For a growth stock investor like me with a sense of history, investing maxims 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 investing principles!
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 losses short" before your eyes glaze over.
So what I’m doing today is adding some “how” to the “why and the what” of those basic maxims, offering some ideas about how to actually implement them. This should be timely, too, as we’re kicking off what I am thinking is a sustained bull move—having your ducks in a row is vital to take advantage of the new uptrend.
So let’s get going, starting with the one mentioned above:
1. Cut losses short.
The most straightforward way to cut losses short is to adhere to a hard-and-fast loss limit—our absolute maximum is 20% in Cabot Growth Investor, though we usually cut them sooner. (During the past few years, our average loss in the 12% area.) Generally speaking, I think 10% to 15% is a big enough initial loss limit.
Still, there’s another way to keep losses in check. One way is to work backwards—risk 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. The idea here is that you don’t need to give, say, Home Depot (HD), as much rope as a fast-moving chip stock.
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.
2. Let winners run.
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 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. It’s one thing to say to yourself “I’m going to give this growth 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 is getting crushed!
Because of all this, I’ve always been a fan of booking some partial profits on the way up—selling anywhere from one-quarter to one-half of your shares when you have a worthwhile profit (often 12% to 20%) and all the news is good.
When you book these partial profits, you’ll not only put some money in your pocket, but you’ll be able to give your remaining, smaller position enough rope to develop into a bigger winner.
3. “Only egotists and fools pick tops and bottoms. Which one are you?”
This was a line from a hedge fund manager who made an appearance in the fabulous book Hedgehogging, by the late Barton Biggs. Nobody knows where the top and bottom is, so if you’re going to claim you do, well, you are either full of yourself or full of something else.
But it’s goes beyond that. Every investor would do well to leave their ego at the door and accept the fact that they don’t know what’s going to happen next week or next month. Instead of predicting, just following along with what the market (and stocks) are actually doing produces far better results.
That doesn’t mean there’s no room for judgment, of course. But way too many investors either stick with terrible losers (or sell out too quickly of eventual winners) because they predict a big snapback (or big correction) is coming. Just go with the evidence instead.
4. Let the market pull you into a heavily invested position.
We’ve found that your own P&L can be your best market-timing 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 once you start a new buying spree. For example: 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 to let 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 as the rally proceeds.
A Growth Stock with Big Potential
Besides the fact that the intermediate-term trend is still up, there are a few other facts that have me leaning bullish when it comes to the overall market.
First, the number of stocks hitting new lows on the NYSE has dried up dramatically during the past four weeks. It’s a sign of a robust broad market, especially after the multi-month decline we saw.
Second, there have been a handful of “blastoff” indicators that have flashed green. I wrote about one last week (the percent of S&P 500 stocks above their 50-day lines). Most of these portend heady gains during the next six months.
Third, sentiment is still tame. Whether it’s the bullishness of individual investors (near multi-month lows) or money flows by traders (funds in the bullish Rydex funds are below average), there’s plenty of evidence that lots of money remains on the sideline.
There are still some flies in the ointment (growth stocks are performing just so-so and the longer-term trend is questionable), but, while I am holding some cash, I’m also OK buying strong growth stocks.
One name that’s on my watch list is Sprouts Farmers Market (SFM), which I wrote about in Cabot Top Ten Trader about a month ago:
“Sprouts Farmers Market’s motto is ‘Healthy Living for Less,’ and many consumers are signing on—the company is a relatively small (217 stores in 13 states at year-end) organic grocery store that offers reasonable prices and presents a unique layout concept that’s proven to be a hit. The stock is strong following a great fourth-quarter report that confirmed the growth story is intact—sales rose 27% (bolstered by a solid 7.4% leap in comparable store sales, the 35th straight quarter of comp store growth), while earnings rose 50% and cash flow gained 25%. Importantly, cash flow margins stayed about the same, easing fears of price erosion. (In fact, Sprouts isn’t backing down from larger peers, jumping into Florida recently and challenging giant Publix.) Thus, the near-term trends are encouraging, yet big investors have been buying (Fidelity and T. Rowe Price own a combined 26.5 million shares, or 17% of the company) because of the big-picture possibilities—Sprouts is aiming for 14% annual store growth for many years, boosting its store count to 1,200 eventually from 217 today. (The long-term target is for about 16% annual earnings growth during its expansion.) Management thinks this is possible as half its customers are coming from traditional grocery stores, and new stores have historically returned 35% within three or four years. It’s not changing the world, but Sprouts has a proven concept that’s gaining traction, and has a huge amount of expansion potential. We like it.”
The stock is acting well, and while it’s not the kind of issue that’s going to light up the sky, I think more and more institutional investors will be adding to their position as the story unfolds. Buying on dips with a loss limit in the 25 to 26 area is one way to go.
Chief Analyst of Cabot Growth Investor
and Cabot Top Ten Trader