It’s all About the Outliers
The Trick of Avoiding Big Losers, Capturing Big Winners
Protecting the Network
I recently skipped on down to Florida for a week off with my wife, daughter and in-laws. The weather was great for all but one day, and about the only source of any stress was my jaw-droppingly bad tee shots during a couple rounds of golf. First rounds of the season, though, so no worries.
As usual, the time out of the office allowed me to step away from the day-to-day grind of the market and look at the bigger picture–not just in terms of the market (I still think we’re relatively early in a new bull phase), but also in terms of my own trading. I’ve learned many new tricks of the trade lying lazily by the pool.
Anyway, I was reviewing some past trades and the overall market when I stumbled upon a reality that I was always aware of, but never really put into words. And that is the subject of my Wealth Advisory today: Investing is really a game of outliers.
The way I think about it is this: If you review your trades for any one- or two-year period and sort them from biggest loser (money-wise) to biggest winner, my guess is that you’ll find the “middle 70%” cancel each other out. In other words, the vast majority of your trades will add up to zero (or near zero), meaning that it’s the big losers and big winners that determine how your portfolio performed.
Logically, then, what you want to do is let your winners run and cut all losses short … which is the foundation of every solid growth stock investing system. However, there’s a lot more you can do than simply using loss limits and trailing stops.
The first thing to realize is that the method you use to, say, cut losses short, can also affect your ability to produce winners. They’re intertwined.
For example, I recently examined a real trade from my records back in 2009. Salesforce.com (CRM) had gapped up on earnings in mid-August, and everything was in place for higher prices–the price action (up 16% to new highs), volume (five times average) and the firm’s story (the leader in the cloud sector, which at the time, was just beginning). I bought the stock around 53.5 or so on the day of the gap; it closed around 54.
I immediately set a mental stop to keep any potential loss very small, placing it just below the low of the earnings day. (In many cases, the best earnings winners will never fill any of their earnings gap.) The low that day was 51.34, so I placed the stop around 51. That worked out to a loss of just under 5%. Sounded good to me–the smaller the better, right?
Well, CRM pulled back a bit with the market in the days that followed and just barely knocked me out on September 1. (See chart below.) I wasn’t too upset–a loss of less than 5% meant the trade did little harm to the portfolio.
But look what happened afterwards–CRM pushed to 68 in mid-November and 75 by the turn of the year. (The original mid-August gap up is on the far left hand side of the second chart.) Knowing myself, if I hadn’t been stopped out on September 1st, I almost certainly would have held on until the gap lower in January, selling in the 68 to 70 range. In other words, net-net, the only thing my overly tight stop did was get me a 5% loss, instead of a nearly 30% profit.
While I won’t claim that a 30% gain qualifies as a “big winner,” my point is that if you’re extremely risk averse and cut losses too short, you can actually cost yourself quite a bit of money.
Thus, on the loss side, my advice is simple–be willing to give a stock 8% to 15%, in general, before abandoning ship.
Holding on to a couple of longer-term winners is tougher than cutting losses. The real trick is to develop what we call staying power–that is, a combination of a profit cushion and the mental wherewithal to sit through the inevitable deep, quick, scary corrections that even the best stocks have.
It’s easiest to hold on to a long-term winner when you have just a single share of stock; the money invested is so small that you can sit through a 20% or 30% retreat without breaking a sweat. Of course, with one share, you’ll never make any real money.
Thus, the goal is to put on a position size that’s small enough so you don’t freak out when a stock suffers a sharp retreat … but large enough so your portfolio reaps some serious benefits. (Unfortunately, there’s no perfect position size–Carlton Lutts, Cabot’s founder and a great investor, could calmly sit through a stock’s downturn even if he had 25% of his account in the stock. Personally, that sort of drawdown would freak me out. But the point is that everyone has a different threshold, and you should strive to find yours.)
My point is that you need to focus on developing at least a few large winners during a bull market. Make it a point of emphasis in your own trading. If you’re the type that constantly takes profits when you’re up 10% or 15%, try to take partial profits instead (selling half your shares) while holding the other half with a trailing stop.
If you’re the type that gets nervous about losing even a 5% profit, consider buying smaller amounts initially, so that the swings of a few percent don’t impact your psyche.
And if you’re the type that is so risk-averse that you’ll never put on a large initial position, then consider building a position over a few weeks, averaging up two or three times (if the stock heads higher) so that, if the stock does get cranking, you have a good-sized position.
There’s no magic bullet, but just remember that, in the big picture, it’s the outliers that will determine the lion’s share of your performance.
As for the current market–I’m bullish. Of course, I’m also keeping my feet on the ground, knowing that after a three-month advance, some sharp shakeouts or even a full-blown 5% market decline could be in the cards. But the overall trend remains very healthy, both among the indexes and leading stocks.
My biggest piece of advice for you right now is to stay focused on the leaders of this advance. In my experience, it’s around this time where investors either (a) fall back in love with some old, past leaders whose best days are behind them, or (b) start buying up speculative or lagging stocks.
In a bull market, you might get away with buying a few dogs, but your best course of action is to stick with the primary or secondary leaders of the advance. (See the first section of my last Wealth Advisory, dated March 5). In this environment, if you buy the right stocks at opportune entry points, your odds of success are very high.
For my stock idea today, I’m going to highlight a second-tier leader that recently gapped up on earnings. Better yet, the stock really hasn’t been a leader before, so it’s fresher merchandise–meaning institutional investors are likely to want to own more going forward.
The stock is Sourcefire (FIRE), an emerging leader in Internet security. Here’s what I wrote about it in Cabot Top Ten Trader back on February 27:
“The rise of organized hacker groups like Anonymous and LulzSec has propelled cybercrime and cyber-security out of the darkness of corporate server rooms and into the limelight of mainstream news. This new era of online crime has prompted corporations to invest heavily in network security, directly benefiting companies like Sourcefire. Sourcefire’s 3D (for discover, determine and defend) software and FirePOWER acceleration technology secure networks and applications without sacrificing performance and efficiency. The company’s main customers are located in the finance, government, health care, manufacturing and technology industries. The latest round of cyber attacks against the federal government and major financial institutions was a boon for Sourcefire, prompting better-than-expected fourth-quarter earnings from the company. What’s more, citing its strong market position, the company also said it sees fiscal first quarter revenue of $40 million to $42 million, easily topping Wall Street’s consensus estimates.”
The stock exploded higher following those first quarter results–FIRE shot ahead 26% on 10 times average volume. Granted, the stock wasn’t the most well-traded name before the report (about $17 million of daily dollar volume), but the move was decisive and took the stock out of a multi-year rest period.
I don’t call FIRE a first-tier leader; it’s not going to be an institutional favorite anytime soon because of its relatively low trading volume. But I do think it’s a new leader, and the combination of the stock’s explosive earnings move, its resilience since the gap and the firm’s history of strong sales and earnings growth, means higher prices are likely.
You could buy a little in the upper-40s, but I prefer to look for weakness, aiming to get in around 45 with a stop around 38 or 39.
All the best,
Editors Note: Mike Cintolo is editor of Cabot Market Letter, the company’s flagship publication. Hulbert Financial Digest–the keeper of the keys when it comes to newsletter performance–just ranked Cabot Market Letter as the #5 Letter (out of 146!) for five-year performance. Mike has achieved steady, dynamic gains by combining top-notch stock picking (he already owns most of the leaders of the new bull market) and disciplined market timing, allowing subscribers to sidestep bear markets and keep what they’ve earned. If you’d like to benefit from his system and discover the leaders of this bull cycle, we urge you to give Cabot Market Letter a try today. Click here now!