Tag Archives: ideas

Investment Strategy: When To Sell A Stock?

By Rupert Hargreaves Deciding when to sell a stock is often a more complicated process than buying it in the first place. Indeed, holding onto a loser for too long can severely curtail long-term returns. The same can be said if you hold onto a winner for longer than needs be as a sudden shift in market sentiment might see the majority of your gains erased. With this being the case, refining your selling process is a vital part of developing your investment strategy. This is a topic the February 29 issue of Value Investor Insight looks at in an interview with Danny Bubis, Ben Ellis, Jay Hedstrom and Amar Pandya of Tetrem Capital Management , which has produced an annualized return for investors of 8.9% since 1997, vs. 7.1% for the S&P 500. When To Sell A Stock? Investment strategy: When To Sell A Stock? Tetrem seeks out companies using a value approach: beaten-down stocks reflecting an unwarranted pessimism over the persistence and sustainability of their businesses. Of course, the selling process starts when the fund first buys an investment and research on each company is focused on modelling each potential investment’s fair value on the basis of normalised earnings in the base case, bull case, and bear case and the justified multiple for earnings in each of those scenarios. When these scenarios have been calculated, the fund’s analysts assign probability weightings to each case, and then use this probability weighting to calculate the potential upside the security. Generally speaking, the fund is looking for $3 of upside for every $1 of downside. Why does Tetrem Capital use a probability-weighted fair value calculation? Well, according to Danny Bubis this approach helps the fund better frame things in terms of risk versus reward and results in better investment decisions. When it comes to selling, Tetrem’s team has decided to refine their selling process after observing that many of the fund’s missteps have involved sticking with losers too long or not letting winners run long enough. To counter these mistakes, the fund’s team is making a more concerted effort to have high conviction buys push out more marginal ideas. The key test here: if the stock in question fell 10% to 20%, would the fund step in and aggressively buy more? If the answer is no, then there could be better ideas out there. Another rule the fund has introduced is that when something happens, which puts the original investment thesis at risk, the weighting in the fund is immediately reduced to 1.5%, a normal weight the fund is around 3% – no matter what the stock price does. These two parts of the firm’s investment strategy help Tetrem manage the downside; when it comes to the upside, the fund also has a rule in place to ensure that it does not get caught out by letting a winner run too long. Upside management technique Tetrem’s upside management or profit taking method is based on its fair value probability calculation. In the interview with Value Investor Insight, one of the fund’s current positions, Microsoft (NASDAQ: MSFT ) is used as an example. Originally, Tetrem acquired Microsoft when it was a beaten down by the market due to its entrenched management, reliance on PC and weakness in consumer markets. However, over the past two years, the company has transformed itself and successfully adapted to a mobile-first, cloud-first world. The stock is up 100% in five years, excluding dividends and Tetrem’s probability fair value estimate has increased alongside the stock price, as the company has grown and developed with the market, the probability of the bull case is higher, and the probability of the bear case is lower. This floating fair value probability estimate helps Tetrem’s team stick with compounders longer than it might have done without the floating calculation. Disclosure: Rupert may hold positions in one or more of the companies mentioned in this article.

