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Stock Ideas Investors Daily Edge Working the Plan - What to Do with a Losing Stock
Stock Ideas Investors Daily Edge Working the Plan - What to Do with a Losing Stock 
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By Chris Johnson Did the market get what it wanted on Tuesday? The FOMC dropped interest rates by 50 basis points, doubling most expectations. So will the double-down move by the FOMC spark a solid longer-term rally or will the market wake up with a hangover in a few days after the FOMC party? |
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| Working the Plan - What to Do with a Losing Stock |
| Wednesday, 12 March 2008 | ||||||||
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Maybe we could start a club, but it wouldn’t be very exclusive. It seems everybody belongs to the cadre of people who made dumb stock decisions at least once. After writing about my reactions to my bothersome loser stock that I bought on a tip without investigating for myself, lots of readers sent comments. Let’s just say I have company. The interesting thing was that most of them ran on the same theme - remember your discipline. Here’s what Linda M. had to say on the subject: You've just saved me from doing the same things you did! Thanks for reminding me of all the reasons why I bought into my funds in the first place. I will hang on to them and not panic. They all have great holdings and are rated 4 and 5 star by Morningstar, even though I've lost over 10% now. It's not the funds, it's the economy and emotional selling and panic that's affecting them. I don't own individual stocks because I don't know how to purchase them. I also feel safer owning funds. I'm applying what you wrote about to funds, because I believe your words apply to funds as well as stocks. Yes, you’re right, Linda, provided you do have excellent funds. Unlike Linda, I don’t feel safe at all in mutual funds. I hate that they reveal positions only once a quarter and those may be stocks they added the day before preparing their reports, not the losers they held the previous 12 weeks. I hate the excessive trading in most of them, the selection by committee, and me-too backwardness of most funds. And who knows what the going growth rate, return on equity, price to sales, etc. is for the basket of stocks in a fund. It’s too much of a dark hole for my comfort. But if you do not know how to pick stocks yourself and aren’t confident that you are on an upward learning curve and getting better at it, then top-quality funds are your answer. The point here is that Linda knows what she knows. More importantly, she knows what she doesn’t know. Her second point is well taken, too. When the economy is down and so is the stock market, it shouldn’t unnerve you too much to see your stocks dropping. A falling price doesn’t necessarily mean anybody is being smart. As long as you can follow the underlying fundamentals of the business, you can judge a company’s capacity to rebound and carry on when the economy improves. That’s another reason I prefer individual stocks instead of funds myself. With a fund, you have to trust the managers. At the extreme other end of the investment world, Curtis H. buys individual stocks and works his plan diligently. He has no mercy for losers: I take out the emotional aspect of trading. This has been a very difficult process. I do the research i.e. P/E , profits, momentum, and the yearly moving average of the stock. If the price of the stock is within 5% of its yearly average, more than likely it will hit up against the high and sell off. The key is to be the first in (buy low) and the first out (sell high) of a position. Trading is a very predatory environment … I set stop losses but I never set a price to get out when the stock is rising. Curtis has a plan. He sticks to it. But there’s one little bit of confusion here. Curtis is not an investor. Trading and investing are fraternal twins. They look a lot alike, but they have genetic differences. Curtis is a trader. He’s clear on that point. Trading is a good thing for those who do it successfully. It’s a lot of work and takes constant attention and good knowledge of technical signals. But trading is quite different from long-term value investing or even long-term growth investing. The timeline matters. An investor might do exactly the opposite of Curtis, as befits his style. When Curtis is rightly selling out as a trader with short-term criteria, an investor might even buy more of stocks that are down on their luck if their research shows them a good prospect for long-term performance. Everybody knows Warren Buffett, so I will use him as an example. You don’t see him drop core positions because the stock dropped, yet his long-term record is incredible. His short-term record, however, often reeks. Even on his shorter-term positions (which last two or three years), he exhibits the “strong-hands” style of the investor. He will hang on through a drop that would upset most people. The length of your outlook makes a big difference, as I can show you with a real example. I remember several years ago, I recommended Office Depot in Fleet Street Letter. It promptly fell about 47 percent, right out of the gate. How embarrassing. But all the reasons for buying were still active, so I stuck with it, nervous, but determined to stay on system. A few months later, news broke that Warren Buffett had secretly bought the stock at about the same time. Office Depot bounced up on the news of Buffett’s stake, and the company also did what it should. The stock recovered all its loss and added 100 percent in the next year. In six years, it was up 500 percent. This only worked out because of the long-term horizon for investors. For a trader, sticking around to take a full 47-percent loss would have been suicide. The trader would have been out quickly with a much smaller loss on such an adverse move and gone on to better trades. So, discipline involves not just using your system, but having one that is correct for your goals. Curtis is a trader. Momentum and average price fit what he’s doing. They are not great fits for the investor who should be following the underlying fundamentals of the business. A third variation from Rob R. bridges the investor-trader divide. Rob acts like an investor and hangs in there for the long run … to a point. But he uses a trader-style tool to make it easier: I think we all know that empty feeling watching our stocks slide into losing positions. Having been down there one to many times and needing to preserve capital I almost always buy puts to cover my positions. The hard part is making the decision and waiting can be costly. I don't believe it’s too late to start hedging. There’s a nice compromise in this approach. You can watch the market do its thing knowing you have puts in place to protect you. The put option will give you the right to sell the stock at whatever price you chose when you selected which put to buy. If the stock falls and rebounds, fine. The stock’s a winner. If it falls too much, that’s also fine, because you can exercise the option to sell your shares at the chosen strike price.
Using puts like this makes sense for investors with large positions or, as Rob notes, to preserve capital. A good case for that would be a block of stocks that you plan to cash out in a year or two but want to keep following as close to the planned selling time as possible. Because the market can always act like it is now, it would be too risky to stay in stocks if you are going to need all the money. Normally, you would switch money you’d need to tap soon into something less volatile than stocks to be sure it was there when you wanted it. But with a protective put, you can ride the stock knowing you can get out at a good price no matter what the market does. My system? I’m long-term and value oriented. I follow the business and ride through the bumps. Three things make this possible. One, you have to do your research before buying and keep up with it periodically to make sure the business is on track. Two, you must have a truly long investment horizon, five years or more. You don’t need to stay in any stock that long if it turns out to be a bad idea, but you should choose stocks that you expect to go the distance. And three, you need a nice-sized portfolio so that one bummer doesn’t kill you. By the way, Andy is helping me set up a blog page for more frequent observations, and I hope I can do mine as nicely as he’s doing his. I’ll give you a heads up when it’s ready next week or the week after. In the meantime, check out Andy’s blog at vergeasia.blogspot.com. It’s free and unencumbered. You won’t have to take any surveys, give your mother’s maiden name, or any other bothersome things. Just read and enjoy. Most of it is centered on Asia investing, and you’ll find some good tidbits there along with insights that aren’t going to show up in the mainstream. Respectfully, Lynn Carpenter P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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