Thursday, January 15, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Jan. 15, 1998) -- Every so often, a much-followed stock gives up the ghost and questions and comments regarding safety nets and sell stops begin appearing in the Workshop message folders. A prominent example from years past is U.S. Surgical <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: USS)") else Response.Write("(NYSE: USS)") end if %> in the early 90s, which gave up massive gains very rapidly. This was repeated in 1995 when Micron Technology <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MU)") else Response.Write("(NYSE: MU)") end if %> soared and then plummeted, almost in the same breath. And as recently as last year, 3Com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> joined the crowd when it lost more than half its value.

The natural question is, Wouldn't we have protected our gains if we had used some kind of sell-stop discipline? The answer is, yes, but... (and you knew there would be a "but").

Last summer a group of readers undertook a fairly extensive research project to test different sell-stop disciplines. What they discovered is that for every case where a sell stop saved one from such a mammoth decline, there was at least one more occasion where the same sell-stop discipline got one whipsawed. The stock would have bounced right back up after the sell stop kicked in, generating an unnecessary loss.

Overall, there was no percentage level at which one could place stops consistently and not lose as often as gain by their use. Since the group's study was completed, I've abandoned attempts to use any such kind of program.

But there are other possibilities for protection schemes to save one's gains. With the rapid rise and fall in 1997 of International Paper <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IP)") else Response.Write("(NYSE: IP)") end if %>, many Foolish Four followers have discussed the idea of taking a profit when a stock reaches a certain gain and moving the money elsewhere.

This, too, I've argued against because it seems like a way of guaranteeing you will not get any massive winners, but it does nothing to prevent big losers. Overall, I see it hurting the long-term returns of the portfolio.

There may be a compromise, however, that will allow one to hedge the bet without doing too much damage in either direction. Before I explain the approach, let me emphasize that I've never tested it nor used it personally. I've read about it in the past, and think it may be a compromise if you're set on using some kind of profit-protection plan. It's entirely your call whether to consider such an approach.

Instead of using a pre-set sell stop percentage or selling a stock that reaches a certain profit, this theory would have you sell a portion (say one-third) of your stock position when it hits a profit of 30%. That way, you're taking some of the money from a winner and moving it into other stocks to spread it around, but you haven't completely left the winning stock if it continues to post gains.

You would then sell another third of your original shares if the stock hits a 50% gain. And finally, you'd put a sell stop in place where you took your first profit in case the stock begins to crater. That way, the very least your profit would be is 36.7% (2/3 at 30% and 1/3 at 50%).

Of course, such a plan doesn't even come into effect until your stock gains 30%, and that guaranteed 36.7% wouldn't come into effect until it also crossed the 50% profit level, which obviously doesn't happen to every stock choice.

The advantage of such a plan is that you're not going to give back all of a gain by holding a stock too long. You lock in a piece of the gain with the first third at 30%, and the second third at 50%. Then if the stock does fall apart and you sell the final third back where you took the original profit, you still have a nice gain on the stock.

The disadvantage is that if you're riding a winner like Dell Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>, you've pulled out of 2/3 of your position very early in the stock's ascent, well before the stock really even got moving. The problem, of course, is that no one knows ahead of time which stocks are going to act like Dell and which like International Paper.

If you use such an approach -- and I'm not recommending you do; I'm only laying out a theory I've run across -- be aware of its strengths and weaknesses. The basis of all decisions should be informed reasoning. Fool on!

[Want to be the first Fool on your block to get a copy of Robert Sheard's forthcoming book? Click here to pre-order your copy of The Unemotional Investor.]