Why the #1 Rule is the #1 Rule
But You Still Have to Take Some Heat
In a Bull Market, Look for Bull Market Stocks
With the market having hit a pothole last Wednesday and Thursday, it’s a good time to review what I consider the #1 rule for growth stock investors–cutting losses short. Interestingly, I remember a conversation I had back in 2003 with Carlton Lutts, our founder and a great investor, asking him what he thought was the most important “rule or tool” (as we call it in-house) and he said it was letting winners run. That was classic Carlton; without some big winners you’re never going to make any big money in the market, which I totally agree with. But I still think that protecting capital is the first step, at least for the vast majority of investors.
No matter what rule you’re talking about, though, most investors only learn to follow it after being burned a few times. I can’t tell you how many emails I’ve gotten from subscribers that say something like “Man, it took me a few years to really appreciate it, but after riding a bunch of stocks down 50% or 60%, I’ve finally learned to let stuff go quickly when it’s not working out.” As an advisor, that warms my heart because cutting losses is really the quickest and easiest thing you can do to improve your results. I’ve seen it dozens of times.
However, in this Wealth Advisory, I wanted to explain why cutting losses is so vital … but also why taking the idea to an extreme can be counterproductive. And, of course, I’ll also tie in some dos and don’ts when it comes to setting your loss limit.
But first, let’s start with why cutting losses is important. It all revolves around the Loss Curve, which displays just how unfair investing really is:
The bottom row refers to the size of the loss, while the left hand values refer to the amount needed to gain to get back to break-even.
Simply put, the more you lose—whether it’s a single trade or the value of your overall portfolio—the harder it is to get back to break-even, never mind set new highs. A 10% loss isn’t hard to recover from, relatively speaking; if your $10,000 turns into $9,000 (a 10% drop), you have to make 11.1% on that remaining money to get back to even.
Yet as the losses steepen, so does the recovery necessary to get your money back. A 20% drop means you have to make 25% on what’s left to get back to even; if you hold onto a 25% loser, it’s going to take 33% to return to where you were; a 33% drop requires a 50% gain; and a 50% loss means you have to double your money … again, just to get back to where you started. And from there, the numbers only get more daunting!
Now, if you’re a value investor who owns 25, 30 or 35 stocks, maybe the occasional big loss isn’t a big deal. But if you run a concentrated portfolio like I do (generally between 8 and 12 stocks when fully invested), a couple of 40% or 50% losers can be devastating, not just to your overall account value but possibly more damaging—to your psyche.
My experience is that investors who don’t routinely watch their risk and cut losses short spend a lot of time and energy simply trying to get back to some previous high-water mark in their portfolio. The classic example was 2008, which caused such major losses that most investors are still no wealthier than they were back in 2007; more than five years later many are just wishing to get back to that prior peak. But even in lesser downturns, too many investors let their portfolio fade by 15%, 20% or more, usually because they hold on to some stinkers, failing to get out when they should.
Of course, there are other reasons investors struggle (including poor stock selection, which I wrote about in my last Wealth Advisory), but I think the unwillingness to admit they’re wrong and take small losses is the #1 reason many investors put up poor returns. And that’s why cutting losses short is my #1 rule for growth stock investing.
Now, I’ve been writing about the value of cutting losses since I started at Cabot in June 1999, and thankfully many of you have listened, adjusted and benefited. But soon after somebody converts to making sure no loss gets out of control, I often get an email like this:
“OK Mike, I hear you loud and clear about cutting losses; in fact, I haven’t taken a loss of more than 10% during the past few months. Yet my overall portfolio has done nothing but head south during that time–it seems like all my trades end up in losses, even though I own some good stocks. Help!”
I often go back and forth for a bit and maybe chat on the phone to get a better idea of what he’s doing wrong. And eight times out of 10, the answer is that, instead of being numb to losses like they were before, they’ve become hypersensitive to them!
The classic example is the investor who does some research, likes a story and chart, and goes ahead and takes the plunge. Then, two days later, some analyst downgrades the stock or the market has a nasty selloff, and the stock falls a few points and he bails out; the stock didn’t hit his loss limit, but he gets nervous and sells.
Another pitfall is what I call the square-peg-round-hole problem when it comes to loss limits. Some investors will buy Home Depot, a relatively steady stock, and use a 10% loss limit. But then they’ll buy Netflix and use the same 10% loss limit … even though the latter stock is two or three times as volatile as Home Depot! The result is that many investors will get knocked out on what is effectively “noise”—the stock didn’t really do anything abnormal, but it forced the buyer out.
