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The power of letting winners run

Most investing missives focus on finding and backing winners. The logic makes sense. One of the better ways to enhance portfolio performance is to improve the feedstock of investments into the process. The downside is that strategy around portfolio management often gets short shrift.

A challenging aspect of portfolio management is the handling of extreme winners and losers. It tests both the process and psyche of portfolio managers but also how they manage the positions within the overall portfolio.

Dealing with extreme losers is the most common problem. A 2014 study by J.P. Morgan found that, over 25 years, 40% of all stocks in the Russell 3000 index suffered a catastrophic loss of 70% or more from their peak. Another study by Blackstar Funds found that 39% of stocks had a negative lifetime total return. Big losses happen with surprising frequency.

All those losses can make for a pair of silver linings, though.

The first is that, because losses occur so frequently, investors get plenty of experience on how to handle them and have developed clear frameworks for how to manage extreme losers.

The second is that, at least when wrong on the long side, the position size has shrunk and whether the portfolio manager decides to sell is of much less consequence.

The challenge with extreme winners

Handling winners is a more complex task, especially at the extremes. Conventional wisdom is keen on locking in profits with some form of the saying such as “You never go broke taking a profit.”

But locking in profits on winners cuts against the defining advantage of investing in equities: losses are capped while gains are not. The lean-but-long right tail of winners overcompensates for the limited losers. The same J.P. Morgan study found that only a third of stocks manage to beat the benchmark. In other words, it’s a small subset of winners that more than make up for a huge chunk of losers.

Closing out a winner purely for the sake of locking in a gain snuffs out the long tail of potential upside. For example, the BlackStar Funds study found that 6.1% of the stocks in its 24-year study of the Russell 3000 outperformed that benchmark by more than 500 percentage points.

Imagine having an approach to selling which embraces locking in a profit at a 50% gain only to find out that the sold stock then outperformed the benchmark by nine times the size of your profit. Even if the benchmark went nowhere, it would take another nine-plus 50% gains from other positions to make up for the forgone gains. A fundamental approach that embraces locking in small gains in stocks can make for the worst of both worlds: it retains the risk of loss but eliminates the long tail of potential upside that more than offsets the regular flow of losses.

Worse, the odds of an investor catching lightning in a bottle with the proceeds of selling a winner are unlikely given that the base rate says that roughly two-thirds of stocks underperform their benchmarks. The more times that process is repeated, the more likely an investor cashing in winners is to generate benchmark-trailing results.

There are two other good reasons to err on the side of not rushing to sell winners.

The first is that study after study, including the beautifully titled Trading Is Hazardous to Your Wealth, reflects that portfolio turnover is inversely correlated to performance. On average, these studies all point to the average high-turnover investor underperforming the average patient investor.

The second is for tax: longer holding periods can allow for more favourable taxation on individual gains and make for fewer tax drag pit stops on the compounding journey.

Where the rubber meets the road

And so logic would say that letting winners run is a sensible plan for the typical long-term investor. As usual, though, the answer on whether and how far to let an individual stock run begins with an “it depends”.

For starters, know that having a long-term approach is not an excuse to not stay on top of new information and how a thesis is evolving, even if that investment is working out well. Indeed, as a position swells to take up more room in the portfolio, so should it gobble up more of the portfolio manager’s mindshare.

Investors who let winners run should also brace for a more concentrated portfolio as the winners expand and the losers shrink. Greater concentration typically also makes for greater volatility, which can unsettle some investors. I personally prefer backing my best ideas with conviction as it suits my temperament and is well supported by empirical research.

There’s also the matter of valuation. Almost every runaway winner looks conventionally expensive at some point, making for a greater chance of a drawdown. That said, outside of broad-based macro factors which affect most stocks (e.g. falling interest rates), companies that get re-rated higher usually do so for a very basic reason: the fundamentals have improved and are beating expectations. As a long-term, high-conviction investor, my Darwinian bias is to let such companies grow to be a larger part of my portfolio and let those that fall short shrink.

Just how large a position size that is tolerable for an individual investor is a function of that person’s individual circumstances, including their willingness and capacity to take that risk. What suits me may not suit you. Big picture, though, long-term investors would do well to ponder what kind of returns they may be leaving on the table by ‘locking in a profit’ next time around.

 

Joe Magyer is the Chief Investment Officer of Lakehouse Capital, a sponsor of Firstlinks. This article contains general investment advice only (under AFSL 400691) and has been prepared without taking account of the reader’s financial situation. Lakehouse Capital is a growth-focused, high-conviction boutique seeking long-term, asymmetric opportunities.

