Helpful Investing Maxims

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

But for a growth stock investor with a sense of history like me, 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 printed with wise sayings!

My only beef with these maxims is that you can only hear “cut your losses short” so many times before your eyes glaze over.

So what I want to do today is to add some “how” to the “why” and the “what” of those basic maxims; instead of just reciting the basic advice for growth investors, I’ll give you some idea 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:

Cut Losses Short.

The simplest way to cut losses is to make sure no stock ever shows you a loss of more a certain amount; we’ve used the 20% maximum threshold in Cabot Market Letter for decades (although that is the absolute cut-off; our average loss is 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 way is to work backwards, so to speak. That is, figure on risking the same dollar 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, a low-volatility, high-quality stock like 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 dollar amount.

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.

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.

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, honestly, my experience is that the method you use to hold onto 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 stock 20% on the downside” but it’s another to sit tight when the stock has fallen “only” 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 the stock will shake you out at some point.

Because of all this, I’m generally a fan of booking 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 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, in which you buy 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.

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 heading up. The exact formula isn’t as important as planning what you want to do and how large you want each position to get, and then following that plan.

Let the Market Pull you into a Heavily Invested Position.

We’ve found that your own profit and loss can be your best indicator of how bullish you should be. 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, because your P&L will be 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 respond to this email.

The current market environment remains choppy and challenging; there’s a slight upward tilt to the major indexes and the majority of leading stocks, but only barely. In fact, one pattern I’m seeing over and over on charts of individual stocks is a one-, two- or three-week surge sometime during the past four months (usually because of a big earnings gap), followed by a month or two of choppy-to-down action … before the stock finds support and starts higher again.

The bottom line is that profits can be had, but it takes time, good stock selection and the ability to sit through very tedious pullbacks and choppy phases. Because of that, I am giving my current holdings room to maneuver, but I’m also holding a good-sized cash position and waiting patiently for lower-risk entry points.

That said, there are pockets of strength out there, and one that has just come to life in a very big way is Chinese stocks-after 18 months of up-and-down action, the sector has surged! There are no sure things, especially in this environment, but it looks like a kick-off to me.

There are a bunch of Chinese stocks acting well, and one that’s recently showed up in Cabot Top Ten Trader is Ctrip.com (CTRP), the leading online travel agency in that country. Here’s what we wrote about it in Cabot Top Ten Trader on March 30:

“Ctrip.com is a Chinese online travel agency that began as a simple consolidator of hotel accommodations, but has expanded to offer guided tours and travel management services for corporate clients. With 10 previous appearances, Ctrip.com is no stranger to Top Ten, but the company has fallen out of favor with investors, both as a Chinese stock and as a company whose earnings trends have been down for three quarters. There’s no doubt that Ctrip.com is the leader among Chinese travel companies. Building on its dominant position among Chinese hotel consolidators, the company has steadily diversified into airline ticketing services, packaged tours and corporate travel arrangements. Services now also include visa processing, car rental, Internet advertising, travel insurance, online check in and seat selection. The company’s March 19 Q4 earnings report reignited investor interest: while the company’s earnings dipped to an 11-cent loss for the quarter, it was still ahead of analysts’ estimates. The real grabber was management’s guidance for Q1, which forecast revenue gains of between 40% and 50%, the best results since 2010. The good news from Ctrip.com is reinforced by similar upbeat news from competitors. This is a nice turnaround story with the power of China behind it.”

The stock had been dead money for about 18 months, but then exploded higher on earnings three weeks ago and, after a brief, tight pause, has pushed higher. Yes, it’s extended here, and is likely to pull back some, but I think you could consider a small position in the 58 to 62 range, with the idea of slowly building the position should CTRP’s new uptrend continue.

To receive more updates on CTRP and additional momentum stocks, take a trial subscription to Cabot Top Ten Trader. The advisory features a wide array of stocks and sectors you can benefit from in as little as 30 days. Our most recent issue features a diverse mix of strong stocks, including a leading auto stock, that has the opportunity to bring you double-digit returns in the weeks to come.

Sincerely,

Michael Cintolo
Chief Analyst of Cabot Market Letter and Cabot Top Ten Trader

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