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WHEN SHOULD WE SELL
By Donald Pearson
Every broker, financial planner, and investment advisor that I know addresses this part of the business differently. As I review the portfolios transferring into our management, in many cases no one focused on the selling part, and this could be the most important reason for a portfolio’s underperformance. As often as needed their formula for selling should be reviewed for each client and overhauled when necessary.We see over and over that the time needed for research to sell is not given the same priority as the amount of time set aside for buying.
It is my opinion finding the right stocks to purchase to build a well-diversified portfolio is one of the most difficult endeavors one can do successfully. I will also add that selling at the right time can produce the same, and in many cases more, benefit for the overall portfolio’s success, although this is an even more difficult challenge. The most important lesson to learn about selling is no one will be right all the time, yet if you remain committed to your system, and if it’s a good one, you can be right more often than not, and this will produce very favorable results.
I’m going to try to outline our system by using real account decision making over the last few months and the information gathered that led to the actual sell. It always begins with the negative news of the day or a company’s reported earnings. Disappointing earnings or bad news becomes the immediate alert to research the company.
Many of your customized portfolios contained AmerisourceBergen and Alliance Bank last week, yet today they are no longer there. As their reporting numbers were less than we expected, this became an opportunity for their review. Once our systems of evaluation alert us to slow or no growth, we begin to look for replacements. You may have seen them
exchanged with R & G Financial or Bed & Bath if your portfolio needed a stock from these sectors for diversification. We didn’t see this as a selling event. We saw this more as a portfolio improvement. Simply said we just traded up.
Almost all of our full-size portfolios with fifty or more stocks have two, three, or four home builders. For two years now the news has been consistently negative because this sector has supposedly peaked and interest rates are on the rise. Many advisors and brokers have said sell, sell, sell. We have held firm, and still do today, believing there is still more to be had with them. In yesterday’s news, Pulte Homes, the #2 U.S. home builder, increased its forecast to 20% annual growth for the next three years. When this announcement was made, the stock went up 9%, and this news lifted the entire sector. Do we plan to leave this sector in the immediate future? No. Do we have this sector under close watch so we can execute a timely exit strategy when it appears the right decision? Yes. For those that had Orleans Holmes in their portfolios recently you’ll notice this was sold because their performance lagged the industry standard.
A few months ago we had Coventry Health under our review process simply because the stock price was dropping quickly. When they announced the acquisition of another company, their stock price went from $53 in October to $39 a share in November. If we had placed stops on our selections of 5 or 10%, it would have been sold from everyone’s portfolio. Imagine being sold out of this and then probably not being able to find something as good as what you’ve just sold. We would also have had the problem of at least 15% or more going to Uncle Sam for the profit. We are committed to Coventry as a top stock choice. It is a part of our core holding when we build a new portfolio. In less than three months the stock recovered from this dip. Yesterday Coventry reported another outstanding quarter, and the stock climbed
$3.00 for the day. It closed at $62.00 and proves again why a discipline is needed when making these decisions.
Sometimes the toughest decision is whether or not to sell when the news is bad, yet the fundamentals are good. When Freddie Mac came under investigation, we sold. That proved to be a neutral decision as far as stock recovery. We also sold Pfizer a while back, and that proved to be the right decision. I also want to point out we’ve made some decisions that, if we could do over, we would do differently. As I’m writing this article, W Holdings is on our alert list and may be sold before you receive this investment letter. Their fundamentals are strong as their 21% gain in profits for the last quarter indicates. They are also under investigation by the SEC. If any wrongdoing or criminal mischief is found, the price of the stock will suffer significantly. Just the negative news that’s published already has affected the share price by several percent. We will continue to monitor this closely, and when the decision is made to sell we can execute the order within five minutes. This is a real value compared to a mutual fund that may take as long as a year once the decision is made.
One of the reasons we continue to advocate a portfolio size of 48-60 stocks, is so that no one stock can maintain a large enough percentage to impact overall performance. If each holding is approximately 2%, and it suffers a 40% negative price adjustment, it still is less than 1% of the overall portfolio. Occasionally we are asked why we sell so little, while occasionally others believe it’s too often. I can tell you when a portfolio is built, we believe nothing will be sold for at least three years. Everything bought is perceived as undervalued with double digit growth projected for several years. It is the unknowns and the unexpected that triggers the sell. It might be competitive activity, market change, poor performance, or a host of other variables. A client once said to me, you’ll never have to apologize to me for taking a profit. I’ve also learned if we enact the sell because the indicators say we should, it’s comforting to know our research team has a suitable replacement waiting. Sometimes the trading fee of $9.95 or $15.00 might be the best bargain of the year. Whenever we reference our performance results for you this is always with any and all management and trading fees subtracted. As we begin what we hope to be our fifth consecutive year of outperforming the market indexes, our focus will continue to be on making the right decisions.
