Let Your Winners Run

Includes: BA, JNJ, MCD, MMM
by: The Hedged Economist


You can't go broke taking a profit, but you can under-perform the market.

Every stock won't be a winner, so maximize the size of the winners.

Cherish your winners because you only have a few big ones.

Don’texpect any stock to always be a big winner.

BA,JNJ, MCD, MMM  as examples.

In previous postings about portfolio management, letting your winners run has been mentioned numerous times. One should construct a portfolio that can accommodate that approach. At any given point in time, some stocks will have a good run and become overvalued.

For a dividend growth investor selling the big winners and taking profits may seem appropriate since higher-yielding stocks are available. However, that ignores the potential lag between dividend growth and the increase in the value of the stocks. For example, right now, Boeing (NYSE:BA), 3M (NYSE:MMM) and McDonald's (NYSE:MCD) are poster child examples of portfolio holdings that are overvalued. There are undoubtedly articles on SeekingAlpha questioning whether now is the time to take profits in those stocks. However, the false sirens sound can surface with even the most reliable dividend growth stocks like Johnson & Johnson. Ignore the noise. Hold on to the winners.

The chatter can be even louder with growth stocks. The danger for growth investors is that the advice to take profits in the stocks that had a good run is, in fact, a recommendation to abandon the very strategy of growth stock investing. Again, ignore the noise. Hold on to the winners.

To understand why to hang on to winners, one only needs to review how markets advance. BARRON'S had an interesting article in the October 13, 2017 edition. The article is entitled, "Why Stock Market Skew Favors the Few." It summarized two recent studies of stock market performance. Both studies pointed out that across the performance of individual stocks, the distribution of performance is very skewed. A small group of stocks account for a substantial portion of the rise in the total market. Most of the stocks in the market performed below the average, but a few are so far above the average that they bring the average performance up.

One of the studies attributes the entire gain in the stock market since 1926 to the best performing 4% of listed companies. The data is extremely interesting, but the interpretations attached to it could fairly be characterized as meaningless fun with numbers. The data does have some implications regarding the risk associated with portfolios of different sizes. If one holds the S&P 500, there probably will be about 20 stocks that will be the big winners. The probability of holding a 25 stock portfolio that includes one big winner is equally high. Although the researchers are perfectly willing to construct portfolios by assigning stocks to portfolios randomly, they seem to be assuming perverse selection in smaller portfolios. For example, one of the researchers points out how many concentrated portfolios could miss the 20 big winners. It's a lot, but it's totally irrelevant.

Generally, one of the problems associated with this type of after-the-fact analysis of stock performance is that, by the very nature of the research, it ignores any causality involved. Stocks don't just fluctuate going up and going down because they like change. Each stock represents ownership in a company and participation in its future profitability. If a stock has a good run and becomes overpriced, it's because the market believes there is an extraordinary increase in the fortunes of the company. If, as is often the case, that perception gets out of hand, the stock may not perform well for a period of time. If it's accurate, that run will continue.

It is that interaction between the forecast of the company's future profitability and what the company actually is able to achieve in the future that determines the stock's performance. One would only sell winners if one believed there is a systematic tendency of investors to expect too much from companies that previously have been able to achieve a lot. There is a logic to that belief: The ability of the company to perform well has been demonstrated and many investors judge the potential for future performance based upon recent achievements. However, one would only sell the winners if one believed that investors are about to recognize the error in their forecast and to sell the stock.

However, there is other research that is often ignored. Analyses of individual accounts indicate a strong negative correlation between portfolio performance and the volume of trading. While selling stocks that are overpriced seems appealing, the research into how it is actually executed indicates most people don't do it well. Some investors are undoubtedly able to do it very well, but the odds are against any individual embarking on a trading strategy. Most investors sell winners far too early because they can't just sit back and let the winners run. They can't accept that the big winner in any given year may not be the big winner from the previous year. So, they end up in a perpetual search for the next big thing. That the next big thing may be the current big thing is ruled out.

It's not hard to understand why people tend to sell winners too early. Behavioral economists and psychologists have analyzed the psychology of losses and gains. The pop psychology summary is that the regrets from a loss are twice as intense as the gratification from a gain. The research has progressed beyond the rather crude measurement efforts to analyze the actual neuroscience of gains and losses. Consequently, there is little doubt that losses are experienced in a different way from gains.

