Three Pillars of Investing Results
An Earnings Season Surprise
I wanted to start my Cabot Wealth Advisory today with a few pointers on how to handle a “good” problem that many investors are experiencing right now: What to do with a stock that, soon after your buy, has zoomed 20% or more in just two or three weeks.
Paradoxically, it’s these types of situations that cause the most stress and uncertainty. Profits are good to have, but if a stock goes vertical, you’re left wondering how to properly manage your good fortune. The prospect of making a decision–either sitting tight or selling–can cause investors to behave irrationally.
The solution, as usual, is to have a plan and follow it consistently over time. There are only three things you can do when you get a quick, big winner–hold it all, sell it all, or sell some and hold the rest. As I’ve written before, we prefer one of these methods to the others (the latter), but I’ll review the plusses and minuses of each below.
If you decide to hold all your shares, you should aim for a bigger gain over time … but also be prepared for painful corrections along the way. If your stock runs from 50 to 70 in just a couple of weeks, and you decide to hold your position, that’s fine … but don’t kick yourself if the stock then has a normal pullback to 58 or 60.
If you decide to sell all your shares up at 70, that’s fine, too–there’s nothing wrong with booking some profits, especially when you get a windfall gain in a short period of time. However, you shouldn’t get upset if the stock pulls back a few points only to rocket to 80 or 90 in the weeks or months to come.
I actually prefer the third option, which is selling some shares (somewhere between one-third and one-half of your position), but holding the rest. This approach not only allows you to book some profit–thereby rewarding yourself for being right–but also gives you leeway (because you took some off the table) to ride your remaining shares through the inevitable correction ahead.
The goal with this third option isn’t so much to grab the profit but to ride out what could be a major, longer-term move by lessening your risk, which decreases your chances of being kicked out on a sharp (but normal) correction.
If you’re interested in more information on how to handle winning stocks, check out this brief (about five minutes long) video in which I flesh out this topic and provide two examples–one recent (Youku.com (YOKU) and one historic (First Solar (FSLR) back in 2007. Click here to watch the video.
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Speaking of videos, I’ve actually been tempted lately (if I could only find some free time) to produce a concise educational presentation on the three pillars of investing results. I’m referring to your batting average, your slugging percentage and your turnover.
Your batting average is simply your winning percentage. If you made 10 trades, and six of them resulted in profits, your batting average would be 60% (or .600 for you baseball fans).
Your slugging percentage is your average gain on your winning trades, divided by your average loss on your losing trades. Using the above example, let’s say your six winning trades brought you a total of $6,000 in profits (or an average of $1,000 per winning trade), while your four losers lost you a total of $2,000 (or an average of $500 per losing trade). Your slugging figure would be 2.0–that is, $1,000 divided by $500.
The last pillar is the easiest to grasp–it’s simply the number of trades you make per month (or year, or whatever time period you choose).
Obviously, the higher any of these three pillars, the higher your returns. The more winners you have, the bigger your winners will be compared to your losers, and (assuming you’re a profitable investor) the higher the frequency of trades, the more money you’ll make.
The tricky part is that these levers often work against each other. Let me explain.
Let’s say you’re more of a swing trader, holding stocks for a few days to three weeks. Well, you better have a pretty good batting average; the key for your success will be consistently churning out gains, and doing so often. It’s unlikely you’ll have a two-to-one or three-to-one slugging percentage, because you’ll likely be booking both winners and losers quickly.
Conversely, if you’re more of an intermediate- to longer-term investor, your bread and butter will be your slugging percentage. You always hope to have a bunch of winners, but the key will be landing a few enormous winners, while cutting losses relatively short.
Finally, the last lever–your turnover rate–is really something that shouldn’t be played with. If you decide to, say, trade twice as much, I can tell you right now that your batting average and slugging percentage will slide because you’ll probably be forcing some bad trades.
The point here isn’t to reveal a “best” combination of the three (there is none!), but instead to start thinking in terms of these three metrics when evaluating your own results. While you don’t need a spreadsheet that’s exact to the decimal point, you should have a list of your results that you can peruse from time to time.
For instance, say you’re in the midst of a trading slump, so one weekend you start digging into your results. If you notice that your batting average is way down, it’s possible that either the market just isn’t as healthy as it appears, or (more likely) that your stock selection has gone to pot. If you’re slugging percentage is way down, it’s likely that you’ve been bailing out of some high-potential stocks too early … or letting your losses get out of hand.
Again, there are no magic answers in the market–if there were, we’d all be rich–but keeping these three pillars in mind is a creative and also more precise way to evaluate your own trading.
As for my stock idea, I’m going to go with VMware (VMW), a stock that, frankly, I had totally taken off my watch list many months ago. It was a good winner during much of the bull market, but after a mega-run, the stock basically topped out last fall (relative to the market) and has been consolidating ever since.
The story has always been solid–server virtualization, which is hugely cost-effective because it allows each server to be used for many different applications. It doesn’t hurt that this so-called “cloud computing” has become all the rage. But, while growth was good, it wasn’t anything extraordinary (never triple-digit growth or something like that), and eventually, the stock’s valuation got too big for its britches. Hence the long period of lagging action, even as the overall market ramped last fall and so far this year.
However, earnings season has a way of transforming the landscape for certain stocks, and for VMware, it appears to have done just that–sales rose 33%, earnings jumped 50% and the firm raised 2011 guidance significantly. Analysts are now looking for the bottom line to jump 30% this year, and knowing how VMware regularly beats expectations, that figure could prove conservative.
All those numbers are nice, but what caught my eye was the stock’s reaction–VMW surged 12% the day after its earnings report, and more importantly, volume that day totaled 13.6 million shares. That was more than five times normal and the stock’s largest one-day total since July 2008!
Interestingly, the stock surged right back to its old price highs, and has since backed off a few points, as many leading stocks consolidate their recent gains. I think it’s possible to buy a small position (maybe half of the amount you’d normally buy) around here, and look to average up on a strong breakout above 99. After a multi-month rest–before the earnings move, shares had gone nowhere for six and a half months–it looks as if VMW might be ready for another upleg.
All the best,
For Cabot Wealth Advisory
Editor’s Note: Mike Cintolo is VP of Investments for Cabot, as well as editor of Cabot Market Letter, a Model Portfolio-based newsletter of the best leading growth stocks in the market. It’s been over four years since Mike took over the Market Letter, and during that time he’s beaten the market by 14% annually (up a total of 65% since then, compared to a loss of 6% for the S&P 500) thanks to top-notch stock picking and market timing. If you want to own the top leaders in every market cycle, be sure to give Cabot Market Letter a try.