Sell Discipline: The Time To Take A Donut Is When They're Passed

 |  Includes: CRAY, HPQ, IBM, SSYS
by: Peter F. Way, CFA

This old family motto from my tribe fits the hardest investment decision discipline - selling.

When you see a price opportunity that you have been planning for, help yourself to the generous offer. Don't assume that everyone else will leave you a second chance. When that serving tray comes back your way, it may be "empty" of what you wanted, but could have had earlier.

The advantage of putting a profit in your pocket is two-fold: 1) you have the emotional exhilaration of a success, and 2) you can then make a clear choice between what is being offered by either a further trip on the same vehicle, or any of several other alternatives.

That choice should always be the product of a fresh look at the odds for success and the payoff potentials in each case. The chances of making an unbiased selection are vastly improved when you are no longer involved in your earlier victory.

The excitement of the chase is often exhilarating during its conduct, and the temptation to make the gain even larger is endemic. But that is often the trap that makes discipline so valuable. Greed may be good, but being greedy rarely is. Emotional balance usually is better.

So get the excitement by starting a new chase. One based on a new set of targets, a new set of limits, a new sense of enthusiasm, a new case of care and caution.

Finding the discipline to follow

The most necessary element in the new quest is a reasoned purpose, based on what is now possible and practical in today's circumstances. To have a clear sense of that, you need to have an array of alternatives that have highly comparable and relevant descriptions. Those are what make up perspective.

So often the descriptions employed in presenting investment alternatives go no further than the raw materials for a decision. Usually the investor is left with a good deal more of a job than "some assembly required" to get to the point where decent comparisons can be made.

The difficulty frequently lies in the fact that "beauty and value are in the eye of the beholder" and it seems presumptuous to go to a point where the denomination of value in terms of price is acceptable, or somehow justified. Yet it is just that standard of description, in terms of a forecast price, that makes comparisons both possible and sound.

What usually happens is that an investment's potential is described not in terms of its forecast price potential, but in terms of earnings per share, with badly structured guesses as to what are appropriate (often to the appraiser more than to the investor) multiples to be applied. Comparisons that follow become contests over what are appropriate multiples, rather than uncertainty degrees over the earnings prospects.

The earnings uncertainties are always posed in the descriptions, but rarely in any useful, structured way - in ranges of possibility or odds of achievement. Given the latitude that the accounting "profession" accords itself, the comparability between companies of the earnings proffered may make a mockery of the whole process.

Eventually the recognition arrives to us as investors that what prices will ultimately occur depends entirely upon perceptions by persons other than the original investor in question. Then the entire process seems to be a giant guessing game that has no common denominator at any point. So spin the wheel, buy a Lotto ticket, take a chance?

Where to find some help?

Fortunately, there is a common meeting point in the process, among players in the game that are driven by some universal rules, constraints, and objectives. Those universal dimensions are 1) return on capital invested, and 2) ambition, bounded by self-preservation and sense of protection, necessary in a cannibalistic, competitive arena.

That battlefield is where the market-makers [MMs] "play."

Their ultra-serious game forces judgments, about widely-varied objects of attention, into a highly comparable, rapidly changing set of specifics about 1) where best to bet their firm's capital and 2) what it will cost to minimize that capital's risk exposure during the temporary period of its commitment. The game presents thousands of innings a day.

The players reinforce their actions with price-change risk insurance that must have a cost small enough to leave a trade spread adequate to make each particular deal profit-competitive to outdo any others of the moment. So the competition is not just between Ford, GM, and Toyota, or Apple, Google, and Amazon, but also with any of the above and perhaps Krispy-Kreme or Las Vegas Sands.

It is deal dimensions that count, not just industry ones. And well that they do, since that is what brings value judgments back to the common denominator that is ultimately needed by us as investors.

The role of competition

The market-making community is in continual competition, not only among its club-members, but with all their clients. The perceived mission of the clients is to outdo as many client-community members as possible by any legal means available, including "bagging" market-makers whose current price quotes may not - for the moment - be as well-informed about significant facts as the client is.

Hence the need for risk insurance by the market-makers as they expose their capital in the process of providing the "market-liquidity" necessary to "fill" the stub-ends of block-volume trades. The MMs challenge is: how much price change insurance is needed, and what can they afford to pay for it?

To try to minimize those dimensions the MMs each individually maintain world-wide, instantaneous 24/7/365 information-gathering systems and staffs of researchers to evaluate the input flow. These systems are now decades-mature in their technology and reach. Their "advantage" is largely defensive, since most of the information delivered is publicly available, and simply gets to the MMs a few nanos before the clients have it - hopefully. Let's leave aside the things that may get known by either side that are not legal for them to know.

The real advantage of the MMs lies in their own community's activities - knowledge of what the clients are interested in and what they are doing, and may be about to do. It is reflected minute-by-minute in the "order flow" of volume transactions being attempted, under ongoing negotiations, and actually achieved.

These client-action buy-and-sell pressures are what move prices. The MMs get insights into client tactics and strategies from their dozens of phone conversations with clients each market day, hockey game, breakfast conference, or "research field trip" sponsored. Relationships between trading desk personnel at both ends often have been coddled over several years. Each needs the other and from time to time benefits the other, in the longer-term interests of the relationship. All quite legal, and economically justifiable.

