How To Know When To Take Profits In Growth Stocks?
For those of you who bought SINA, BIDU, and RENN in May 2013 when I wrote “Should I Invest In Chinese Equities?” there are some great steak restaurants we can go to next time you’re in San Francisco. The stocks are up 35-65% in three months as the herd finally latches on to their potential!
The number one question we should ask ourselves when our unicorn stocks are going ballistic is: When is it time to take profits? Clearly such performance cannot continue indefinitely and at some point there will be a painful correction. The worst thing one can do is go from making big bucks on a stock to losing money.
One of the other mistakes I’ve consistently made in my 15+ years of investing is selling too soon. Anybody who invested in the mid-90s until now has seen the Asian crisis of 1997, the dotcom bubble of 2000, bird flu pandemic in 2003, and the mortgage market collapse of 2008 destroy a lot of wealth. We have been conditioned with fear to temper our greed, unlike those who just started during or after the latest crisis.
In this post I provide some psychology behind growth investing and when to lock in profits for maximum risk adjusted returns. Please note that executing on such insights is much harder than just providing a framework due to fear and emotion. I make suboptimal trades all the time.
KNOWING WHEN TO TAKE THE MONEY AND RUN
* You don’t know the future. It’s important to hammer home in your head the only thing you can do is make educates guesses about the company’s earnings, business model changes, competitive environment, and macro environment. Even if you predict the correct earnings growth figure, you could still lose money because of lofty street expectations which wanted more. Everything is an expectations game when it comes to investing. The key is to identify stocks which have low expectations by the market. In May 2013, Chinese internet stocks were the perfect candidate because they had been going down for two years in a row and left for dead while its US counterparts headed in the other direction.
* Timing the market perfectly is impossible. I use a three tranche system to leg in and leg out of a position. The time period for buying or selling can vary from as short as one day to as long as a year. It all depends on my outlook for the company and the industry. Three tranches ensures you do not top tick a stock during purchase or bottom tick the stock during a short sale. You are spreading out your execution risk.
* You can never lose if you lock in a profit. Always remember that a win is a win. It’s better to win a small pot with pocket Aces then hold on too long and get crushed by the river for those who enjoy Texas No Limit Holdem. The only thing you will feel is greed and regret if the stock continues to move higher. But since you are selling over three tranches, you should have one-third or two-thirds of your remaining position to ride the stock higher. Always remember your losses when you are feeling the greed of not making more money.
* Compare valuations with the historical range and expectations. Valuations are a tricky, tricky thing to analyze. The biggest factor is earnings forecasts. A stock trading on 20X current earnings might sound expensive if its band has historical been 14-18X. However, if earnings grow by 50% the following year instead of market expectations of 10% growth, then the forward P/E is really only 13.3X vs. 18X and the stock is worth holding on to. Sell-side and buy-side analysts get their estimates wrong all the time. It’s up to you to make educated bets on how good or bad the forecasts.
* Assess whether the story and competitive environment is intact. If the company continues to execute on its promises by reporting solid quarterly results and if the competitive landscape is still relatively benign based on your expectations, then there’s really no need to sell. The best investments are those which you hold for long term where management continues to deliver profitable growth while you just kick back. Speaking to management is the competitive advantage institutional investors have over retail investors. Differentiate between endogenous variables and exogenous variables.
* Recognize your edge. Everybody has heard of Apple (AAL), so it is very hard to get “an edge” on Apple, especially with all its products and supply chain companies saying different things. Very few people have heard of RenRen (RENN), and as a result it’s a less crowded trade with a higher ability for me to uncover potential opportunity. Once everybody has heard of RENN, that is when the stock starts going crazy and when I think about exiting.
* Ask yourself about opportunity costs. In 2008 I was given some “toxic assets” (RMBS bonds, Japanese real estate, NPL and distressed assets) as part of my bonus. I took a look at the latest notional value and it is 2.49X higher with a 22% yearly IRR and a 3% interest yield while I wait for the fund to vest. Great! The problem is that my toxic assets are finally coming due between 2014-2017 and I don’t know of another investment that can do so well at the moment. I would much rather have my old firm keep my money even though it’s been five years already. The best I can realistically do over a five year time frame is probably 10% a year per annum based on my risk profile. If there’s nothing better to invest on a risk adjusted basis, then you probably want to hold on until you can find something better.
* Reset expectations. One of the biggest fallacies investors make is not resetting expectations as the price of the stock moves. Take RENN for example. When I bought at $2.80, it was a left for dead stock with little liquidity and continuous quarterly losses. Now investors finally recognize the $900 million cash it has on its balance sheet and the upside potential if one of its various business models work, especially after Facebook reported great mobile profits. It’s important to try and understand what new investors are expecting at higher prices. Don’t get stuck thinking in the past.
THE DECISION TO SELL IS PERSONAL
I’ve got multiple portfolios that are meant for different things. My main portfolios are boring buy and hold index funds that provide broad exposure to the equities market based on what I think is the proper asset allocation of stocks and bonds by age. My rollover IRA portfolio and a taxable E*TRADE portfolio are where I aggressively chase unicorn stocks that will hopefully blow away the index.
For younger investors who want to try and achieve financial independence sooner rather than later, I continue to suggest taking more risk and investing in growth stocks over dividend stocks. In this latest example, the Chinese internet stocks I’ve chosen have outperformed dividend stocks by 35-60% over the past quarter. It will probably take years for investments in McDonalds, Walmart, Coca Cola and so forth to match such returns. That said, dividend stocks are a solid lower risk strategy for long term investors. It’s always about risk and reward. When you’re young you can afford to take the hits due to time and earnings potential.
Opportunities exist every single day. We just have to go find them. One of the biggest reasons why I started the FS Forum is so that we can pool together our eyes, ears, and ideas in this massive financial world. The Chinese internet stocks are just one example. Think about how many countries, sectors, and companies there are that are listed on the NYSE and NASDAQ alone!
Investors, how do you know when to take profits? Do you feel the stock market is getting a little frothy here at S&P 500 1,700+?