Be Willing to Take Some Heat
Know Your System
Playing the Housing Rebound
I wanted to focus my Wealth Advisory today on a recent email I received from a subscriber, with whom I correspond once every week or two:
I have a habit of placing a protective stop just on top of my entry price once I have a small gain in a position (sometimes only 2% or 3 %; even less if I am very nervous about a situation). That way I will not lose any money if the price moves below what I paid, including commission. Of course, I can get easily stopped out, losing my position.
I seem to need this protection, psychologically. But it probably costs me more money than getting underwater would, in the long run.
Is this a habit I should force myself to abandon?
My answer was basically yes–that is, she should force herself to abandon this type of super-tight stop placement, which is really a form of risk-aversion. Here’s why:
Placing a stop is as much an art as a science. It’s not just there to keep losses small; it’s also there as a feedback mechanism–if a stop is touched, it should mean the stock has shown some type of abnormal weakness. Conversely, if the stop has not been touched, it means the stock is acting “normally” … which means it should be held. Sounds simple, but few investors look at stops this way.
When this subscriber tightens up a stop as soon as she has a profit, she’s going to get stopped out on normal noise–i.e., random movements from the stock or the market as a whole. That, obviously, is something you want to avoid.
I write a lot about risk control, from using stops to position sizing and the like. But maybe I don’t write enough about the need to take enough risk to make your investing worthwhile. Many of us would prefer to crank out consistent, week-to-week gains in the market, place tight stops, take little risk and live happily ever after.
But the market doesn’t work that way. And the point here is that, whether we’re talking about placing stops or some other investment tactic, the goal is to fit the strategy to what actually works … not what we would like to work. And the fact is that placing a 2% stop is not going to maximize your profits. You want to be loose enough to allow for normal ups and downs, but tight enough to limit losses and kick you out of laggards.
Said another way, in the stock market, you have to be willing to take some heat. If you’re not, you’re going to find yourself constantly knocked out of future winners (some of them big winners) simply because you’re unwilling to see a stock go against you for a bit.
If you do find yourself ultra risk-averse, my suggestion is to take smaller positions relative to your overall portfolio, so the swings in the stock don’t have as big an effect. Even so, it’s best to learn to become comfortable with some level of risk–otherwise it will be difficult to make much money.
Above, I wrote that my answer was basically yes when it comes to the question of whether the subscriber’s stops were too tight. Why did I say “basically?” Because, at the end of the day, there really aren’t many bad systems in the market–many of them will produce solid gains. The key is having a system that fits your personality, and what you can handle.
Using the above example, there isn’t anything technically wrong with what this subscriber is doing. If you want to avoid as many losing trades as possible, one way is to set a stop at breakeven as soon as the trade moves in your favor.
The upside is that your portfolio’s drawdowns will be negligible; think of it as a basketball team that makes its opponent shoot five times to hit just one basket. That’s the good news. The bad news is what we’ve already talked about–you might literally go through 10, 15, even 20 trades before finding and being able to hold on to a meaningful winner.
Mathematically, such a system could work. For instance, out of 15 trades, let’s assume seven are sold for breakeven (they rise for a day or two, you raise your stop to breakeven, and then get stopped out), seven of them are sold for very tiny losses (let’s call it 3% each) and one stock actually goes straight up from the buy point and is eventually sold for a 50% gain.
If you assume $10,000 invested per stock, that means $2100 was lost on the 10 losers, while $5000 was earned on your one winner (and, of course, broke even on the rest of the trades). Thus, the bottom line was a profit of $2900.
That sounds fine … and, theoretically, it is. But in the real world, I don’t know of any investors that could live through repeated streaks of just one winner out of every 15 trades! Your mind would be seriously messed with after six, seven or eight straight scratch or losing trades, especially if the market was acting well during that time.
My point isn’t to overanalyze this one subscriber’s system, but to make the point that there is any number of ways to pull money from the market. The question is: can you stick with the system through its inevitable down times?
Every system has these underperforming periods and, in my experience, most investors lose faith after a couple of sub-par months, and start looking for the next great system. Unfortunately, there is no Holy Grail in the market, so any new system these investors switch to will also run into a dry spell sooner or later.
Thus, while every good growth-investing system possesses some similar characteristics (buy good companies, keep losses small, let some winners run, don’t put all your eggs in one basket, etc.), the real goal is to find a system that fits with your own investing style, so that you’ll be able to stick with it through thick and thin.
Early on in a market advance, the true leaders usually act a certain way. They go up! But it’s more than just that; these potential big leaders often break out of basing structures within a couple of weeks of the market turn … and then keep rising day after day, week after week, as buyers overwhelm the sellers.
It’s this blast-off-type of action that, when combined with a great fundamental story and great sales and earnings growth, can clue you in to a big winner in the making.
One stock that fills the bill, but is outside the traditional growth realm, is Eagle Materials (EXP), a leading producer of housing and construction materials. If you’ve been reading me for a while, you know I am pretty bullish on the housing sector; no, I don’t think there will be a repeat of the bubble, but after a historic bust, the industry looks to have finally turned the corner.
Eagle Materials is participating in the move, and here’s what I wrote about the stock in Cabot Top Ten Trader back on January 16:
“Eagle Materials is another housing-related stock that is showing definitive signs of a turnaround. The story, of course, is anything but sexy–it’s a major producer and distributor of cement, concrete and aggregates, gypsum wallboard and recycled paperboard for use in both residential and commercial construction; Eagle is the fifth largest wallboard maker and 12th largest cement manufacturer. Not surprisingly, business peaked back in 2007 (when the company raked in more than $4 in earnings per share) and has been sliding steadily since … though it’s important to note Eagle has remained profitable even during the housing bust, a sign of sound management. And now, with data pointing to a turnaround in the housing sector, including a pickup in new housing starts and permits, investors are looking ahead to what could be a quick rebound. Analysts see this year’s earnings gaining 121% to 84 cents per share, but we think that could be very conservative as most of the costs have been cut out of the system, allowing for any rebound in business to fall right to the bottom line. Quarterly results are likely out in early February.”
Earnings did indeed come out the first week of February, and they were terrific–revenues were up 19%, cash flow was up a huge 45% and earnings per share of 20 cents were up 67% from the prior year. The stock leapt on the news, and now trades in the low 30s. Impressively, it has refused to give back any of its gains since it got going in late-December.
Encouragingly, the average analyst estimate for fiscal 2013 (which actually starts this April) is now $1.23, up from an estimate of 86 cents before the quarterly report. Frankly, I think even this could prove conservative if the housing market indeed comes back.
Pullbacks are possible, but I think EXP is a solid play on the rebounding housing sector. A small buy here is possible, though ideally the stock will retreat to 31 or so, offering a better entry point.
All the best,
Mike Cintolo is the editor of Cabot Top Ten Trader and Cabot Market Letter, our flagship publication. Combining top stock picking, market timing and portfolio management, Mike has bested the S&P 500 by about 5% annually during the past five years–a period that encompassed bull, bear and choppy markets. With a solid bull market, now is a great time to get in Mike’s program so you can take advantage of the leaders as they lift off. Click here to learn more.