And the process provides a means of defining the expectations of what the market-moving clients may be likely to do, how far it may go, and how long it may take. All are subject to human error from the perception of likely events in a changeable, rapidly moving future. As the man (Yogi B.) once said, "The future ain't what it used to be."

Still, the resulting forecasts may be among the best available common denominators of what may be coming down the yellow-brick-road of time. Which we all have to deal with.

So by looking at what the MMs are willing to pay to protect their at-risk capital day-by day as they ply their extremely profitable "trade(s)", and understanding the insurance strategies involved, we can learn just how far up and down it appears that prices might move. Then by comparing prior forecasts (at all different levels of imbalance between the proportions of upside and downside being forecast) with actual market outcomes, we can get a sense of how well the MM community understands each issue's prospects in terms of today's forecast.

Nothing resulting is certain or guaranteed, but it all can be expressed by probabilities, or odds of happening or not, of bigger, or smaller or average payoffs.

When to sell?

Now, back to the donuts, and when to sell. Let's take an actual example to clarify what has been discussed.

My example is drawn from the completely random date of 3 months ago May 8, 2013, and the not-so-random stock choice of one that would be confronted with a sale potential since that time. It turned out that the computer manufacturer, Cray Inc. (NASDAQ:CRAY), filled the bill admirably, and allowed us comparisons with International Business Machines (NYSE:IBM) and Hewlett-Packard (NYSE:HPQ).

Here is how the MMs have been forecasting CRAY's prospects daily over the past six months:

Click to enlarge

(used with permission)

Suppose earlier in the year you had been watching CRAY, hoping for a chance to buy it below 20, because it had already run up to above 23. Then the reported first-quarter loss gave you more of a chance than you might have hoped for, and the stock dropped from $21+ to $17 ½ in one day, losing 1/6th of its market value. Maybe this is just the beginning of a bigger loss?

In the following week it drops below $17 and is there at the close of May 8th.

The way MMs were providing market liquidity at that time on CRAY indicated their belief in a potential price range from a low of $15.79 to a high of $19.96. That suggested an upside of +18.3% from its then price of $16.88, and a downside of -6.4%, so there is almost three times as much upside potential as drawdown exposure. And the upside target has been holding up well, without further decline after the initial shock. But are there better alternatives?

A look at a dozen and a half other computer firms tells the following story, as seen by the market-makers:

Click to enlarge

That downside from $16.88 to $15,79, 26% of the full forecast range, is what we use to calibrate the upside-to-downside balance measure, the Range Index. So CRAY's R.I. is 26. IBM's RI at the time was 36, and HPQ's was 37, so those two had less than twice as much upside prospect as down. The comparison with major big-cap stocks is good, and indeed none of the others have lower Range Indexes than CRAY's 26.

Look at how well all these stocks had previously done in the months after forecasts of Range Indexes at least as attractive as this day's (5/8/13). Only SanDisk (SNDK), Stratasys (NASDAQ:SSYS) and Storage Technology (NASDAQ:STX) had average gains in double digits. All three, plus CRAY, had profitable experiences in 7 out of every 8, or better, experiences.

Combining those high ODDS for success with the less than 8-week (40 market days) average holding periods it took to achieve their double-digit average past PAYOFF performances, provides triple-digit annual rates of gain in each case. This table has been ranked by the odds numbers, reflecting their importance as noted in our prior article. The results for EFII are wounded by its high Range Index with more downside than upside.

So CRAY's donut looks yummy, and when taken (invested in) provides the desired satisfaction on June 17th, some 27 days later, as on the market's serving tray its price rises above target to $20.15. Now it may be consumed (liquidated) the next day before the close of $20.68.

Well, was this digestion premature? (Remember, this is an illustration.) The blue-background Block Trader Forecast [BTF] chart above shows CRAY continuing to rise to its present level of $28. In hindsight, we could have had a lot more. All we got was a gain of +20% in 27 days, a "measly?" annual rate of +500%.

That's what we know now. But what did we know back on 6/17/13 when it was time to eat the CRAY donut? Here's what the block traders thought about the computer stocks at that time.

Click to enlarge

That puts CRAY down among the stocks with only 2 winners out of 3, since its market price rose faster than its forecasts, taking its Range Index up to 43. Better choices are up near the top of this list, which has been ranked by the odds of having a profitable investment from previous Range Indexes like today's.

EFII and STK look like sure winners - until we consider the samples underlying the odds data. There are less than a dozen examples, only 7 and 4 here, which run the risk of all coming from one particular market period. Conditions then may be an aberration, or not likely to recur for some long time. Further, with less than a year's past forecasts to look at in these two stocks, this concern is magnified.

The number 3 choice, Stratasys , avoids the problem with 84 prior RIs like today's over a 3+ year history, and nearly 9 out of 10 profitable. Looks like the MMs are on to this 3-D printer technology participant. It seems like a best-flavored donut at this time with tasty triple-digit rates of gain possible. So take a bite.

To make our illustration complete, SSYS yesterday reached its 6/17 forecast sell target of $100+ with a closing price of $103.11. Thus our high-carb diet continues with another 20% profit ingestion in 40 market days (8 weeks) at an annual rate of +210%. Time to look for a new donut, since SSYS's Range Index now is up to 42? Well, it still has a +12% upside, and its past performance just got strengthened.

Remember the discipline; let's see what else is being offered. We need to see if there may be more attractive jelly donuts on today's tray, or maybe a cream-filled one. . .

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.