In and Out ... Then In Again
A market without strong trends requires flexibility, so consider this twist on the old buy-and-hold: buy and sell shares and then buy them again.
By Jeffrey R. Kosnett, Senior Editor
From Kiplinger's Personal Finance magazine, June 2004
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What could be simpler than buying a stock and holding it forever -- or at least five to ten years at a minimum? You make one decision, keep commissions low and postpone taxes on your gains. It's a way of investing we've always endorsed.
But the truth is, buy-and-hold investing isn't always what it's cracked up to be. Few stocks rise in a straight line indefinitely, and shares of even the best companies can, and do, endure lengthy periods of stagnation. Consider General Electric. Sure, it has meandered, but the behemoth's stock is right where it was in 1999. Microsoft, another giant, is at its June 1998 level. Coca-Cola? Stuck in a rut for seven years.
Instead of buying a stock and placing it on autopilot, we suggest this alternative: Buy and sell some shares ... and buy again. It's not day trading or even monthly trading, but a plan for managing -- not just owning -- your stocks. It means you stay ready and willing to sell and also to repurchase, especially if you like the company for the long term.
The immediate reason to consider an in-and-out strategy is the high level of stock prices. Hundreds of stocks are at or just below their five-year highs or even their all-time peaks. The overall market, selling at 19 times estimated 2004 profits, is perhaps reasonably priced -- but could be vulnerable to a setback should today's low interest rates begin to rise, as is widely expected (higher interest rates would make bonds and money funds more attractive in comparison with stocks).
Throw in all the other uncertainties--from fears of terrorism to sluggish U.S. job growth--and it's no wonder many experts foresee a market that over the next couple of years takes two steps forward, two steps back and then repeats the pattern. In that kind of scenario, the nimbleness with which you manage your stocks will determine your portfolio's performance at least as much as the stocks you buy in the first place. Here are three ways to know when it's time to trim your positions and when to buy the shares back again.Home on the range
Many stocks move inside a "trading range": When a stock's price (or, sometimes, its price relative to earnings or some other yardstick) reaches a certain level, some investors sell and take their gains. Then, after the stock drops to the lower part of its range, bargain hunters appear. Nobody can predict exact tops or bottoms, and you'll get frustrated trying to do so. But as a rule, you can resolve to buy in the bottom half of a stock's range, sell when it gets near the top of the range and keep repeating the process, says Mark Keller, chief investment officer for A.G. Edwards Asset Management, based in St. Louis.
The trick is to identify the range. The easiest kind of range to spot is when a stock trades in a pattern that is recognizable on a price chart. Consider the action in Wal-Mart. Five times since 2000, the stock of the retailer (symbol WMT) has run to or just above $60. Each time, the stock subsequently retreated to the mid $40s. At that point, buying picked up and the price charged back toward $60 or a little higher. The repetition is uncanny.
You may ask why you should expect Wal-Mart's stock to stay stuck in this range, given that the retailer regularly generates higher profits. Because of that, Wal-Mart, at $57 in mid April, is a far cheaper stock, on a price-earnings basis, than it was five years ago at $57. And it will become even cheaper as long as earnings continue to grow. But as Wal-Mart gets bigger, earnings can't rise as quickly as they did before, so the stock is gradually sliding into a lower P/E range (fast growers typically command higher P/Es than slow growers).
The stock sells for 24 times the $2.37 per share that analysts expect Wal-Mart to earn this year, according to Thomson First Call. That is well below the stock's P/E range from 1998 through 2002, but well above the P/E range from 1994 through 1997. And it's just a hair below the average P/E of 27 for 2003, according to Value Line. So, it makes sense to trim your stake in Wal-Mart as it approaches $65 (at $65, it would sell at 27 times estimated 2004 earnings) and contemplate buying back the stock as it approaches $50. You can find earnings histories and P/Es from Standard & Poor's (available through many online brokers) and from Value Line, which charges $538 a year for its online investment survey. Two good sources for charts, at no cost, are Finance.yahoo.com and Bigcharts.com.
The unvarnished stock price isn't always the best fence around a range. For example, many financial stocks trade up or down on their ratio of share price to book value (a company's assets minus liabilities).
Look at the progress of Progressive, which sells car insurance to drivers with poor records. Relative to the premiums it collected and the payments it made to clients, Progressive (PGR) had a lousy 1999. And in 2000, it lost money on claims for the first time since 1991. Over those two years, the stock tanked from $58 to $15.
But even if your eyes glaze over at such arcane concepts as insurance-loss ratios, shareholders who paid attention to the ratio of Progressive's price to its book value could have avoided calamity. In 1999, when the stock peaked, its price-to-book ratio hit a sky-high 4.5. The typical ratio for property-casualty stocks at that time was 1.5 to 2, and Progressive's usual level is around 2.5.
