How to Sell Stocks Profitably

Featuring Lutts’ Logic:

How to Sell Stocks Profitably

General Motors and the Automobile Business

An Attractive Little Automobile Stock

Last week I received the following note from a reader:
“Since I just started investing in early March 2009, and linked up with you folks shortly thereafter, I’ve been mighty lucky (too early to call my successes SKILL), and have seen my two portfolios (IRA and separate investment account) grow from $70,000 to $155,000 and from $150,000 to $200,000 respectively.
“My question is about when you normally sell stocks that have done well.  Do you sell when a stock’s price has advanced X% even it that means you might miss out on continuing upward movement?  Instead of percentage increases, do you, instead, sell when the dollar increases have reached a certain level?  Do the tax implications of holding onto a stock long enough for capital gains to kick in impact your decision to take a profit?  You likely use mathematical formulas, chart analysis and other sophisticated tools and in-depth data that I’m not qualified to use or don’t have access to.  If that is the case, then I’ll have to continue to take a profit from each stock when my “gut” tells me to, but that is a pretty lousy system.
“I have the same questions as above regarding the point at which you sell a stock at a loss.
“My guess is that a lot of your inexperienced, newer subscribers are as perplexed over this issue as I.  Therefore, if you want to respond to your general readership and use me as an example, feel free to do so.
“Thanks ahead of time for your reply!”
Atlanta, Georgia


First, I don’t think you were lucky; I think you were courageous!  When you started investing, back in early March, most investors were scared to death of stocks, while the man on the street feared the economy was headed for 10 years of no-growth … or worse.  Now, of course, they all feel a bit better, partly because the market has rallied tremendously since then.

The ability to avoid the curse of group-think is a tremendously valuable trait in the investing business, and if you can maintain that ability, I think you’ll do very well with your investments.

So what to do now, with all these paper profits?

In general, you should work to hold your best-performing stocks as long as they continue to perform well, while getting rid of your worst performers, continually upgrading your portfolio so that it is always composed of healthy stocks with good prospects for advancement.

In practice, this means you should watch their charts, and that, of course, is where it can get complicated.

Many technical analysts, including us, watch the 25-day and 50-day moving averages of stocks, asking their stocks to stay above these lines, and selling if they don’t.  (NFLX and RGR had been good examples of this in recent months, coming close to their 50-day averages several times, but always recovering.  NFLX, though, broke down today.)

A similar method is to ask the stock to simply close each day above its lowest close of the previous week, selling if it doesn’t.  Both these methods can be implemented by using automatic stop orders placed with your broker.

These systems are fairly simple, but they have their drawbacks, the biggest of which is the whipsaw.  A whipsaw happens when a stock rebounds soon after your system has told you to sell it.

You can add complexity, and improve your results somewhat (and avoid some whipsaws), by studying trading volume patterns as well.  Growing volume on up days is good, while increasing volume on down days is bad.  Gaps up on big volume after an earnings report (we’ve seen several of these recently) can be very good, predicting further upside, while the converse is true for gaps down.  A heavy-volume down day, perhaps two to three times normal volume, can be a great sell signal.  (We saw this in late-April with MYGN, when heavy selling foreshadowed the poor earnings report of early May that sparked wholesale dumping.)

On the other hand, if trading volume is below average on a pullback, it can tell you there’s no power behind a stock’s move.  If your stock dips below its moving average on lower than usual volume, you might hold on, and thus avoid being whipsawed.

Another way to avoid whipsaws is to sell on strength.  You might do this if a stock gets to be too large a portion of your portfolio, and you want to rebalance to reduce risk.  You might do it if you think a stock is “running out of gas,” advancing to new highs on decreasing volume.  (Look at QSII recently.)  And you might do it if you (L.S., with your ability to run contrary to the crowd) believe the broad market has become overbought in the short-term and is due for a correction.

There’s a fair chance of that now, with this two-month rally in the rear-view mirror and worries now easing about housing, swine flu, GM’s future, unemployment, consumer spending, etc.  Trouble is, if you follow all these suggestions about taking profits quickly, you’ll have a hard time building really big profits over the long term, and taking advantage of the power of compound growth.

So, for companies with the best investment prospects, I encourage you to take a longer perspective.  Maybe sell 10% of your shares if the stock gets extended, but be more patient about holding through corrections, particularly if fundamental growth prospects appear to still be sound and you believe the stock has not yet reached the Point of Peak Perception.

The Point of Peak Perception is the point at which a well-known stock tops out, simply because everyone who wants to own the stock owns it by then, expecting great things for the future.  There are no buyers left to buy.  Perceptions among investors can only get worse.  And as perceptions erode, the sellers take control, driving the stock down as they exit looking for greener pastures.

Microsoft, Intel and Citigroup, for example, are well beyond their Point of Peak Perception while Brinks Home Security (CFL), Green Mountain Coffee Roasters (GMCR) and American Superconductor (AMSC)–all recommended in Cabot advisories recently–are still far from it … meaning the profit potential is greater in these stocks.