SERVICES AND LOWER COST
By Donald Pearson
09/30/2004
When we discuss trading with our clients, the questions most often asked are about how often we make trades within an account, and why do we buy so many stocks that appear to drive up the costs. (Whether buying or selling, $15 taken from an account for each transaction is $15 gone.) I hope to convince everyone that although trading does carry a cost, it might be considerably less expensive once you understand the consequences of not utilizing this opportunity when needed.
Obviously, selecting the right companies (buying), based upon their performance and the impact of their product line, is paramount. For whatever reason, if a company falls out of favor, it must be sold. We also carefully analyze the tax consequences (selling) for each account where profits will be exposed to capital gains.
We have concluded that an account with approximately 50 stocks is the best size from both a manageable and a diversified prospectus. Too many will dilute the core value of a portfolio, and too few will reduce the umbrella of diversification needed in today’s difficult environment. The Dow model is managed with 30, the NASDAQ has 100, and the S&P has 500. Most mutual funds have approximately 175 stocks and keep them within the account on the average of only nine to ten months. Our selections are chosen with the belief they will remain within the portfolio for many years, and selling becomes the exception rather than the norm. Although selling is not our intent, we can and will sell when we believe it is the right thing to do. With fewer stocks within the portfolio and being the immediate decision makers, our ability to react rapidly once the decision is made gives us a huge advantage.
When questioned, I also like to refer to performancesurprises, and their immediate impact. A good example of this is Merck, or Possis Medical. Yesterday MRK removed Vioxx from its selling inventory and the stock dropped more than 30% almost instantly. POSS dropped over 40% on August 25, after their AnjioJet blood clot treatment failed to help heart attack patients as originally thought. The day before these announcements both were the same companies, it’s their stock price that suffered. When we build a portfolio with 50 stocks and each stock has a 2% vested interest, the down side referenced becomes 30-40% of 2%. Perhaps now having more stocks with a slightly higher starting cost looks more attractive. Most people don’t realize mutual funds build their trading costs into the fund itself so the investor doesn’t see them, and doesn’t realize he or she actually pays more in fees.
Speaking of trading fees, I am happy to inform everyone that effective November 1, trading fees will be reduced to $9.95 for all buy and sell activity if your account or combined accounts have a value of $500,000, or more, as of October 15. TD Waterhouse has also given us authorization to include other family members living at the same address. If your portfolios are currently below the $500,000 threshold and you would like to add additional funds, or if you wish to transfer assets from another brokerage house to get them at or over the needed amount, simply call us and Marie, our account manager, will assist you with this.
For those who currently do not view your accounts on our web site, you can call us, and we will set you up for online account viewing within one business day. For those who continue to receive more brochures and business reports in the mail than wanted or needed, you might also contact us, and we can have these stopped for you.
Just a personal note — it feels great informing you of additional services that we offer, and the costs for you may be less. Something different for sure!
LOOKING AHEAD
By Donald Pearson
08/05/2004
When it comes to meeting your financial goals, knowing what’s ahead is only the beginning. Today we are concerned with presidential elections, inflation, oil prices, rising interest rates, and even terrorism. Fixed income investments appear to be less attractive now than they have been in a decade. Ten year bond yields are already down a percentage point from their 2003 lows and will probably drop at least another half point in the near future. This is not good news for those with fixed income investments. Bonds perform well only when we are in a period when interest rates are in a downward cycle. We are also more than halfway through the earnings season, and we are receiving more than the normal number of surprises. What is most concerning, corporate profits for many are hitting record highs, yet their stocks do not receive the lift expected. In many cases this does explain why the stock market is down for the year. When this type of reporting occurs, the price-earning ratios of their stocks continues to go down and in some cases, significantly.
I must admit it requires a discipline on one’s part to watch an individual stock, or an entire portfolio, shrink in value, while at the same time realize a buying opportunity is presenting itself. The twelve months trailing P-E ratio for the S&P 500 is currently around 17, and this is the lowest it has been since 1996. We may have more to give up before the market turns, but at some point the turn will come. The S&P has fallen 4.8%, and the NASDAQ 9.7% this month already, and that represents a nine-month low. Many stocks are still not cheap, but many others are definitely fairly priced, or in some cases undervalued. If you have done your homework, you can find exceptional values in different sectors. And if you do, this does not mean they are going to go up the day you select them. A good example of this is within the medical sector. People continue to age, and additional drugs and services are needed. Many companies meeting these needs are reporting their earnings above where they are forecasted, yet their stock is going down in price. What does this mean to me? Opportunity is knocking!
The hardest part of a strategy, even a good one, is staying the course when you see your principal or your profit declining. Even though we are again in a period of market floundering, it is important to remember a principle we all know only too well: A strong economy will help the market in spite of short-term interest hikes. If I asked you to name the top-performing sector for the past five years, and the gain that sector returned, could you do it? The answer is the casino and gaming stocks, returning 28%. Will they continue this leadership? I don’t believe they will. Although the medical sector is also getting punished at the time of this writing, I believe this is an area where tremendous opportunity awaits those who do their homework and search out the quality companies. Remember we are planning for at least the next five years and in most cases even further. So as important as the next twelve months are, and we all want to be winning all the time, never lose sight of the long-range objective. Corporate profit projections continue to be bullish through 2006, and most forecasters believe they will probably continue even further.