It’s Not All About Earnings

Earnings, earnings, earnings: On Wall Street, profits are king. Headlines are filled with references to prominent companies’ earnings – panic often ensues if a firm falls even a few pennies short of analysts’ profit expectations. And when pundits talk about valuations, either of individual stocks or the market as a whole, they more often than not base their assessment on the price/earnings ratio. But earnings don’t always tell the whole story. In fact, oftentimes other metrics can provide an even better gauge of how a company or the market is doing. The Price/Sales Investor strategy I track on Validea.com is a good example. The key variable it looks at is the price/sales ratio – PSR – which compares a company’s market capitalization to the amount of sales it has taken in over the past year. The approach is inspired by the work of Kenneth Fisher, who in his 1984 investing classic Super Stocks pioneered the use of the PSR as a way to evaluate stocks. Fisher thought there was a major hole in the P/E ratio’s usefulness. Part of the problem, he explained, is that earnings – even earnings of good companies – can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter’s profits into the next quarter’s losses, without regard for what’s truly important in the long term – how well or poorly the company’s underlying business was performing. But while earnings can fluctuate, Fisher found that sales were far more stable, and a better gauge of a company’s strength and prospects. On Validea.com, I track a number of strategies I’ve developed based on the approaches of history’s most successful investors. My 10-stock Price/Sales Investor portfolio is one of my best performers, averaging annualized returns of 10.5% since its mid-2003 inception vs. just 5.8% for the S&P 500. How exactly does the Price/Sales Investor strategy work? It starts, of course, with the PSR, looking for companies with PSRs below 1.5, and really getting excited when a PSR is under 0.75. One caveat: Because companies in what Fisher called “smokestack” industries – that is, industrial or manufacturing type firms that make the everyday products we use – grow slowly and don’t earn exceptionally high margins, they don’t generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products. The Price/Sales Investor approach looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4. The Price/Sales Investor method also incorporates several other criteria based on Fisher’s work. They include: average net profit margins of at least 5% over the past three years; debt/equity ratio of no higher than 40%; positive free cash flow; and inflation-adjusted earnings growth of at least 15% per year over the long term. For companies in the technology and medical industries, it also looks at the price/research ratio – the firm’s market cap divided by the amount it spends on research. The more research spending the better (since good research can lead to future profits), with a price/research ratio under 5% the best case. Fisher isn’t the only investment guru whose research has pointed to the PSR as a great tool. James O’Shaughnessy, another of the strategists upon whom I base my investment models, made the metric a key part of his top growth strategy in his 1996 classic, What Works on Wall Street . O’Shaughnessy found that a combination of a high relative strength over the past year (relative strength is the percentage of stocks in the market that a particular stock has outperformed) and a low price/sales ratio (under 1.5) was a dynamic combination that could identify hot growth stocks that were still cheap. As always, when using a quantitative screening model like my Fisher- or O’Shaughnessy-inspired models, you should invest in a basket of stocks to diversify away stock-specific risk. With that in mind, here are a handful of picks that these 2 approaches are high on right now. Sanderson Farms (NASDAQ: SAFM ) : Mississippi-based Sanderson, founded in 1947, is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared food items. It employs more than 11,000 employees in operations spanning five states and 13 different cities, and is the third largest poultry producer in the United States. Sanderson ($2 billion market cap) has a growth/value combo that impresses my Fisher-based model, which likes its 31.7% long-term inflation-adjusted EPS growth rate and 0.7 price/sales ratio. The strategy also likes that Sanderson’s debt/equity ratio is less than 1%, and that it is producing nearly $5 in free cash per share. Thor Industries, Inc. (NYSE: THO ) : Thor ($3.2 billion market cap) manufactures and sells a wide variety of recreational vehicles throughout the US and Canada, including the Airstream line of campers and trailers. Its products include conventional travel trailers, fifth wheels and park models. In addition, it also produces truck and folding campers and equestrian and other specialty towable vehicles. Thor gets high marks from my Fisher-based model, in part because of its 0.76 PSR. The strategy also likes the RV-maker’s 17% long-term inflation-adjusted growth rate, lack of any long-term debt, and $2.78 in free cash per share. Foot Locker, Inc. (NYSE: FL ) : This specialty athletic retailer ($9 billion market cap) gets strong interest from my O’Shaughnessy-based model, which likes its 1.2 PSR. This approach also looks for firms that have upped earnings per share in each year of the past five-year period, which Foot Locker has done. And, as I mentioned above, it likes to see strong momentum behind its holdings, and Foot Locker’s 12-month relative strength of 72 fits the bill. Southwest Airlines Co. (NYSE: LUV ) : This one-time upstart has become a major player in the industry, taking in nearly $20 billion in annual revenues. The Dallas-based firm operates Southwest Airlines and AirTran Airways, and gets strong interest from my O’Shaughnessy-based model. A big reason: its 1.4 PSR. The strategy also likes its persistent earnings growth over the past five years and its solid 72 relative strength. Disclosure: I am/we are long SAFM, THO, FL, LUV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Q1 Asset Class Returns

The first question we had to ask ourselves after looking at the returns in March was, “Are the asset classes becoming increasingly correlated?” Here’s what happened in March by the numbers: 7 of the 8 Asset Classes recorded positive returns in March 4 of the 8 Asset Classes posted significant returns in March (Above 4%) 10.32% – The return of Real Estate in March 4 – Number of slots Real Estate moved up in the asset class scoreboard after March 2nd place – Where Managed Futures currently ranks despite a down month in March Real Estate: A double-digit return in a month is something you cannot ignore. What’s with Real Estate? The ETF we use (NYSEARCA: IYR ) tracks 100 different real estate companies , but the rebound could have something to do with another asset class… bonds (interest rates). Bonds: Depending on what Bond Market you watch, it was a big month. With the ETF we use is only up around 3% on the year, but the High Yield bonds cracked the Top 25 for best all-time monthly performance {Disclaimer: Past performance is not necessarily indicative of future results}. For those that have been following along the low interest rate environment we’ve been living in for almost a decade, low interest rates are good for people looking to purchase a home or refinance their mortgage. World Stocks, U.S. Stocks, and Commodities: Is the fact that these three asset classes all moved in tandem in March a coincidence or are these markets showing their true colors or being highly correlated? Last Week, we charted the current rolling 30 day correlation of the S&P 500 has to Crude Oil and not only has the correlation been increasing, 2016 has shown the highest correlation over a two year period. Managed Futures: Finally, Managed Futures had a tough month with the U.S. Dollar experiencing a choppy downward market. Combine that with the $VIX returning to the lows we saw constantly throughout 2014 and some of 2015 , and it was a struggle for managers to capture trends in choppy markets. We know the managers that we work with were long commodities but late reversals in the markets took away any gain made earlier in the month. The good news is that combined with the strong first two months of 2016 is enough to keep Managed Futures in 2nd place, despite a down March. Here’s the full look at the Q1 performance of 8 asset classes. Click to enlarge Click to enlarge (Disclaimer: past performance is not necessarily indicative of future results.) Source: All ETF performance data from Morningstar.com Sources: Managed Futures = SGA CTA Index, Cash = 13 week T-Bill rate, Bonds = Vanguard Total Bond Market ETF (NYSEARCA: BND ), Hedge Funds= IQ Hedge Multi-Strategy (NYSEARCA: QAI ) Commodities = iShares GSCI ETF (NYSEARCA: GSG ); Real Estate = iShares DJ Real Estate ETF ( IYR ); World Stocks = iShares MSCI ACWI ex US Index Fund ETF (NASDAQ: ACWX ); US Stocks = SPDR S&P 500 ETF (NYSEARCA: SPY )