Both of these problems boil down to one fact: In the stock market, you have to be willing to take some heat. Nobody is going to be able to buy stocks that simply go up, up, up as soon as they take a position. Sure, you’ll occasionally catch a tiger by the tail, but as any trend-following investor during the past two years can tell you, there will be plenty of times a stock bobs-and-weaves for two or three weeks before getting moving.
Right about now, you might be completely confused; in the first section I told you that cutting losses is rule #1, but right now, I’m telling you sometimes people get into trouble by cutting losses too tightly. But the solution isn’t convoluted; the idea is to plan where your loss limit will be BEFORE you make the trade (and, secondarily, how you’re going to trail a mental stop) … but then be comfortable losing that amount if necessary, unless something clearly changes (market timing turns negative, etc.).
Many investors tell themselves they’re comfortable losing 10% or 12% or whatever the number is, but then once the stock falls 5% they’re panicking and want out. It’s kind of like the casual casino player who brings a wad of $700 to gamble with, but as soon as he’s down $250 after a bad run at craps, he heads to the bar … often just before the table turns hot. I can tell you that’s a big no-no, as you’ll end up owning a bunch of winners but will actually lose money on the trades because you forced yourself out too early.
Honestly, I could write for hours about things like stop placements, portfolio management and the like; in fact, I’m thinking one of my main presentations at the Cabot Investors Conference this August (email me for details) will be about those topics. For now, though, suffice to say that it’s vital to cut ALL losses short if you’re running a concentrated portfolio … but to also give stocks room to breathe for a few weeks as long as they don’t trip your pre-determined loss limit.
After a heady advance from mid-November lows, and a straight-up advance since January 1, the market and some stocks finally showed some heavy selling pressure last week. In the intermediate-term, there’s not enough evidence for me to conclude the uptrend is over; most stocks, sectors and major indexes are still above their 50-day moving averages, which themselves are advancing at a good clip.
That said, the prior advance was long enough, and the selling pressure last week was heavy enough, and the damage done was noticeable enough (housing stocks and many commodity-related names broke down), that it would be surprising if the pullback was completely over. In other words, I expect more weakness going forward.
Thus, while I’m not taking major defensive steps, I am advising people to pare back on their losers and laggards and raising a little cash (this assumes you’ve been heavily invested for a few weeks like we’ve been in Cabot Market Letter). But I’m trying to hold onto my top performers, because if the market does find its footing in the days ahead, the best names will likely add to their gains.
What about new buying? I’m not opposed to it, but I advise you to pick your spots in the near-term; I’d be thrilled to see the market move straight up from here, but the odds are against it, at least in the short-term.
Thus, today I want to present you with a bigger, well-sponsored stock that I think still has great upside if the market keeps going. It’s BlackRock (BLK), the huge money manager (and owner of the iShares franchise); interestingly, many “bull market stocks” have, at least so far, shrugged off the market’s gyrations, which is a positive sign.
Here’s what I wrote about BlackRock back in mid-January, when I named it my Editor’s Choice for the week in Cabot Top Ten Trader:
“As the general market has heated up, I’ve noticed more and more “Bull Market stocks”—brokerage, investment bank and asset management firms, each of which directly benefit from higher stock prices and increased trading activity—pushing to new highs. BlackRock might be the granddaddy of the group; the company has an almost unbelievable $3.8 trillion of assets under management! Obviously, that’s not all mom-and-pop investors, but big institutional pension and hedge funds, as well as some very wealthy individuals. One big driver is the firm’s iShares business, which was acquired in 2009 and has been a big hit; BlackRock’s top brass alluded to a secular shift into ETFs and more passive investments, which plays right into iShares’ hands. Best of all, management is committed to returning cash to shareholders—it just hiked the dividend 12%, resulting in an annual yield just south of 3%, and continues to buy back shares quarter after quarter; the company repurchased about 5% of its shares last year, and has authority to buy another 5% going forward. With sales growth picking up, earnings growth accelerating and the potential for better-than-expected earnings in 2013 if the market continues its winning ways, I think BlackRock has solid upside.”
Earnings are expected to rise 13% this year, though I think that’s likely conservative, especially if the market’s bull trend continues. BLK isn’t going to make you rich, but I also think it can surprise on the upside if the market behaves itself.
As for the stock, it hasn’t gone much of anywhere during the past month. To me, that lack of spunk is offset by BLK’s resilience of late; it’s still perched right near its peak. If you really want in you could buy some here, but ideally, the market will have another shake in the days ahead, possibly dragging this stock toward support in the 230-235 area—that would be a solid buy, and you could use a tight stop around 215 if you get in.
Until next time,
Editor of Cabot Top Ten Trader
and Cabot Market Letter
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