I’ve owned a stock for a while, and it was just bought out and soared on the news. I’ve never owned a stock that got bought out—should I sell it? Sell some? Hold through the merger?
Mike Cintolo: My general answer for all buyouts is similar: We never look a gift horse in the mouth, so we generally sell on any buyout news. We have seen a few instances where a bidding war erupts with some of these firms; thus, if you want to hold for a week or two to see if some over-the-top bid comes in, that’s fine. What I don’t like is just holding the stock forever—sometimes these deals can fall through (in which case the stock plunges).
What about buyout rumors, where a stock rallies on rumors that it might be bought out? I usually ignore them, unless the ensuing rally trips some sort of sell rule (say, if the stock’s been running for months and then explodes higher, maybe I’ll sell some). But if you buy or sell based on rumors in the market, you’ll be making 25 trades every day. Stick with the facts.
Is it worth holding through earnings?
Mike Cintolo: We take the long view when it comes to earnings reports—we’ve always held our shares through reports, figuring that, over a few years, we’ll have more wins than losses. Plus, if you sell ahead of earnings every time, you’ll never hold a stock for more than a couple of months … and that makes it hard to notch a big winner.
However, my main conviction when it comes to earnings is that you should be consistent, and to live with your decision—if you want to hold through earnings, then do that with all your stocks, and then live with that decision. Don’t hold onto the first two stocks, then sell the next two, then hold the next, etc. The odds are you’ll end up selling the ones that gap up, and holding the ones that gap down!
You can also consider applying some prudent portfolio management rules ahead of earnings. For instance, you might decide to sell one-third of your holdings ahead of earnings if you don’t have a profit of, say, 10% or more. But, again, if you do this, be consistent and follow your rules.
Long story short, it’s no secret that earnings season is something of a crapshoot short-term, but you can survive and even thrive if you follow a well thought-out plan.
I know you guys stick with what the market is doing, but don’t you have to factor in the Iraq/Gaza/Ukraine/China/Federal Reserve actions into your thinking? Can’t any one of these things cause the market to drop precipitously if something goes wrong?
Mike Cintolo: In the short-term, yes, any “shock” event can take the market down. But major tops almost always take time to build, and the reason is simple—big institutional investors take time to distribute their “overvalued” stocks. And, just as important, it takes time for psychology to change enough to move from bull to bear.
Market-wise, nearly every top through history has shown common characteristics like divergences, expansion in the number of stocks hitting new lows (often while the indexes are near their bull market peaks) and some major breakdowns among a few key institutional-quality leading stocks. That’s what our indicators are generally focused on.
If you’re a short-term trader, sure, any news event can hurt you, and maybe you have to factor that into your thinking. But, usually, it’s the thing that few people are watching or paying attention to that affects the market—the major hotspots of the world are well covered and often already discounted by stocks. That’s why we prefer to simply follow the market itself.
How does Cabot pick growth stocks?
Mike Cintolo: Cabot’s growth stock selection system starts by focusing on stocks that are strong, going up faster than the general market. These stocks are said to have positive momentum. But we need to see more than that. Behind each stock, we want to see a great growth company. In most cases we require a company to be demonstrating strong growth of both sales and earnings. And we want to find a story that convinces us this great earnings growth is likely to continue in the years ahead. How does Cabot determine that a stock is strong? We look for stocks with strong relative performance (RP), sometimes called relative strength. These are stocks performing better than the general market over the long-term.
What are the characteristics of a great growth company?
Mike Cintolo: In short, we want to see a company that appears capable of multiplying its earnings rapidly. Characteristics we like to see include a revolutionary product or service, mass markets, high barriers to competition, excellent and innovative management, high profit margins, triple-digit revenue growth, and accelerating earnings growth.
How do I know when to sell?
Mike Cintolo: No one picks winners all the time. Sometimes your stocks will go down right after you buy them. If they do, you should get out of them, keeping your losses small. On the other hand, you should hold your winners as long as they are doing well, cultivating them with the hope of holding on for the huge profits that can develop over several years time. The key to success is letting the profits in your winners get larger while keeping your losses small. The most important rule in growth investing, and the hardest to learn is, “Cut your losses short.” That means if your loss exceeds 15% or 20% at the end of any trading day, you sell. Period. On the other hand, you will have many winners, and knowing when to sell them is more difficult. In general, though, we believe it is wise to sell when a stock has underperformed the market for eight weeks or more. The stock’s RP (relative performance) line is a good indicator of this.
Isn’t it risky to buy stocks hitting new highs?
Mike Cintolo: For growth investors, no. Remember, a trend, once established, tends to persist longer than expected. So if you’re convinced a stock’s trend is up and you’re convinced the business is capable of great earnings growth in the years ahead, you should buy. Because the most likely trend is up! At the root of this, you will generally find a shifting change in the public’s perception of the company. We call it sponsorship. As more and more people come to develop improved opinions of the company, it’s natural they will buy more of the stock and drive it to higher prices.
Why are earnings so important?
