Stock Picks | Bubble Charts Dilemma - When To Sell?

22nd Dec '14 by David Brightside

7 comments 5543 reads

I find your bubble charts most helpful but they give me this dilemma: my portfolio chart of eleven uk stocks is in the top left segment - good but expensive. However they were all cheap when I bought them. They still all show a good stock rank. They pay increasing dividends and forecast annually increasing profits and are cash generative.. I rate the quality and management of the companies. Should I sell proven winners with more mileage in them or run them?

David Hutt

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David Brightside

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7 comments

Cuthbert C

23rd Dec '14

"...Should I sell proven winners with more mileage in them or run them? "

Yes of course you should.

Edward Croft

23rd Dec '14

Can I paraphrase your question for other readers:

If you are someone who likes buying 'good, cheap' companies, then how do you decide to hold them if the become 'good, fairly valued' or even 'good, expensive' companies ?

I will share my philosophy about running winners, and it's not the consensus view - it's much more an empiricist's view.

It's very much acknowledged in the literature that value and momentum are the two primary powers behind stock market returns (often called stock market anomalies). While most investors understand the value effect, not many appreciate the momentum effect. But they are flip sides of the same coin - value shares often outperform due to the power of mean reversion (cheap things become fairly valued), while momentum shares often outperform due to the power of trends to persist.

If you buy good shares when they are cheap you are exposing yourself to the value effect (mean reversion) with an added boost from the compounding impact of companies that can reinvest in themselves at higher rates of return without dilution. A double whammy.

But once they've become fairly valued you no longer can count on the value effect helping you out - all you have to drive your market return is the quality of the shares. And higher quality shares do tend to outperform - but not nearly as much as cheap shares or momentum shares.

So - the question I always ask myself when value shares become fairly valued is - "has this stock (which was previously a value stock) now become a momentum stock ?" If so, then I'm happy to continue to hold. If not, then I may consider selling. It's better to own a fairly valued or expensive share if it's exposed to the momentum effect - either with strong price momentum, or strong earnings momentum.

There are many pure contrarian investors (like David Dreman) who will categorically cut all value stocks once they've returned to a market average valuation. Dreman's done very well with that philosophy, but I think out and out value investors risk medium term underperformance by denying the power of the momentum effect. Many have suggested that Buffett has been a momentum investor. He'll buy quality / value, but hold momentum.

The easy way to check this is to use the other bubble chart tab "Quality + Momentum" rather than just "Quality + Value". Often a portfolio can move from what I call a QV portfolio to a QM portfolio. Whether one is comfortable with that is a personal decision.

I would though say that it's important to have a strategy, and stick to it - not let your strategy morph too far from value to momentum. It's very important not to fall in love with your stocks. To attain truly exceptional outperformance requires a lot of discipline !

David Brightside

23rd Dec '14

Thanks very much Ed, for taking the time and giving valuable input. Like magic, running the Q/M screen moves everything across from Q/V top left to Q/M top right quadrant.
Suggestions that Buffett is a momentum investor is a helpful insight. Perhaps he would say it should be a predictable consequence of getting your Q/V decision right.
"Very important not to fall in love with your stocks"......... I know, I know... Easier
said than done.

mpat89

26th Dec '14

how does one view these bubble charts?

Murakami

26th Dec '14

Hi, we explain that here in the FAQ section: http://help.stockopedia.com/knowledgebase/articles/478642-how-can-i-analyse-the-stockrank-distribution-of-my

marben100

27th Dec '14

Here is my personal view on this issue...

Buying and selling doesn't have to be an "all or nothing" decision. I tend to look at it as an asset allocation issue and pose the question to myself: "how much of my portfolio do I wish to have in this one company"? When prices change sufficiently that the proportion invested in any given company deviates significantly from the target, I will buy or sell accordingly. As with Ed's suggestion, I only tend to change the target proportion slowly in response to alterations in pure value metrics due to price movements (and/or newsflow). This approach brings two benefits:

It ensures that your cash is allocated sensibly, and risk is controlled.
Psychologically, reducing a holding as a result of this process is a "win win": if the share price continues to advance, you still gain in your remaining holding (just a little less than you would otherwise have done); if it declines, you'll be pleased to have banked some profits.