For more articles and papers by Lakehouse Capital, please click here.

 

9 Comments
Robert
February 21, 2020

An old economist's take: develop a linear decision function which prescribes for you an: " x%-gain -> y% sell down of the holding by value " action at each time point on the linear time scale...then if the share price retreats a% at a future point, and IF YOUR REASON FOR ORIGINALLY BUYING THE STOCK HAS NOT CHANGED SIGNIFICANTLY, top up the stock by b%.
Adding another element of complexity: if the stock increases c% from the b% top up point/stock price, and IF YOUR REASON FOR ORIGINALLY BUYING THE STOCK HAS NOT CHANGED SIGNIFICANTLY, then this signals a further potential run-up by the stock, so top up by a further d%. Your risk tolerance - and [dare say] overall mental stability - should determine what % you use each time [5%, 7.5%, 10% or whatever] ...and of course that % can be slightly adjusted over time because [as we all know] the only-constant-thing-in-successful-investment-is-change..

= A mechanical process that takes away the need for potentially dangerous subjective judgement...and remember: 1. if you think a stock is imploding, dump it - you can always return to it later [maybe]. 2. if not a stock imploding, a price fall is probably only a reflection of a relatively small number of holders selling to take profits, getting cold feet or simply needing the capital tied up in it for other purposes. 3. Everyone is a genius after the event [the CSL lamenting in the "comments" to the post, a classic example] and no one will EVER be an investment genius before the event 4. betting on the stock market is not that much different to betting on a favourite jockey, saddle cloth number, or race favourite in horse races....and every bet has it's uncertainties and risks...and a savvy approach [decision function] is paramount in managing every evolving financial risk and uncertainty!!

Good luck everyone

John Wilson
February 13, 2020

This is an issue which hasn't received the attention it deserves. All of us get bombarded with "take money off the table", "minimise losses", "diversify" etc. These are all good advice, but what about the other side of the coin - "let winners run". The problem is how to make the decision to get out or to let a holding run.
Most of us have held CSL at some stage: it is a freak. In 1994, I decided it was worth a go, and bought the 2000 guaranteed allocation in every name I could think of - as I recall, there were 14000 shares in the names of me, my wife, our kids, the family trust etc. I was thinking of getting some in the dog's name. I sold all but 2000 when the price reached $8 - I had "achieved a great profit", and subsequently sold some to get a "better" weighting.
If I had a crystal ball and held on to those shares, after the 3 for 1 share split and the price rising to $330, those parcels would now be worth almost $14m!
There must be some way of seeing this. When I originally bought in the float, I thought CSL was a good business. Why didn't I hang onto more?

Richard Rouse
February 13, 2020

Sir
I have been involved in the share market as a sole trader, starting off in a small way in the late 1980s. I was interested in your comments on letting your profits run. In June 1994 I bought 2200 shares in the CSL float
@ $2.30. I sold these in Jan 1996 @ $4.07, a profit of $4220 incl. divs & brokerage, or ~46% in 18 months.
As a beginner, I thought I was pretty smart, but seeing as those shares today are worth $726,000, it has been an expensive lesson. I think I have learnt from this and other experiences, that it is better to buy and hold than to be a trader, provided you do it right.

Andrew
February 17, 2020

Richard, the 3 for 1 share split means your holdings would have been worth $2.178m.

Rod
February 13, 2020

A case for the Trailing-Stop-Loss!?

SMSF Trustee
February 13, 2020

Rod, only if you went into it as a trade rather than as an investment decision designed to earn long term income with growth. An investor, rather than a trader, will decide to exit because they no longer believe that the income will be delivered and that income growth is no longer possible, not merely because the market is volatile!

RJM
February 13, 2020

Agree Rod, but "Trailing-Stop-Loss's" easy to model hard to action! (in my experience) Greed Vs Fear!

Gary M
February 13, 2020

Agree, but there are also many examples of companies that have run hard, and they are now well off their highs or dead. Axcesstoday is one the market loved and now even bondholders have lost money. Sometimes, it's best to take some chips off the table.

Justin D
February 16, 2020

Agree Gary but I think Joe refers to investors selling quality businesses because price may be running at highs where the businesses have bright prospects ahead. A good example to your point would be NAB. Today's share price was the share price it had in 1999 but I don't think Joe based this article on the likes of NAB.

 

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