Consider Selling When Your Stock Does This

|
Includes: AFL, ALL, CFG, COF, CVS, EVHC, F, LEN, LNC, MET, MS, NAVI, PFG, PHM, PRU, RE, SPY, SYF, TAP, TRV, UNM
by: Kurtis Hemmerling

Summary

Stocks making short-term extreme price moves should be examined closely.

Prices often revert over short periods of time.

Replacing such stocks may provide additional returns without additional risk.

I have developed hundreds of investment portfolios over the years, and I would like to share one of my top tips that will hopefully enable you retain more portfolio return without adding undue risk.

This article's portfolio tip is to consider replacing any holding which exceeds its benchmark by at least 20% in a month.

The stock is not replaced if it is still one of the top ranked stocks. But it should be replaced if a higher ranked stock exists.

Why This Portfolio Strategy Tip Works

Have you ever owned a stock that rapidly shot up in price to hit your price target?

Prices shooting up like a rocket

Did you sell? Many don't because they read message boards and articles which suggest that the price might go much higher. What often happens is that you hold onto your stock far too long and watch the excess returns dwindle over time and are left with average returns.

When a stock makes a rapid short-term increase, it sometimes goes up month after month with persistence. But more often the stock settles back down due to over-reaction.

Below is an excerpt from the Momentum research paper by Jegadeesh and Titman (2002).

Jegadeesh (1990) and Lehmann (1990) examine the performance of trading strategies based on one week to one month returns and find that these short horizon strategies yield contrarian profits over the next one week to one month. These studies of very long-term and very short-term reversals generally led to the conclusion that stock prices overreact to information.

When you own a stock that makes an abnormal run over a short period, such as a month, analyze your reasons for owning the stock and strongly consider replacing it with another stock on your watchlist. You don't need to sell the stock if it is still highly attractive according to your buy criteria. But a careful analysis might reveal that value metrics (or some other set of factors) have dropped. Or a better stock exists. Now is the time to replace it.

Practical Application of Portfolio Tip

I will demonstrate this sell rule using value investing. I rank stocks according to the basic Portfolio123* value ranking system. Stocks receive a rank between 0 and 100. It is a comprehensive value score based on the following factors:

  • Price to earnings (ttm)
  • Price to earnings (projected current year)
  • PEG ratio (long-term earnings growth expectations)
  • Price to sales (ttm)
  • Price to free cash flow (ttm)
  • Price to book

This ranking system would have you buying the following S&P 500 stocks:

Ticker

Name

Rank

Trailing PE

PEG Ratio

Price to Sales (ttm)

Price to Book (ttm)

Yield

(PRU)

Prudential Financial Inc

99.8

5.71

0.99

0.74

0.85

3.51

(MET)

MetLife Inc.

99.6

9.85

0.84

0.81

0.89

3.49

(UNM)

Unum Group

99.4

8.43

1.09

0.76

0.91

2.37

(EVHC)

Envision Healthcare Corp.

99.2

19.48

0.78

0.65

0.81

0

(F)

Ford Motor Co.

99

5.94

0.49

0.29

1.26

6.37

(LEN)

Lennar Corp.

98.8

13.54

0.53

0.98

1

0.31

(LNC)

Lincoln National Corp.

98.6

7.68

0.89

1.08

0.96

1.91

(COF)

Capital One Financial Corp.

98.4

20.07

0.83

1.55

0.96

1.65

(TAP)

Molson Coors Brewing Co.

98.2

8.8

1.51

1.2

0.97

2.72

(PFG)

Principal Financial Group Inc.

98

7.4

1.12

1.25

1.43

3.49

(ALL)

Allstate Corp (The)

97.8

10.31

1.08

0.9

1.47

1.94

(RE)

Everest Re Group Ltd.

97.6

24.76

0.4

1.37

1.11

2.28

(TRV)

Travelers Companies Inc. (The)

97.4

17.29

0.77

1.22

1.56

2.36

(CVS)

CVS Health Corp.

97.2

10.07

0.86

0.36

1.73

3.04

(MS)

Morgan Stanley

97

15.63

0.8

2.13

1.4

1.82

(NAVI)

Navient Corp.

96.8

11.97

N/A

0.72

1.05

4.53

(AFL)

AFLAC Inc.

96.6

7.62

1.76

1.62

1.47

2.28

(SYF)

Synchrony Financial

96.4

13.28

0.75

1.58

1.87

1.72

(CFG)

Citizens Financial Group Inc.

96.2

12.35

0.59

3.14

1.05

2.07

(PHM)

PulteGroup Inc.

96

16.9

0.28

0.96

1.99

1.22

Suppose you had purchased the 20 top-ranked value stocks in the S&P 500 in 1999 and held until today. You sold if a stock was removed from the S&P 500 index and you replaced it. You also bought when dividends piled up and you needed to purchase an additional stock with the excess cash. All positions were held equal weight.

S&P 500 Value Stocks Top 20

Next, we add one simple sell rule. If one of our holdings had a one-month price increase of more than 20% relative to the benchmark (SPY), we checked whether the stock was still one of the top 20 value stocks. If so, we did nothing and held. If not, we sold the stock and replaced it with a stock which was in the top 20.

Reversion to the mean value investing

While annual portfolio turnover obviously increased, it is not ridiculously high at 63%. Our compound annual growth rate was 3.5% higher which translates into double the total returns since 1999 as opposed to not using this rule.

Additional Tests on Factor Styles

I have added the chart below so you can compare the difference in annual performance and Sharpe ratio (since 1999) of the buy and hold approach vs. the out-performance sell rule in these 50 stock S&P 500 portfolios based on various themes.

B&H CAGR

B&H Sharpe

Outperform Rule CAGR

Outperform Rule Sharpe

Top 50 Value

11.64%

0.57

13.50%

0.62

Top 50 Growth

5.58%

0.29

8.58%

0.46

Top 50 Quality

8.97%

0.51

9.06%

0.55

Top 50 Momentum

7.83%

0.4

11.51%

0.68

Summary

I do not believe that you should switch stocks around in your portfolio unless you have a good reason to do so. I also believe that when a stock uncharacteristically shoots up in a very short period of time - that constitutes a good reason to re-evaluate the stock. Prices that rapidly rise often pull back. This is a good time to consider replacing it with a stock that you find more attractive. This one portfolio management rule works on probably 90% of the models I have designed and it just might work for yours too.

* Please note: The reference to Portfolio123 is a partner link. You get twice the free trial period at no additional charge. If you later use their service I may receive a modest commission at no cost to you. I have been using Portfolio123 for portfolio designing since 2011.

Disclosure: I/we 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.