How To Know When To Take Profits In Growth Stocks?

Sina stock on fireFor 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 

RenRen Stock Chart

* 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.

Baidu stock chart

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!

Dividend stocks going nowhere

Dividend stock index performance.

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+?

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    Guess you’re too risk averse to play in the mREIT territory where the return currently can be upwards of building 10 years faster than MCD. When Uncle Ben decides to cut the purse strings, it’ll definitely be time to get out of them until they settle.
    But what about oil, such as SDRL? That’s got a dividend of about 8%/yr. This is going to be one of the stocks that I use to diversify my portfolio more within the next year. I had some in the past, but shifted that money over to mREIT for the time being.

    As you said, it’s a personal choice to buy and/or sell. :-)

    • says

      The 25-35% correction in the mREIT sector this summer makes the space look much more interesting. Did you buy after or before the collapse?

      I’ve already got ~35% of my net worth leveraged to multiple properties so to invest more into the real estate sector via equities is not that appealing. What is your current net worth make up and what percent of your network or portfolio consist of mREIT?

      I’m just going to try and stick with what I know. 50% returns in Chinese stocks is better than a poke in the eye! I’d love to read a write-up/analysis of your mREIT picks. Definitely pitch me and your readers your idea! Thx.

      • says

        I got out just before the correction, and back in before the dividend was getting paid. This time it was by luck since I was trying to set a stop-loss sell but did a sell instead, and I waited until I thought it was bottomed out but misjudged it a little bit. Thankfully they didn’t sell for the amount that I put in for the stop-loss, but sold slightly below the current market price at the time.

        Basically, what I’m trying to do is to speed up dividends in my portfolio. The thought is if I buy 100 shares, I have to wait until the end of the year to get the dividends that the stock pays out. However, if I purchase 400 or more shares, I’ve effectively cut 1 years growth down to 1 quarter. Trading the stock has relatively minimal cost ($8 or so), but of course can add up.

        Net worth makeup is 75% 401k which is limited to the alright funds they provide. The other 25% is a combination of rollover IRA and brokerage account. I don’t consider our house as part of our “normal” net worth makeup since we may or may not sell the house.
        Since I can only buy/sell stocks within the non-401k assets, that’s where I do most of my trading. Currently I’m 90% mREIT and 10% cash, building up the cash by depositing cash into those accounts, and letting the dividends go back as cash into the respective accounts.

        I can see that having about 35% of your net worth leveraged in multiple properties would give you reason to not put more in the RE sector. I think that physical RE is a great investment if you are achieving a good return after paying all the associated fees, especially that 6% realtor commission. But for me, I can buy/sell RE in equities a lot faster and for a lot less than that commission, IMHO.

        Looks like a good reason to write up and article on my blog I guess. :-)

        • says

          Yeah, definitely do a write up on mREITs. Much better than just commenting why someone doesn’t dare to buy mREITs without any perspective.

          How much dividend income are you currently generating?

          FYI, I can buy/sell equities just as fast as you can buy and sell equities for less commission too. The difference between us is our portfolio diversification where I’m 35% exposed to equities instead. But who knows, that 35% might be a nice chunk of change.

  2. John S @ Frugal Rules says

    Knowing when to take profits is a huge thing, especially in growth stocks. So many just fly blindly and end up making a mistake that could cost them. I tend to look at the fundamentals, and assuming they’ve stayed the same, then I’ll ride it out until something changes – or the herd is going gangbusters over it. Once that happens, I start looking at if it’s time to take my ball and go home. I hate losing out on more gains, but I’d much rather have the gain I do have then to lose it altogether. In terms of the S & P now, it’s hard to say. I’ve pulled out of a couple of positions to take the gains and currently looking for some opportunities.

  3. says

    Holy moly those are some beautiful growth stock charts! Boy it’d be nice if my entire portfolio looked like that. I’m a pretty low risk investor though so I tend not to buy single name stocks. But I am wishing I had made that run up on Baidu. Wow. You’re exactly right though that there is no way to time the market perfectly. Making a profit takes a lot of research and being proactive, watching the markets and staying on top of news and trends.

