Let Your Winners Run

"Bulls make money. Bears make money. Pigs get slaughtered." The point of this Wall Street adage is that you can profit by owning stocks or by betting against them, but you run the risk of losing big-time if you get too greedy. I think the Street undervalues piggishness, however. In trying to beat the market, nothing is more important than developing the fortitude to stick with a big winner. A few great stocks held for many years can turn an otherwise average portfolio into a stellar one. Even Warren Buffett has said that relatively few stocks have accounted for much of his prodigious performance.

Fear of flying. Research shows that individual investors sell their winners much too soon (and hang on to their losers too long). Consider someone who bought Apple at $7.50 in August 2002 and sold it 20 months later for $15 (both share prices are adjusted for a subsequent stock split). Smart trade, right? Not when you realize that Apple now sells for $185. Premature ejection is a problem for professionals, too. In my own case, I've sold holdings in Fuel-Tech, Deckers Outdoor and PetroChina way too early.

Why is it so hard to hold on to winners? Friends tell you not to be a pig. Talking heads on TV say a big gainer is overvalued. Deep down, you worry that the stock will soon plunge, leaving you with a round-trip, or worse.

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I know the feeling. In August I bought shares of dry-bulk shipper DryShips. Within two months, they had doubled. Sure, I felt elated, but part of me felt terrible. I worried that my gains might quickly vanish. I reflexively feared that DryShips might now be overvalued, simply because of the change in its price.

Given these kinds of conflicting emotions, how do you hold on? First, try to be rational rather than emotional. "When a stock rises dramatically, you have to revalue the company," says hedge-fund manager Mark Sellers, of Sellers Capital, in Chicago. "Has the value of the company changed or just the value of the stock?"

Forget how much you've already made (trust me, the stock is unaware of your $26,500 profit). Instead, focus on the company and its future. If it was an undervalued asset that has now reached fair value, or if it's a purely speculative stock that, mirabile dictu, has doubled in a month, by all means sell.

If it is a great company, however, try to determine its current fair market value before doing anything. When you own a terrific company, you don't want to sell simply because it is fairly valued today. That's because the company will continue to grow.

Of course, determining fair value is easier said than done. Shares of Apple, one of my largest holdings, fell from $149 to $111 last summer, the dreaded 25% pullback that everyone wants to avoid. But I did nothing, having calculated Apple's fair value at $200. I arrived at that price by figuring that Apple should trade at 35 times my higher-than-average earnings estimate of $5 a share (excluding the interest Apple earns on its cash holdings) for the fiscal year that ends in September 2008. That took me to $175. Adding the value of Apple's cash holdings took me to $195. I added another $5 per share for deferred income on iPhone sales, although this estimate could prove low.

When I'll sell. CNBC's Jim Cramer says to take some profits off the table when you have a big winner. That's poppycock. Why sell shares of your best company to buy shares in a lesser enterprise? I will sell some Apple at $200 or $225, when it becomes an unwieldy part of my portfolio. (Now, if taking some money off the table lets you sleep better or allows you to hang on to part of a position that you'd otherwise sell in its entirety, do it.)

When in doubt about how to handle a big winner, think of the greatest investors of all time. They tend to have low turnover -- because they let their winners run.

Columnist Andrew Feinberg writes about the choices and challenges facing individual investors.