As for taking losses, here’s an email that arrived this week from a long-time subscriber from Rochester, Minnesota.

“Tim, the first and greatest lesson I have learned from you (also your father and O’Neil) is when the stock loses ground (pick a number, 8% or 10% or 15-20%),  SELL ! SELL ! SELL !  We have an advantage over the Big Boys who are unable to move large volumes of stock. My number is 8% to 10% or when the momentum is adverse. Just SELL and move on.  This kept me out of trouble with the bear market last summer but no one escaped unscathed.”

What can I add to that?  There’s no shame in taking a loss; the shame lies in holding a loss and watching it get larger.  But you can minimize your loss-takings by buying smart, and by practicing market timing, favoring cash when the market’s broad trend is unsupportive, as it was last year.

As for your question about taxes, we don’t consider them much, and neither do the majority of our readers.  One simple strategy is to use your IRA for investments that might be shorter-term, and your taxable account for investments with a better chance of lasting longer.

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Today we learned (no surprise) that General Motors lost $6 billion in the first quarter.  The company’s revenues dropped 47% in the quarter, to $22.4 billion, while industry revenues dropped “just” 21%.

While the lion’s share of the blame for the company’s troubles must go to management (and to the unions), I think a lot of people don’t realize that the U.S. federal government–now playing the role of rescuer with taxpayer money–was hugely complicit in steering GM and other U.S. automakers into trouble with its CAFE (Corporate Average Fuel Economy) regulations, which exempted “light trucks” and thus encouraged the development and overproduction of SUVs.

Thanks in part to this encouragement (subsidy), American automakers built the best SUVs in the world.  But the big profits from these vehicles blinded management to upcoming demand for smaller, fuel-efficient vehicles–including hybrids–and here we are.  What the world now wants, GM and Ford and Chrysler do not sell.

And thus the stocks are cheap.  Ford is valued at $17.5 billion today, or 14% of the past 12 months’ revenues, while GM is valued at just $1 billion, less than 1% of the past 12 months’ revenues.  These stocks might be good value-based “turnaround” investments today, but that’s not our style.  

In the long run, the automobile business in the U.S. is shrinking.  Foreign competitors with lower costs will always be able to under-price U.S. manufacturers given a level playing field, so if you’re interested in the auto business, I suggest you look overseas.

My favorite automaker story today is Build Your Dream, a little Chinese plug-in hybrid car company.  You can’t easily buy the stock yet, but I’m intrigued by the fact that the company, currently the world’s leading producer of rechargeable batteries for mobile phones and laptops, is now charging into the plug-in hybrid car business.  Warren Buffett bought 9.9% of the company last September.

There are other Chinese manufacturers, but none that you can buy easily.  It’s still early.  But I have great expectations that high local demand and low-cost manufacturing, combined with a freedom from legacy costs and legacy thinking, will make some of them big winners in the years ahead.

The European companies, Volkswagen (VLKAY) and Daimler (DAI), are suffering like the Americans, though less badly.  And while I drive a German car, I find no attraction in their stocks.

Honda (HMC) and Toyota (TM) look better.  They suffered less in the bear market, and they’ve recovered well.  Their Relative Performance (RP) lines are looking healthy, too.  And they pay decent dividends, 1.9% and 3.1%.  

But all these manufacturers are big old companies, and thus offer far less profit potential than smaller and faster-growing companies in industries like technology, health care, entertainment, etc.

There is, however, one auto stock that’s intriguing.  It’s Tata Motors (TTM) of India, with $9 billion in revenues over the past 12 months.  Tata acquired Jaguar last June, and we were impressed to read early this year that the top marques in the J.D. Power quality rankings were Jaguar and Buick.  And now Tata’s come out with the $2,500 Nano, a car designed for the masses of India that has the potential to succeed like the original “people’s car,” the Volkswagen Beetle.  Tata has already received 203,000 orders, including deposits of–brace yourself–77% of the selling price.  The first cars will be available in July.  And Tata pays a dividend of 4.5%

Furthermore, Tata (TTM) has an attractive chart.  After the market bottom of early March, the stock bounced from 3 to 8, and over the past four weeks it’s built a very nice and tightening base under 8, apparently building steam for a breakout into new-high territory and another advance.  I think the odds are pretty good.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Editor’s Note: Global stocks rallied in April, pushing the Dow Jones World Index up 12%–its largest monthly jump since the index began in 1991. The Dow Jones Industrials Average rose 7.4% for the month, its best two-month performance in seven years. And now Cabot Market Letter says: It’s Time to Buy! From the market’s bottom in March 2003 to the recent low in March 2009, the S&P 500 lost 18% in total and the Nasdaq lost 3.5%. Cabot Market Letter, however, left them in the dust: Advancing a total of 94% during the past six years (nearly 12% per year). Don’t miss out on the first innings of the new bull market. Get started today!


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