  4. says

    I learned that I, in fact, have NO IDEA when to take profits from an investment.

    It was a hard truth to accept, as you would say, Sam.

    But one of my favorite sayings in investing is, “No one ever got hurt taking a profit.”

  5. says

    It feels a bit high to me, but I’m not an expert or anything. I put a 5% trailing stop order on a few stocks that seems high. I’ll be happy if it goes a bit higher and won’t be too sad if we have a correction.

  6. says

    I struggled with the question before and probably will again. I bought Amgen at $9 and sold at $45. A very handsome profit, however I missed out on a number of stock splits and growth. No regrets, but it is something I think about when this question comes up. I think you have to look forward and think about the next opportunity. Is it a better opportunity compared to letting it ride?

  7. says

    I have been stock trading for about 6 years now and one thing I will say is I live and die by numbers. If I make 5-10% on a stock transaction, I sell. If I make 10-20% on an option transaction, I sell. My attitude is always sell when you’re ahead. I also live/die by these numbers when I am in the read. I bought FB at 29 and Sold at 35 that say when they jumped up close to 15%. 30%. People were asking me why I moved so quickly to sell and why not stay on the bandwagon. My attitude is very simple. Live/Die by your numbers :-)

    • says

      I like the discipline David! You tighten your risk control to lose less, make less. But over the long run, given stocks return 6-8% on average.. 10-20% is in the ball park. I’m gonna let 30% of my position in these Chinese internet names ride. I’ve seen things get out of hand before and don’t want to miss out on madness.

  8. says

    You are a prophet as usual Sam – though you have such a knowledge of what to look at in a stock based on this article, and I’ve only been investing a short time, so I may get there on day too. I had RENN and AAPL, but sold too soon – out of fear. I now hold a hand full of dividend stocks to try and ride out the last few months of the year with more gains.

    I feel the stock market is getting a little too frothy. With the DOW close to 16,000, my gut tells me that there has to be a correction down at some point, by 1,000 points or so. But who knows – so far that hasn’t happened, except for the dip about a month ago that quickly bounced up.

    When you research a stock like RENN, how did you find out their cash on hand – is it just from their investor relations on a website somewhere?

    Thanks as always for sharing Sam.

    • says

      Just luck Jeremy, with a little bit of more luck!

      I listen in on all the quarter conference calls before and during ownership of the stock. You can find the income statement and balance sheet estimates online on Yahoo Finance and elsewhere. You can also read their public reports e.g. 10K. There is so much info.

      And then of course you can read investing focused sites to find ideas as well.

      Although you sold too soon (we all do), you still made money so that’s great! Can’t get it right all the time.

  9. says

    I’ve only ever held one true growth stock. Luckily, I never had to contemplate when to sell, since it got bought out from my hands. I wish I could have held onto it afterward.

    I am the absolute king of selling too early. I’m naturally very conservative with my valuations, so what I define as cheap is usually a lot cheaper than the market. I always try to invest in something I could see myself owning for a long time to remove decisions about when to exit.

    That may be why I’m a little cautious seeing 1700 for the S&P, especially when growth stocks (TSLA, FB, YELP, etc.) are green even on down days. I think the market is frothy, and my cash position is growing.

    The average S&P 500 component trades for 19x earnings, and 15x forward earnings (based on numbers from the SPDR ETF). I think that’s rich. A 15x forward earnings number implies serious bottom line growth for the average index component. I don’t buy it in this environment. Earnings this Q were generally weak across the board. No thanks. I’ll sit in cash…bargains are few and far between.

    • says

      The S&P 500 at 19X sure does look expensive now. I’m going to look for laggards and will share in the FS Forum if I find any. I’ve got a large cash pile myself.

      TSLA, FB, YELP performance is incredible. Now just think about where that money is going to flow…. SF real estate. Got to get ahead of the game.

      Try and take some more risk JT. It’s the biggest regret I had when I was in my early 20s. I shoulda swung for the fences more often.

