When To Run Your Winners?

The Motley FoolA very successful investor once told me that good investors are not always the ones that have the greatest ability to pick winning shares. Instead, he pointed out, they are generally those who are willing to cut their losses if things are not going right.

In his view, bad investors hug losses for too long and snatch profits far too early. The upshot is that they end up with small profits and huge losses.

So is the successful investor suggesting that we should run our winners and cut our losers?

Watering the weeds

The concept of “running your winners and cutting your losers” is so entrenched in stock market investing that many accept it to be gospel. But life is never that simple.

Peter Lynch once said: “Some people automatically sell their ‘winners’ – stocks that go up – and hold on to their ‘losers’ – stocks that go down, which is about as sensible as pulling out the flowers and watering the weeds“.

He went on to say: “Others automatically sell their losers and hold onto their winners, which doesn’t work much better. Both strategies fail because they are tied to the current movement of the stock price as an indicator of the company’s fundamental value

Peter Lynch is right, which explains why he was immensely successful as a money manager. Between 1977 and 1990, his Magellan fund averaged 29% return a year.

Point is, if we use the market as a guide to determine the true value of a company, then we are almost certainly on a hiding to nothing. We need to remember that shares move up and down for lots of reasons. And most of those reasons have nothing to do with the underlying business at all.

The thorny question

So rather than trying to predict what other investors may or may not buy and sell; second-guess what American politicians may or may not do and attempt to forecast when the US Federal Reserve may or may not taper, try instead to base your investment decisions on something more tangible. That is always going to be more rewarding.

For instance, look for companies that produce things that can generate reliable revenues. That would be a good place to start. Here in Singapore, we have lots of businesses that fit the bill. Some of those companies are integral components of the Straits Times Index (SGX: ^STI). So you don’t need to venture too far to find them.

So where does that leave us with regards the thorny question of running your winners and selling your losers?

“Running your winners” should, in fact, refer to the companies you already have in your portfolios. In my view, winners are companies that are increasing their profits, improving their competitive position, rewarding shareholders with decent returns on equity and those that can pay increasing dividends. They should be kept.

Run your losers

On the other hand, businesses that are losing ground to competitors, slipping into cash flow problems, losing their competitive edge and generally showing signs of decline are losers. They should be cut.

The upshot is that we should not judge a ‘winning’ company by its share price performance after we have bought it. There is nothing more irrelevant to an investment decision than our original buy price.

Regardless of whether the shares rise or fall, what counts is how the underlying business is doing. Another thing that matters is whether the valuation reflects what is going on in the business. In fact, if the share price falls after you have bought it, you might even want to run your losers by buying more.

As I started with Peter Lynch, I will let him have the final word because I don’t think I can put it any better than he has done.

The legendary investor said: “A price drop in a good stock is only a tragedy if you sell at that price and never buy more. To me, a price drop is an opportunity to load up on bargains from among your worst performance and your laggards that show promise“.

Those sage words come from an investor who would have, in 1977, turned $10,000 of your money into $270,000 in 13 years.

This article first appeared in Take Stock Singapore.

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