When I am asked what my personal thoughts are for the market, I always reply that my opinion, as that of so many others, is nothing more than an opinion. Last year I thought, along with many others, that the index would go up 8-12%, and it went up around 23%. Almost every one of our clients had a performance return of near 40% or more. Although all of the indexes are down year to date, I still believe ending the year favorably is still a reality. As my father has said so many times, one does not buy the stock market when one buys individual stocks. Research, and many hours of ongoing commitment are the key. Throughout this time period (earnings season) we are hard at work using the company’s reporting information, and our in house formulas to make important short and long-range decisions.
Our task is more challenging because we actually build and maintain each portfolio for all of our clients. This makes the satisfaction of outperforming the index truly more gratifying because of our hands on approach. Even though we did outperform last year’s S&P index of plus 23% by more than 17% on average, this is now a history lesson. We are now hard at work trying to do it again, and if we can it will be our fourth consecutive year.
2004 MIDYEAR REVIEW
06/30/2004
We’ve got six months behind us with six months yet to go before this year is complete. As always, we’ll use the events of the last six months to adjust portfolios and our strategies to continue on the road to success. The most important lesson learned from the first six months is: Things are not always what you think they will be, and you cannot always believe Alan Greenspan (or anyone who predicts where we are going and how we are going to get there). Mr. G told us at every opportunity he had earlier this year that the economy was growing at a perfect clip, Bush’s tax rebates were great medicine to stimulate the economy, and the deficit was not an issue. About eight weeks ago Mr. G changed course and told us the economy is growing too fast, the deficit should be addressed, and interest rates will probably be raised in June or July, with additional rate hikes expected. Anytime someone with his impact on market conditions makes a complete turnaround with his opinion, you’ll see an immediate market swing. This is why there was a huge down period at that time.
If you are favoring certain sectors, the negative news can impact your portfolio’s performance on a short-range basis. We have been very bullish on homebuilders and financials for several years. Although many investors took an above average hit on their stock prices when Mr. G spoke out, they are all now returning to their pre-Alan speech. As an example, homebuilder sales in May surged 14.8% to a new high in spite of predicted higher interest rates. The market indexes are finishing the first half of the year near even, in spite of a solid start at the beginning of the year. People entering the market in mid to late February, March, or early April are actually in the negative right now because of the stock market’s reaction to this change in direction.
Even though much of this information doesn’t sound positive and optimistic, nothing could be further from the truth. Once you’ve digested all of the current information, and you believe you know the impact this will have on the market, the rest is not difficult, only time consuming. Simply said, it’s time to plan the work and work the plan.
I believe everyone has decisions to make with homebuilders and financials held within their portfolios.
We will be reducing our homebuilders holdings, and keeping only the best after our research is completed next week. The same can be said with financials, some will be sold simply because rising interest rates will have a negative effect on their performance. As an example, many of you will see Washington Mutual (WM) sold from your portfolio within the next few days. This has been a CORE holding for PCI for several years. WM has reported two down earnings quarters, and now displays minimal growth potential in the months and years ahead with interest rates on the rise. Only portfolios built for exceptional low risk will keep it, and this is because of its 4+% yield coupled with a single digit price earnings ratio, i.e., safety. Although we will be selling a large amount, WM will remain a part of our CD Buster (model portfolio).
We continue to closely watch all of our financial holdings because there are banks and bank stocks that will actually prosper from a rate hike. Many mutual funds take months and years to complete this exercise for their shareholders such as Fidelity’s Magellan Fund. At last count it had 361 stocks in its portfolio, while our ideal managed portfolio has between 44 and 52. We can do the actual change in less than an hour after the final decisions have been agreed upon predicated on our research. So now, the most important question should be: What does the second half of this year look like?
It’s my opinion the second half of this year should be one of growth for the market, barring any serious terrorist intervention. All the market indicators are pointed in the right direction and companies continue to report earnings on the rise. Even an interest rate hike, when managed correctly, can have a positive reaction to the market. Read Chris’s article on Page 5, and you’ll have a better understanding of this. You may see above average activity within your portfolios over the next few months as we customize them to the changing market conditions. As a true optimist I see this to be an opportunity and a challenge. Our job here is not to control the market, as we know we cannot. Our mission is to outperform the indexes continually. Even if we miss from time to time, the strategy never changes. We search for growth companies 30% or more undervalued with three or more years of solid upside potential. Knowing the market index returns 11.4% annually on average, or has over the last 30+ years, portfolios under our management can really continue to prosper as we apply all we’ve learned from the first half of this year.
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