      • says

        Last time I took a flyer I did it with LEAPS on Ford. Sold too soon, and turned what could have been 3-500% into +/- 50%. It was the only position ever where I didn’t follow my original plan getting in. I just couldn’t handle it. I never sweat my investments, but that position tore me up.

        Value can pay, too. The best stock in my portfolio right now is CNRD, which after adjusting cost basis for a special dividend in 2012 is up nearly 100% in less than a year. Still trades for right around 4x EV/EBITDA despite the pop. More than half of my 11 best ideas each year have doubled or bought out at 100%+, despite the fact that they were all unsexy, undervalued, and underloved boring businesses that will never even get the chance to show up on a WSJ headline.

        Value investing has been perverted into ultra-conservative blue chip dividend investing for income seekers. It grinds my gears that the value label has been slapped on that style. I just want to differentiate the two. It’s a pet peeve of mine.

        • says

          Leaps! Nice. The real juicy stuff for Multi bagger glory!

          I’m a value investor all the way. I don’t like chasing momentum, but there is lots of value in momentum sometimes too. No need to get caught up in investor descriptions I say. Risk/reward and that’s it.

  10. Shaun says

    If I’m up big and am considering getting out I try to put a trailing stop on it. Although what usually happens then is it dips just enough for me to sell then skyrockets and doubly angers/screws me.

    A win is a win as far as I’m concerned though so it doesn’t bother me too much. Especially if that win was quick. If I buy a stock and a few days later it zips up like 5-10% I pretty much always sell because I figure if that happened every time I bought a stock I’d be doubling my money in no time at all. Not sure if thats a terrible strategy or not. Works for me though.

  11. says

    Yeah, I’m sitting on some TSLA stock which is rocking! Probably too good to be true. Do you think it’s worthwhile to sit on it and go long?

  12. says

    If I was in your shoes I would probably sell Sina and Baidu, because I would be content with those profits. At the end of the day it all depends how risk adverse one is and how much play money is on the table. We all get caught up with trying to push the investments to reach new goals, but the profit you initially thought you would make is already there so why not take it and move on. I rather be happy now than have regret later with a correction. If the stock splits and continues upward, it doesn’t mean you’re a loser as you already won. I hope that made sense to you.

    • says

      I agree. And I did sell roughly 70% of my holdings and went completely market neutral by buying SDS, the ultra short SP500 ETF on Monday. Just in case the stocks go higher, at least I’ll have some exposure. Losing money on 30% position doesn’t feel painful at all to me, especially with the profit buffer.

  13. says

    I usually take profits at around 10-15% since a lot of the stocks I buy tend to move up and down by 5% every other day. Since like you say I can’t time the market its not a profit until I sell and cash in. So I take a little off the top and sit back and wait. I let if run if I am playing with house money and already pulled my investments back into my account to buy another holding or wait on a pull back to buy more of the current position.

  14. Mike says

    I guess you are a lot more into the stocks scene than I am. I much rather invest in real estate, websites, and mobile apps. Things that I feel like I have a little bit more control over long term. Stocks almost seem to be a little too wild for me since any bad news (no matter how small) can drastically effect a company’s stock price.

  15. Will says

    Sam,

    RENN has run up to $4.56. With earnings coming out tomorrow (8/14/13), do you think its a good time to take profits?

    • says

      Crazy move today. Who really knows? I’ve sold some today, but still have 25% of my original position remaining and will ride to whatever. Even of RENN goes to $0 now, which it won’t, I’ll still be up with this method.

      • says

        So it has really worked for you, hasn’t it? :) Interesting to see someone really riding stocks out, I would be struggling to hold on anything that has moved into the profit zone!

        • says

          I’ve sold 75% of my holdings in these rocket ships and will just let the remaining ride. I don’t know the future but every single one of the stocks have breached my Target Prices.

  16. Phil says

    Good forum.

    I have some outrageous experiences/plans to add, but too late (in the PM) to do so now.

    Enjoyed reading your material, along with feedback from members.

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