Hold Winning Stocks and Cut Losses Short

The Boston Celtics need to win one more game to beat their old foes the Los Angeles Lakers in the battle for primacy of the basketball world.

The Boston Red Sox are in first place in the American League, miles ahead of their archrivals, the New York Yankees.

The New England Patriots came “that close” to winning a Super Bowl earlier this year.

In short, sports fans in Boston are in hog heaven.

But there’s something wrong in the sports world that’s been on my mind in recent years.  It’s not performance-enhancing drugs.  It’s not sky-high ticket prices.  It’s not crooked referees and umpires.  And it’s not enormous salaries.

No, it’s the way the allure of the big money in professional sports, combined with tax policy, has turned so many colleges and high schools into feeder programs for the sports industry.

So What’s Wrong With This?

First, it undermines schools’ roles as educational institutions.  I’m a big fan of education, and when I see it overwhelmed by the forces that drive sports, it bothers me.

Second, because schools are tax-exempt, the system provides what is in effect a taxpayer-subsidized source of athletes prepped for big-league play.  In other words, if these sports-preparation institutions commonly called colleges and universities were taxed for these activities, your own taxes would be a little bit lower.

The big winners in the cozy arrangement are the professional sports leagues, which get well-prepared athletes at minimal expense.  Sure, they spend a little money wining and dining top athletes and giving out a few cars under the table (visualize that), but that’s peanuts compared to what they’d need to do if the schools weren’t in the business of preparing athletes for them.

Schools that are successful in creating winning teams win, too, by sharing in TV revenue and using sports as a draw for alumni contributions.  In fact, many schools have become financially dependent on their sports programs.

Also winning are the athletes who get a college education (or some semblance thereof) who might otherwise not have attended college.

Similarly, there are many winners among the “regular” students who find that top-notch sports programs help build character and add dimension to their otherwise academic life.

The Big Loser

The big loser, however, is the taxpayer.  And that’s all of us.

The topic of college sports was in the news back in the fall of 2006, when Representative Bill Thomas, a California Republican and outgoing chairman of the House Ways and Means Committee, asked the NCAA to justify its tax-exempt status, given the amount of money coming in from the TV contracts and the fact that coaching salaries had reached seven figures.

The NCAA responded that coaching salaries were competitive with those of other top educators, cited high building expenses as justifying tax-exempt status, and also noted–in response to the observation that many top athletes received substandard educations–that it was getting better at educating athletes whose first priority is the athletic arena.
Then the chairmanship of the Committee changed … and nothing happened.  In all likelihood, nothing will happen in the years ahead.  The entrenched interests are just too strong.

But just imagine what the landscape would look like if tax policies were different, if the tax laws were changed and college (and high school) sports were treated as moneymaking operations.

It’s hard to imagine.  Would top sports schools suddenly become a major source of revenue to the IRS?  Would less successful sports programs fold?  Would colleges, forced to compete harder on the academic front, improve their programs?

Would the presence of fewer career athletes on campus be a plus for academics?

The chances of this happening, of course, are very slim.  The entrenched interests are very powerful.  Still, it bothers me.  If you have an opinion, I’d like to hear it.

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Buying is Easy, Selling is Hard

On the investment front, my topic today is selling.

Buying is easy.  You find a stock you like; you envision the profits you’ll reap in the weeks and months ahead as your stock soars.  And you buy, with a heart full of hope.

Selling, on the other hand, is difficult. Most beginning investors sell wrong.  They take small profits on stocks that then go higher.  They fail to sell their losers, telling themselves the stocks will rally, that the market, in effect, is wrong.  And they end up with a portfolio of big losers and no winners!

If you want to end up with a portfolio of big winners and a few small losers, you have to reverse your thinking.  You have to hold winners and sell losers.

For example, last May, Novatel Wireless (NSDQ: NVTL) was added to the Cabot Market Letter Model Portfolio.  The fundamentals promised great future growth and the stock was in a strong uptrend.  Unfortunately, just two months later, our small profit disappeared when the stock fell through its 50-day moving average on heavy volume.  We recommended selling and got out the next day at 21, taking a loss of just 1%.  The stock did rally for a while, but by the end of the year it was down to 16 and by this April it was down to 7!  If we had stayed with it, saying, “but the fundamentals look fine!” our loss at that point would have been 65%!  (Since April the stock has rallied; it’s now up to 11.)

In short, selling the loser quickly prevented us from having to deal with a much larger loss. When it comes to winners, on the other hand, patience often pays.

Patience Pays Off

For example, back in March of last year, Cabot Market Letter bought First Solar (NSDQ: FSLR) for the Model Portfolio.  The company was young and growing fast, and the stock was strong.  The profits accumulated fairly quickly.  By early July, our stake had doubled!  In fact, we actually recommended selling a third, because the stock appeared due for a correction (the correction lasted three months), and because we wanted to reduce the over-weighted stock’s effect on our portfolio. 

In October, we again sold a third of our holding for the same reasons after the stock gapped up on good news.  This left us with about 44% of our original shares … and this time the stock kept climbing. 

Then in early January, with our profit at 288%, we advised selling another third.   The main reason this time was the broad market’s weakness–acting defensively, we brought the portfolio’s cash level up to 60%–while the secondary reason, once again, was to reduce the stock’s excess influence on the portfolio.   After this sale, we had 30% of our original share left.

And then we sat patiently, while the stock dropped to nearly touch its 200-day moving average at the market bottom.  (All the while, of course, the news out of the company has been great.)  Since then, the stock has worked its way back up to new highs.  In the meantime, we’ve seen more young solar stocks enter the arena (ENER is very impressive and has been mentioned here before).  We’ve also seen many of the original strong players lag far behind (STP, SPWR, ESLR).  But First Solar has proven worth keeping.

Now, you might argue that if we had sold none of FSLR along the way, our profit would be even bigger today, and that is true.  But our risk would be higher, too, and you need to always balance risk and potential reward.  By selling portions after strong upmoves, we reduced risk at the right time.  But by keeping the majority of our position after each sale, we cultivated a long-term holding that’s still among the leaders of a high-potential industry.

In sum, by buying smart, selling losers quickly and letting winners run, the Model Portfolio now consists of eight stocks (when it’s fully invested there are 12).  Three are rather large winners, four are small winners, and one–bought June 5–is a small loss.  And the portfolio is up 0.5% year-to-date, while the S&P 500 is down 7.7%

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Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory


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