But Progressive wasn't involved in fraud, nor did it have a pile of bad loans on its books. So, in early 2000, when the stock hit $15, just above the company's book value then of $13 per share, investors were presented with an obvious opportunity to jump back in. Now, at $89, Progressive trades at 3.6 times today's book value. That's pushing things.
Ride the cycles
Companies -- and their stocks -- don't all dance to the same economic tune. Some are more sensitive than others to the overall ups and downs of the economy and to interest-rate trends. And with short-term interest rates at multigenerational lows, many economists expect the Federal Reserve to start boosting rates later this year to prevent the economy from overheating.
Based on his studies of previous cycles, strategist Ed Yardeni of Prudential Equity Group suggests that investors quickly cut their exposure to economically sensitive groups when the Fed begins to hike rates. Among those groups are automakers, homebuilders, makers of household appliances, railroads, and construction- and farm-equipment com-panies. The converse, of course, is that you can buy these groups back when interest rates start to fall. What to buy when rates rise? Try shares of brewers and soft-drink makers; people quench their thirst no matter what the Fed does.
Beyond the matter of interest rates, it's crucial to know what makes a business tick. That knowledge enables you to sense when sales and profits may be peaking--almost always a good time to sell.
Consider Deere. We've suggested the stock (DE) several times in recent years on the assumption that as crop prices were rising from depressed levels, farmers the world over would upgrade their aging tractors and harvesters with new, more efficient models. This scenario has come to pass (farmers have also been able to obtain cheap financing), and it explains why Deere, at $73, has more than doubled since 2000 and is at an all-time high. Selling at 18 times analysts' 2004 earnings estimates of $4.13 per share, Deere doesn't appear to be particularly expensive.But Deere is the kind of up-and-down company you need to watch closely. For now, things are looking up. In February, Deere forecast a bountiful harvest in 2004, predicting that sales of farm equipment, the company's largest business, would jump by 20% to 22%.
What might darken the rosy outlook? Keep an eye on commodity prices. If corn, wheat and soybean prices start to sag, farmers will suffer and so will Deere's dealers. In this case, astute investors will begin to bail instead of waiting for Deere to announce that it won't be able to meet its earlier optimistic goals.
By the same token, a rebound in commodity prices would be the tip-off that it is safe to tiptoe back in to Deere. But don't count on the stock sinking back to the $30 at which it traded in 2000. There may be plenty of fits and starts with blue-chip "cyclicals" such as Deere, but the long-term trend is up. Look for the stock to bottom in the $45 to $50 range the next time the farm economy runs aground.
Bad-news vibes
You know the drill: A company says it won't meet analysts' earnings estimates or issues some other disheartening news, and its stock craters. Many investors, fearful of the cockroach effect (which holds that disappointments, like roaches, generally come in bunches), sell first and ask questions later.
If you own the torpedo du jour, be prepared to act. If the news is so chilling -- hints of crime in the suites, earnings restatements, a mysterious executive departure -- that your faith in the company is shattered, run and don't consider a return at any price. Anyone who dumped Enron for $42 a share, when then-president Jeffrey Skilling quit but didn't come clean as to why or what was wrong, did better than those who held in vain and got nothing.
However, many shockers aren't so cataclysmic. The disclosures that cause so much anguish on Wall Street often represent temporary, easily fixed problems. After you consider the facts, decide whether you think the company can get its problems under control quickly. If that's your conclusion, don't sell immediately. Instead, guard against an aftershock by entering a stop-loss order to sell at 10% below the stock's close on the day it takes its initial plunge. For example, if you own a stock that has tanked from $25 to $20 because of bad news, you place an order with your broker to sell automatically if the stock subsequently touches $18 (10% below the $20 close).
The stop-loss strategy gives you a chance to stay on top of the stock and await further developments. A case in point is Cardinal Health (CAH), a giant, diversified health-care concern. Its shares fell from $64 to $55 one day last July when chief executive Robert Walter surprised investors by saying that Cardinal's rate of earnings growth would slow from 20% a year to 15%. He blamed tough price competition in Cardinal's biggest segment, drug distribution.
As it happens, Cardinal never fell below $54 so you would have held on to the stock had you followed our stop-loss strategy. And a good thing that would have been. The shares recently stood at $70. But even if you had sold all or part of your Cardinal stake, a bit of reflection might have given you second thoughts. Anyone even casually familiar with Cardinal knows that the company is so wide-ranging that a slowdown in just one part of its business, even if it was a big part, hardly justified a $4.4 billion reduction in its stock-market value. This was one instance when the roach came alone.
--Reporter: Joan Goldwasser
