won't be left behind by fear, with your P&L telling you that you're on the right track.

I could go on, but these four common maxims are useful ... if you know how to apply them. I hope I helped on that front; if you have any questions or comments, don’t hesitate to email me directly at mike@cabot.net.

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As for the market, my thinking is really getting divided into two separate time frames. On a very long-term basis, I am thinking more and more that we're in the seventh or eighth inning of this secular bear market (which began in March 2000).

I say that mainly because of history (these phases often persist from 14 to 18 years or so, depending how you measure it), but also because of the extremely choppy market action since February 2011 (a characteristic of late-stage secular bear markets--check out the late 1940s and the late 1970s) and because of sentiment, with risk-aversion the name of the game, and with most investors preferring the safety of 3%-yielding bond funds or blue chip stocks to anything with a higher valuation.

Thus, I really do believe that, looking out five years (if not a lot sooner), we’ll be well into a new secular bull market, where the market makes higher highs over time, where trends persist instead of ending after six or eight weeks, and where growth stocks with revolutionary new products are leading the way. It really is something to keep in mind despite all the depressing news and uncertainties out there.

However, in the short- to intermediate-term, there’s no question that the selling pressures that began in a modest way in mid-September have gradually accelerated; early last week it looked like the clouds were parting but the severe distribution on Thursday (in the Nasdaq) and Friday (in everything) threw cold water on that idea.

I’ve been slowly raising cash in recent weeks as more stocks come under pressure, though to this point, it's not a complete disaster out there. When looking for new buys (or even names to put on a watch list), I really want to see evidence of strong support in recent days or weeks; bottom fishing not allowed.

On that front, I think eBay (EBAY) can continue to do well. Now, the company isn’t the most exciting; it now has $13.5 billion in annual revenue and is well-known to just about everybody. But that’s kind of the point; in this environment, institutional investors want surety and safety, and eBay delivers on both fronts.

More specifically, the stock reacted very well to a solid-but-not-spectacular quarterly report last week. Both sales and earnings rose 15%, and earnings estimates were hiked slightly as analysts remain optimistic about the firm’s PayPal subsidiary, which saw revenues advance 23%. Moreover, the upside potential for PayPal’s offline initiatives is huge, with a big deal with Discover’s merchant network that will kick in next year.

Bottom line, you have a reasonably valued stock (22 times earnings) that has already reported a beat-and-raise quarter, whose growth should gradually accelerate in the quarters to come. That’s why the stock lifted back to all-time highs last week despite the shaky market.

I don’t expect EBAY to make you rich, but I do think shares are a decent buy in the 46 to 49 area, with a stop a few points below your cost; my guess is that big investors will support the stock on weakness, even if the market remains under pressure.

All the best,

Michael Cintolo
Editor of Cabot Market Letter

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Michael Cintolo can be found on Google Plus.

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