Did you ever watch a school of dolphin or porpoise as they follow closely beside a boat? Of course, no single one can stay two feet in the air all the time; but, each rises from the water, arches gracefully above it for as far as he can propel himself, and then knifes back into the sea. Shortly after the first emerges, another does the same, and then another. And so on. The effect is that, at any one moment, a number of the graceful animals are above the surface, glistening in the sun, and there is a constant presence there.

We buy shares of quality companies to hold until we want or need the money. The “rule of five” tells us that, of every five companies we select, we can expect four to do as well or better than expected, but one is likely to disappoint us. And, occasionally, the herd will bid up the price of one or another of our companies to a point where we can no longer expect as healthy a return going forward as we did because we have already enjoyed much of the appreciation. In any of those cases, we will need to replace our companies with others that will better meet our requirements.

Ellis Food for Thought, Fundamental Investment Views, Investment Concepts, NAIC Veterans' Lounge porpoises, portfolio management, rule of five, save the best, when to sell

Today, I think I’ll post something about investing for a change. You’ve been pretty patient about my indulging myself and mouthing off about current events. So I owe you one!

Some years ago, I accepted an invitation by the American Association of Individual Investors (AAII) to participate in their regular feature: “Pro Pix,” a contest that, until I came along, was restricted to professionals who were willing to vie with each other to produce the best performing portfolio over a six-month period. I accepted the challenge with the condition that I be permitted to use the required bi-weekly commentary to tout the virtues of long-term investing and make it clear that a six-month time horizon was not a reasonable basis on which to judge success.

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Gary Simms, a “frequent flyer” on this blog, recently posed two excellent questions, each of which merits a separate post. This is the first.

To paraphrase: “If the fundamentals—sales, profit, or earnings growth—are what drive the price of stock, why does a decline in a stock’s price so often come before the fundamentals decline?” Great question!

Stock prices decline for only one of two reasons: fantasy or fact.

By “fantasy,” I mean shareholders have jumped to a negative conclusion from some event,  rumor, story, or combination of those. Acting on their hunch, the herd is simply guessing what might happen and getting out before it does. (Institutional investors are not immune from this behavior. Their colleagues, like lemmings, are often afraid not to jump when they do, for fear they might have missed something they shouldn’t have.)

More often than not, the "event" is not even related to the company, or even the industry it’s in. It could be merely the opinion of some talking head on Bloomberg or the like; and conjecture about how those imagined consequences might affect the company are sometimes pretty far fetched.

Read more…

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As I said in my last post, each quarter you should analyze growth from last year to the current year and do it in the same order the items appear on the income statement. I submit that the best bet is to compare the sum of the data for the last four quarters with the similar period the year before. That way, it will take a down trend or a significant decline—more than just a single quarter—to get your attention. Read more…

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While we advocate expending the least amount of effort necessary for investment success, one urgent requirement is monitoring your portfolio to catch the poor performers before they do too much damage.

Our “rule of five,”—a convenient, statistical pigeonhole into which we can cram every failure—suggests that fully four out of five companies we select will do just fine, one even doing better than we had expected. The nice thing about that is, if we’ve selected carefully, the eighty percent of those we’ve selected will perform well enough to keep our portfolio’s performance from being too badly damaged. Read more…

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There are three—and only three—situations when you, a long-term investor and company part-owner, might want to sell stock you own:

1. When you want or need the money – After all, that’s what you’re doing this for, isn’t it!
2. When revenue or earnings growth declines – the company can no longer maintain the fundamentals that induced you to buy the shares in the first place. (Defensive Strategy) Or,
3. When expected total return declines – an excessively high market price puts your five-year plan way ahead of schedule. (Offensive Strategy)

Read more…

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A question arose recently on one of NAIC’s message boards asking whether the time was right to sell a stock that had gotten a little ahead of schedule in appreciation, and whose return had declined some. “Isn’t it time to get out and take some of the profit?” [My thanks to Ron Cooper.]

The quick and simple answer is “Never sell a stock to take a profit!”

I would hastily add that this does not preclude your replacing a stock with one of as good or better quality, and a better potential for return. But there’s an important distinction between those two concepts. Read more…

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