To illustrate the impact of the difference in the way people experience loss and gain, consider a stock has gone up 50 points in 12 months and becomes overpriced. If it pulls back 25 points, the feeling of loss will be as intense as the entire 50 point game. However, the stock only needs to have an equal probability of going up 25 points for the financial risk/reward to be balanced. However, it needs to go up another 50 points for the experienced or psychological risk/reward to be balanced. Consequently, there is a psychological bias in favor of selling in order to lock in gains.

You may have noticed in the illustration above that the reference point was the price after the 50 point gain. That was done intentionally, but without a whole lot of research findings to justify its use. That people establish reference points, often referred to as anchors or anchoring their perceptions, is well-established by behavioral economists and other observers. Informal observation seems to justify a belief that there is a tendency to anchor at high points. The greatest value ever achieved becomes the reference point. It would be equally legitimate to refer to the 50 point price increase followed by a 25 point price decline as a 25 point price increase. However, over any long period of time, that requires a level of accounting and data retention that many people don't consider justified. It also requires not re-anchoring the reference point.

Interestingly, one often sees investors refer to their yield on cost. Continually calculating the yield based upon the initial cost is a way to manage re-anchoring. Similarly, those dealing with taxable accounts have to continually retain the basis for their investments. So, the tendency to change the reference point or anchor is not universal. However, regardless of the reasons for the tendency to sell winners prematurely, the phenomena has been widely documented.

Selling winners also ignores the evidence of persistence (the tendency for stock price trends to continue). Excellent research done by Andrew Lo and others has uncovered the existence of persistence in many asset prices. It has become the foundation of many momentum-investing strategies. But, the important lesson is that forecasting how long that persistence in the uptrend will continue is very difficult. Most investors should accept the fact that they are not going to be good at it. Granted, it is appealing to think that one has the gift for identifying when trends will reverse themselves. There is a lot of money to be made doing it, but it is much more difficult than selecting a portfolio of long-term holdings that meet the investor's unique objectives. The approach of selecting and holding a long-term portfolio only requires being right once, when a purchase is made. The alternative of buying with the intent of selling if the stock becomes overpriced requires being right at least twice. Being right once seems easier. It also means only one commission.

While my objective is to become a successful investor, becoming a successful stock trader is a legitimate alternative objective. There are numerous Wall Street sources that will help one to try to become a successful trader. After all, Wall Street's earnings are to a large extent based upon the amount of trading that occurs. If the objective is trading, then identifying when winners realize their full potential is almost a prerequisite for successful trading. Each trade requires that it be done successfully at least three times. It requires being right when the stock is purchased in the first place. It then requires being right when the decision is made to sell it because it is overpriced. Unless one is liquidating the portfolio, it also requires being right when selecting the stock to hold as replacement.

If one is thoroughly convinced that it is possible to identify when overpriced stock will correct, there are a variety of strategies other than selling the winner that can be employed. They have been discussed in previous postings where the overpriced stocks mentioned in this posting were discussed. However, the comment was that there were potential catalysts for a pop in the stock's value that made all of the strategies unappealing. Purchasing puts would've been a waste of money, selling covered calls probably would have resulted in stock being sold, and only selling cash covered puts would have had a high probability of a positive return. Recent performance of the stocks, and especially the reaction to the earnings releases from Johnson & Johnson (NYSE:JNJ) and 3M illustrate the point. However, all four of the stocks mentioned have been overpriced for a while, and all of them have increased in price since that was first noted as overpriced in previous postings.

While all four stocks are being held in the portfolio, it would be easy to misinterpret the point of this posting. It is not about those four stocks. Rather, it is about how to address overpriced stocks in a diversified portfolio. That I am holding onto those four stocks should not be taken as a recommendation. The portfolio also has over 30 other holdings (For a list see "Dividend Growth Portfolio Update" Oct. 16, 2017, Dividend Growth Portfolio Update). Each investor is responsible for doing his or her own due diligence and developing a portfolio strategy. The point of this posting is that selling even overpriced stock should be undertaken with full understanding of the risks involved in exiting any position.

Disclosure: I am/we are long JNJ,MMM,MCD,BA.

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.

Additional disclosure: These stocks are part of the portfolio referenced in the posting