You can’t go broke taking a profit. However you can underperform the market if you sell too soon. So how long should you let your winners run?
Consider, for example, animal healthcare company Zoetis (ZTS). This is a stock that has been performing very well over the last several years, as shown in the following chart.
And if you had taken profits on Zoetis in 2018, when it was up a lot, you’d have missed out on even more profits in 2019.
Some fundamental analysts say simply that you should sell when the valuation gets too high. However, it is not that simple. Per the following chart, it seems most Wall Street analysts covering this stock just adjust their price targets as the share price rises. Only a single analyst, Debbie Wang at Morningstar, goes against the herd and rates the shares a sell (and she cites valuation).
Specifically, Wang’s price target is only $85, and her report says “with shares recently trading near $125, the stock still looks overvalued to us.”
And for perspective, not only does the share price have significant momentum, but so too does earnings per share and revenues, as shown in the following table.
Many investors and traders will argue that valuation alone is not enough. And that technical and quantitative factors (in addition to, and even in lieu of) fundamental analysis, is required to know when to sell versus when to let your winners run.
And as we’ll learn in more detail later in this report, one of our quantitative models (Emerald Bay) recently added shares of Zoetis less than three weeks ago. Specifically, Emerald Bay buys momentum stocks, and bases position sizes on volatility, with more capital invested in the less-volatile stocks. We’ll have more to say about that trade later.
And from a general market standpoint, we covered the topic of selling things that have been performing well in our most recent edition of Weighing the Week Ahead, titled: Is it Time to Worry about Crowded Trades?
We are sharing the performance of our proprietary trading models as our readers have requested.The models are based on a variety of trading strategies as we will review later in this report. They are also often used in combination with our longer-term fundamental investment strategies.
Expert Picks From The Models
Note: This week’s Stock Exchange is being edited by Blue Harbinger. Blue Harbinger is a source for independent investment ideas.
Emerald Bay: I wanted to highlight a position I purchased on August 21st, Zoetis (ZTS). Are you familiar with this stock?
Blue Harbinger: Yes–it’s an animal healthcare company. Zoetis makes animal health medicines, vaccines, and diagnostic products. It commercializes products primarily across species, including livestock, such as cattle, swine, poultry, fish, and sheep; and companion animals comprising dogs, cats, and horses. Why’d you buy?
EB: Because I seek exposure to the highest momentum names in our large cap equity universe, adjusted for volatility. And, as was mentioned earlier in this report, I like to base my position sizes on volatility with more capital invested in the less-volatile stocks.
BH: Interesting. But are you sure you didn’t buy because you are a dog lover, or anything like that?
EB: I am a trading model, not a person. I don’t trade on emotions like you humans do. I trade on data. I like momentum, and Zoetis is exhibiting plenty of momentum in both its share price and its earnings, as was covered earlier in this report.
BH: Okay. Well I like fundamentals. And according to Debbie Wang at Morningstar (mentioned earlier in this report–the one analyst recommending a sell) Zoetis has a wide moat thanks to its “scale and compelling cost structure.” However it also faces risks such as “(1) Strict regulation or restriction of antibiotic use in animals could harm Zoetis’ production-animal product sales. (2) Lower-margin emerging-market sales will make up an increasing portion of company sales, creating a headwind to Zoetis’ margins. (3) Emerging-market customers may be more price-sensitive and more open to using generic products.”
EB: Morningstar creates quality fundamental research, but they tend to be a value shop, meaning they don’t do well with momentum stocks, and I don’t believe they pay any attention whatsoever to technical and quantitative factors.
Road Runner: While you two argue over how to rate Zoetis, I have a trade to share. I bought shares of Chegg (CHGG) on 9/6. This company operates a direct-to-student learning platform that supports students on their journey from high school to college and into their career with tools designed to help them pass their test, pass their class, and save money on required materials.
Blue Harbinger: Okay, but why’d you buy, Road Runner?
Road Runner: As you know, I like to buy momentum stocks in the lower end of a rising channel. You can see what I am talking about in the following chart.
Blue Harbinger: Um, doesn’t look like a rising channel to me, but I know there is more to you model than meets the eye.
Road Runner: Correct. Besides just buying in the lower end of a rising momentum channel, I look for a certain type of situation (some call it a pattern, others may call it a setup, etc.) where the probability of a particular action is not a matter of chance (50/50) but has been historically noted to result in a greater tendency toward a particular outcome. “Trending in a channel” is one such situation. An equity will often “cycle” between the upper and lower bounds of that channel for substantial periods of time.
My model design attempts to take advantage of this property by identifying stocks trending in an upward channel and waiting until the stock price drifts to the lower bound, making it a candidate for purchase. These types of situations have a relatively high probability of positive outcome with a reasonable profit potential. And CHGG can be seen to be in this type of a situation. This is a short-term trade that has traditionally shown profitability when the right conditions have been met. One way or another, I’ll be out of it shortly – usually after about four weeks.
Blue Harbinger: Okay, thank you for sharing that information. Here is some data in the F.A.S.T. Graph if you want to consider fundamentals.
Holmes: As the resident “dip-buying” model, I purchased shares of Viacom (VIAB) back on 8/14 for $26.92, and sold them just recently on 9/6 for $26.01.
BH: August was a tough month considering the increased volatility(NYSEARCA:VXX). Looks like you purchased right around the time of the announced merger deal with CBS. There was quite a dip upon which you appear to have purchased. I guess you can’t with them all, but it’s important that you stick to your process over time. It’s nice to hear from someone that is not a momentum trader. That’s been a crowded strategy, and when the tide turns, it may turn hard. Thanks for sharing.
Knowing when to sell your winners is easier said than done. In many cases, share prices can keep rising long after traditional fundamental valuation metrics suggest they should not. For example, Zoetis continues to rise steadily, and it seems most Wall Street fundamental analysts just keep adjusting their fundamental price targets upward to match whatever the share price is doing. Technical and quantitative factors, in addition to (and sometimes in lieu of) fundamental factors can be prudent. And while momentum has been a popular strategy in recent years as the economy and markets continue to rise, that can change quickly and dramatically as the market cycle changes. How long do you let your winners run?
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