The world has no shortage of investment strategies.
Many are clear — until you raise the subject of selling. Then it’s as if the strategy developed something akin to a mysterious black hole.
In space, a black hole absorbs light and lets nothing escape. In investing, the when-to-sell black hole leaves the investor in the dark.
A sound strategy shouldn’t leave you wondering when to sell. Successful investing involves defensive selling (to limit losses and protect big gains from shrinking) and offensive selling (to lock in gains while the stock is still in an uptrend).
Today we’ll look at one aspect of offensive selling: profit-taking.
In most cases, you want to take profits after a stock has risen 20% to 25%. Many stocks will form a base after such an advance. So unless you want to sit through a base formation, it’s best to take the profit.
What if the stock goes even higher after you sell? Let it. The goal isn’t to exit at a peak but to book profits in a consistent fashion.
A few elite stocks can be held longer. How do you identify those?
The process starts before you buy.
Other stocks are more like a cul-de-sac: If you ride them too long, you end up circling back to where you started. This is especially true of cyclical stocks.
The stock’s earnings history will aid your judgment. Does it have three to five years of 25% or better EPS growth? Is it a leader in its group? Is its group a leader? Does it sell a brand-new product or service, or is it in a cyclical market?
After you buy the stock, the price action will give you additional clues. If the stock advances 20% in the first two or three weeks after the breakout, you should hold the stock until the eight-week mark. Then you can re-evaluate it.
The best stocks often show a quick 20% gain after the breakout.
Use common sense. If the stock jumps 20% in two weeks and then drops sharply, sell it before it turns into a loss. Most of the stocks you buy are not going to be elite stocks. Even when they are, they won’t always act like it. Sometimes a choppy market will keep all stocks on a short leash. Once again, the 20% to 25% profit-taking rule proves useful.
IBD’s TAKE: The strength of a high-quality growth company’s move in the stock market depends in large part on the strength of the overall market trend. Get an instant feel for the current market by viewing the Market Pulse Table and IBD’s daily Big Picture column, which pointed out the heavy institutional selling that created the market’s major tops in recent years, including March 2000, September 2000, October 2007 and May 2008.
But what if you’re not seeing 20% gains? Review your selection process. If selection isn’t the problem, it could be that the market isn’t giving sizable gains. In that situation, you might take profits at 10% to 15% while holding losses at 3% to 5%.
If 10% gains aren’t doable, you need to wait for a stronger market.
A bull market’s life cycle also affects profit-taking. “Young growth stocks will typically dominate for at least two bull market cycles,” IBD’s chairman and founder, William J. O’Neil, wrote in “How to Make Money in Stocks.” “Then the emphasis may change to cyclicals, turnarounds, or other newly improved sectors for a short period.”
In late 2009, Panera Bread wasn’t an elite stock, but its EPS grew 25% and 41% in the prior two quarters that year.
Panera broke out of a cup-with-handle pattern at 65.34 (1) in early December. After rising 20%, the stock could’ve been sold at 78.41 (2). The stock did rise further, but then it formed another cup with handle.
In June 2010, a low-volume breakout failed (3). But a new base followed that worked (4). The latest breakout notched a second 20% gain (5).
(This column originally ran in the Jan 4, 2011, edition of IBD.)