MARKET RULES: SELL LOSERS and LET WINNERS RUN

Searching the Universe for Solid Investment Theories

In the late 1800s, Daniel Drew proposed that investors 'Cut your losses and let your profits run.' This forever after became one of the most commonly quoted theories for investors. Most consider it a sound concept; in fact, it is one of the most important understandings an investor can have about the stock market. But one obvious question leaps from this theory-- exactly what is a 'winner' and what is a 'loser'?

Is any stock that drops in price a loser? A price drop certainly costs an investor money-- at least on paper. But selling every stock when its price falls a bit will be irrational and expensive, so another definition of 'loser' is required for this theory. A good place to start is to determine if the price fall is a result of an overall market decline (a bear market), or due to specific concerns about the particular industry or company.

Most investors look for the following telltale signs of concern to determine if a particular stock might become a 'loser':

• Declining sales quarter-to-quarter and year-to-year
• Rising debt levels
• Declining profit margins
• Rising inventory levels
• Changes in regulatory or legal environment
• Emerging competitiors or technologies
• Rising interest rates
• An emerging overall bear market
• Events that negatively impact future earnings
• Mergers and acquisitions
• Management changes
• Institutional or insider selling
• Dividend cut or elimination
• Concerns over accounting procedures

Value, in terms of growth potential, is based on earnings and earnings growth. Analysis of earnings and news about a company can give some insight into the quality of earnings. If earnings have been increased by management's firing half the staff or closing several factories, the quality of earnings increase is not as high as it would be if the earnings had risen due to improved sales on new products with higher margins. Slash-and-burn strategies or a new six-sigma type quality program can temporarily boost productivity, but they will run their course quickly and there can be no sustainable improvement without rising sales eventually.

Michael Sheimo recommends three situations that are exceptions to this sell-the-loser rule:

Exception #1: Daily Price Fluctuations
Stock prices fluctuate up and down in day-to-day trading. A glance at any dialy price chart will show what may be considered normal daily fluctuations for any individual stock. Stock prices also move from one trading range to another. For example, a stock price could have a daily fluctuation of $1.10 to $1.20, but it could occasionally move up to $1.30, then drop back to the $1.10 to $1.20 range again. When the stock moves up above the $1.30 for some time and establishes a new daily fluctuation range between $1.30 and $1.50, it is said by traders to have achieved a 'new trading range'. If a stock price falls for a few days, but is still within its 'normal trading range', it may not necessarily be an emerging 'loser', but simply experiencing fluctuations as every stock does for a million complex and unexplainable reasons each day.

Exception #2: Market Decline
A significant drop in the overall stock market can force the price of a winner to lower levels. All stocks can eventually look like losers or become losers. Most often these severe market corrections are a time for concern, but not for panic. As we have seen in recent years, the stock markets around the world can make sudden corrections of 5-20% or more in a few days or weeks, only to rebound just as suddenly and unexpectedly soon afterward. More often than not, stocks that were winners before the correction will again be the winners during the subsequent recovery-- and those who try to time their selling and repurchase of these stocks may very well be disappointed and left out of the next big sudden rally. For those who feel extremely confident in a particular business's prospects (and also very patient to see the company's value again reflected in the share price one day), a sudden overall bear market decline can present an excellent opportunity to accumulate more shares at discounted prices.

Exception #3: Price Advance Followed by a Weakness
A significant upward move to a new trading range, followed by some price weakness, is a fairly normal occurrence. As a stock price makes a major upward movement, many short-sighted investors will begin to take profits. Realizing a profit (and avoiding realizing a loss) is a normal, almost instinctive behavior by most market participants. However, the upward price movement by a 'winner' may have only just begun. Indeed, the most gratifying and financially rewarding stock market experience is watching a stock rise ten-fold (the Peter Lynch 'ten-bagger') in value over several years. Obviously, following your instinct to take small or even modest profits will preclude such celebrations.

Winners are the stocks of companies that demonstrate consistent growth in revenue, earnings, and share price year-to-year. They are often leaders in their industry and have continual new product developments or service innovations. Their products are not passing fads, but things desired by consumers willing to pay high dearly for, and hopefully replace often. They build brand names and create other sustainable competitive advantages. They are well managed and invest capital intelligently with consistently high returns on shareholders' equity. Of course, buying a 'winner' when everyone knows it is a winner, and this 'winner status' is fully priced into the stock is a recipe for turning a 'winning stock' into a 'losing investment'.

Winners should be held, as out theory indicates, until the fundamentals that make them winners begin to weaken or until the price runs too far ahead of the true value of the underlying business. This means that every investor will require a dependable set of quantitative and qualitative business assessment screens in order to measure these important fundamentals and valuation. This is exactly the value our WallStraits Intelli-Vest members enjoy, leveraging our 8-step business analysis process described in our recent book, Building The Perfect Portfolio, and demonstrated continuously since September 2000 in our WallStraits 8 real-dollar portfolio available to Intelli-Vest members only.

Sage@wallstraits.com
Credits: parts of this article are extracted from Michael D. Sheimo's Stock Market Rules, 1999.