A classic illustration application of this policy has been with Judges Scientific (LON:JDG) . I purchased 3 tranches of the company's shares in October/November 2011, below £4.20 (with a view to pound cost-averaging short-term price movements), resulting in a small to midsized holding. Within 4 months the shares advanced by 50% to over £6.50, turning that midsized holding into one that was uncomfortably large, for me, so I sliced 20% of the holding. The share price continued to advance, and I made further topslices @ £8.33, £11.56, £14.54 and finally at £17.35. By the time of that final topslice my holding was down to 25% of the number of shares I'd originally purchased - but of a similar size by £ value! The share price subsequently continued to advance to peak at £23.75 in April this year. You might think "how foolish, giving away those gains"... but now consider what happened next: the share price halved within 5 months, reaching a low of £11.07 in October. Had I just held on, riding a momentum wave, the peak value of my holding would have been huge (~8% of my portfolio) - and the resulting loss on the share price collapse would have severely impacted my overall gains for 2014 (currently showing a total return of +6% for the year).

I have actually taken advantage of the share price decline to repurchase a tranche of shares @ £12.40 - because I still like the investment case for the business and wanted to restore somewhat the much diminished value of/allocation to my holding.

An interesting exercise for me was to examine what my position would have been now, had I simply just held on to my original investment. Had I done so, I would now own approximately 2.5x as many shares as I currently do BUT, at present, not only do I have a slightly larger holding, by value, than that I originally purchased, but I have also had net cash back equivalent to 150% of my original investment (that is after my recent repurchase)! Net-net, my RoI is only slightly less than it would have been by holding on, with a much lower level of risk.

A couple of personal factors that have led to this approach:

I feel I have zero ability to "time the market", so never know whether my timing will prove to have been good or ill-judged, except with the benefit of hindsight
I don't believe in simple price-based stop-losses. I feel that they are just as likely to result in selling at the worst possible time (when the price has dipped temporarily) as in rescuing you from a collapse. When the share price of a holding falls I do think carefully about likely reasons for the fall, and may adjust my holding/allocation accordingly: whether they are purely sentiment driven, or whether there has been any fundamental change to the investment case for the holding.

Others may feel differently about these issues and hence adopt different approaches. The one thing I have learnt over the years, and from being lucky enough to have made contact with many highly skilled and successful investors, is that there is no "one size fits all" approach that suits all investors. Each of us has to find an approach that suits our own circumstances and psychological make up.

Mark

loglorry

27th Dec '14

My approach is quite different for most investments I hold. I tend to buy something that is deep value/distressed. It will either go bust or increase significantly. In many cases it was really very cheap for a reason and you find out later you overpaid. I tend not to go more than about 5% initially.

If it turns out to be the bag of s*** that it probably is you'll be down almost all your investment and so cutting your losses doesn't really make a lot of difference. I quite like fixed income that is still paying something so even when it goes badly wrong you can often recoup say 25% of your investment in the form of coupons .

On the upside case if things do improve and it re-rates then I don't often top slice until the investment has run a long way and often it pays coupons as it does. In many ways you are buying a long dated out of the money option which more often than not goes bust but can significantly re-rate and pay out as it goes.

There are some advantages/disadvantages with this strategy.

You get quite a few losers so you have to run your winners to cover losses. If you were to take quick profits on winners then you can see that this strategy would not work at all so letting winners run to become quite large % of portfolio is necessary but does expose you to portfolio concentration. I tend to just put my head in the sand here. For example I'm now very exposed to LBG fixed income but see it as relatively secure.

By buying things that are already a pile of s*** there is less to go wrong! Judges was interesting but seemed to be growing in a way similar to Quindell - very quickly by acquisition. I'm not for one minute saying they are similar - Quindell is a fraud. However at £17+ there is quite a lot to go wrong! Hence I guess the reasons to top slice.

Another reason I tend to avoid top slicing too much is that the special sits I'm into are more binary in nature. If a bank is bailed out and gets a capital injection that's a step change in the value of its debt securities. In some ways it completely changes the profile of the investment. There is to some extent a natural hedge because the price has re-rated on something very tangible rather than growth stocks where p/e multiples get blown out because investors start to expect more and more growth which may or may not materialise. Furthermore, when these types if fixed income payers re-rate they still throw off large income streams that can be re-cycled to take positions again in similar situations thereby growing the porfolio by additions rather than replacement.

Log

Ps I've no idea if this strategy is any good compared to others but it seems to be working for me.

Pps. I've almost always average into a position long and short but once it hits a limit I tend to stay there but have been known to get quite obscenely overweight if I'm pretty sure.

PPs. I should point out there is a big difference to just buying something cheap (e.g. has fallen a long way) compared to buying something distressed that has a good chance of recovering. Plenty of beaten up AIM O&G stocks out there now but very few have a route out of the mire.

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Bubble charts dilemma - when to sell?

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David Brightside

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