Mike Cintolo: Companies are in business to make money. Thus, earnings are the ultimate score card. Companies that can grow their earnings rapidly and do it repeatedly see their stock prices rise to reflect their success. Conversely, companies that stumble on their growth path see the price of their stock fall. Investors are always looking ahead to what they believe the company’s earnings will be in the future. Thus investors’ perceptions of the company’s prospects can be as important as the reality in the short term. But in the long run, earnings and earnings per share are most important.
What is a price/earnings ratio?
Mike Cintolo: If you divide a company’s stock price by its earnings per share, you’ll come up with a price/earnings ratio, or PE. This simple number reflects how well-thought-of the stock is by investors. A single-digit PE is considered to be low, while a number over 20 is considered to be high. If stocks were commodities, like bananas, a low price/earnings ratio would represent a bargain, a good value. But stocks are not commodities. A high PE simply confirms that investors believe a company will experience fast earnings growth in the future.
What is investing on margin?
Mike Cintolo: Someday your broker may ask if you’d like to invest on margin. In effect the broker is offering to lend you money so that you can invest it and profit from it. The broker is a guaranteed winner, because you pay him interest on the money you borrow and he gets the commissions when you trade with that money. But your profits will be harder to come by. You’ve got to pay that interest and those commissions … and your risk is increased. If you’re doubled up on margin, for example, a simple stock drop of 10% will hand you a loss of 20%! And a 20% drop will give you a 40% loss plus a headache. In general, we don’t recommend investing on margin.
What is market timing?
Mike Cintolo: We are strong believers in long-term market timing, mainly so we can sell stocks and preserve cash when the broad market enters into a major decline. This is not an exact science, but it can be tremendously rewarding to avoid losing money. And we’ve had great success with market timing over the years, so we feel confident in recommending that all investors practice it. On average, Cabot Growth Investor gives two major market timing signals per year. If it’s a sell signal, we work to reduce risk by selling our poorest performing stocks and putting close limits on the others. The object is to reduce the risk of loss and to raise cash for the next buy signal, when bargains abound. When that buy signal comes, we invest aggressively in the best-performing stocks we can find. Interestingly, that’s the time most investors are scared to death.
Isn’t it risky to invest when public sentiment is negative?
Mike Cintolo: To the contrary, that’s the best time of all! The public, in general, tends to react to what has already happened and assumes that the past will continue. Investors have no way of seeing the end of a trend until it’s well behind them. But we know that all trends end when the last holdout joins the crowd … when the last buyer buys or the last seller sells. The trend ends when sentiment reaches an extreme level. Then, because all the fuel for that trend is exhausted, the trend reverses. In general, the better you are at gauging the mood of the crowd, the more confident you will feel about buying when all about you have sold in panic … and moving to the sidelines when most other investors are buying feverishly.
Many of your stocks have already rallied before you recommend them. Why don’t you bring them to our attention a few months earlier, at lower prices?
Mike Cintolo: We don’t recommend stocks earlier because guessing which stocks will successfully rally off their lows is a low-odds play—for every stock that comes back nicely, many more just sit there, or actually decline. We watch stocks for confirmation of strong accumulation before we recommend them, so you see the stocks that offer the best potential. Waiting for the wheat to separate from the chaff allows us to pinpoint leading stocks and avoid the thousands of laggards and mediocre performers in the market.
Do you recommend shorting to profit when the market declines?
Mike Cintolo: Our main message is that there’s nothing wrong with the short side, but it’s important to understand how a downtrend normally acts, especially in relation to an uptrend.The key principle is that stocks slide much faster than they glide; whereas market uptrends tend to persist for weeks, with shares hitting higher highs every few days, downturns do most of their damage in a short period of time, generally followed by lots of choppiness and some vicious short-covering rallies. Thus, you have to adjust your thinking when dealing with the short side.
First, for shorting, it’s usually better to focus on exchange-traded funds (ETFs) instead of individual stocks. ETFs carry much less risk, but can still bring you decent profits if your timing is correct. We suggest sticking with well-traded ETFs that move inversely to a major market index, such as the ProShares inverse funds that track the S&P 500 (SDS), Nasdaq 100 (QID) or Russell 2000 (TWM).
Second, how you handle your positions is different. When buying growth stocks, you want to buy a real leader properly and then sit tight. But when shorting, it’s almost always best to take profits when you have them. Again, it comes down to the fact that most of the damage is done in a short period of time, so getting out while the getting is good is important.
Lastly, it’s best to go short only after a substantial rally in the market, usually into some well-defined resistance area. That doesn’t mean that a downtrodden market can’t continue to slide without bouncing, but eventually, there will be a huge, quick rally (possibly with lots of gaps higher overnight, when shorts are unable to cover) that can cause some big losses. In other words, when shorting, you have to be selective and pick your spots carefully.
Most of all, though, short selling shouldn’t be viewed as a way toward huge profits, but rather, a method of potentially making back some of the money lost during the initial stages of the downturn. The big money is made on the long side, not the short side.