Cree: Managing A Loser

Nov.20.13 | About: Cree, Inc. (CREE)

On October 23, I wrote an article "Why I Bought Cree On The Earnings Drop." In the article, I explained that I bought shares of Cree (NASDAQ:CREE) after the company reported numbers at $63.50 and suggested other investors do the same. Here is how shares have performed since my recommendation.

Needless to say, it hasn't been a joyful ride, and if you bought shares alongside me, you would be down roughly 12%, which really isn't a lot of fun. Over the past few days, I have been doing some soul searching over what to do with my position and would like to explain my thinking, which I believe can apply to other losing positions beyond Cree.

My first question is whether a given position I have is a trade or investment. It is a critical mistake to turn trades into investments and vice versa. What I mean by this is if you bought a stock on a specific catalyst, say a product launch, and the stock doesn't perform well, you should not hold onto it longer than you planned, praying for a turnaround. Similarly, if you own a stock with a multi-year thesis, you should not be a seller simply because it has been a bad month, unless some news came out that had you questioning your original thesis.

I bought shares of Cree on the belief that LED lighting is the future and that Cree will be a dominant player thanks to its technological lead and distribution network. Nothing has happened to change my thesis. With no change in my underlying thesis, my forward looking projections remain the same. I continue to think that LED lighting could account for 75% of the light bulb market by 2020, which would lead to total sales of $120 billion. Within this market, I believe conservatively Cree can easily hold 4% share, which gets me $4.4 billion in sales and $6 in EPS. With those figures, I am modeling an annual return of at least 11.5%.

With my long-term view unchanged, every dollar Cree gets makes the potential reward incrementally better. Clearly, there is no reason for me to sell my holding, but should I buy more? This is where discipline is critical. Right now, Cree is neither my largest nor my smallest holding, hovering near the middle with an 8% weighting. Even if you believe a stock is a "sure thing" (in which case I suggest you evaluate potential risk factors more closely), you should never put all your eggs in one basket.

At my risk tolerance, I don't like individual positions accounting for more than 15% of my portfolio. I like to ensure sufficient diversification so that no stock can destroy my performance (but by the same token, it is now impossible for one stock to drive my portfolio amazingly high; this is the diversification trade-off). In theory, I could almost double down and remain within my parameters, but it is important to recognize reality. Cree, along with many other fast growth, higher multiple stocks like Tesla (NASDAQ:TSLA) and Pioneer Natural Resources (PXD), are clearly out of favor right now. As such, I struggle to see a catalyst for Cree rallying in the near future.

While I was happy with the most recent quarter, Wall Street clearly was not. There really is no positive catalyst to get the stock back on the right track until its next quarterly report in January. Consequently, there really is not a compelling reason to get "more long" the stock here. I plan on waiting to see what Cree reports next quarter to see if light bulb sales accelerate like I am expecting. If the next quarter continues to confirm my thesis and the stock remains appreciably undervalued, I will probably add my position. However, I don't do so until then.

Unrealized losses are never fun, and you can feel like a sucker for buying a stock too early, which I did with Cree. If your underlying thesis remains intact, you should not sell a position simply because it is down. Still, just because a stock you like is cheaper does not mean you should add to your position as you must maintain solid diversification and consider what future catalysts lie ahead that could impact the shares and your thesis.

For anyone who bought Cree on my recommendation alongside me, I am sincerely sorry you are down. I also believe that Cree remains in prime position to capitalize on the shift to LED thanks to its intellectual property and Home Depot (NYSE:HD) distribution deal. I also would remind you that CREE maintains $9 in cash and has the capacity to do a significant share buyback. I continue to believe CREE will trade above $120 before the end of the decade and that investors who are patient and ride out the near-term volatility will be glad they own CREE.

Disclosure: I am long CREE. 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.