We admire people with the courage of their convictions, those who know their own minds and don’t waver. We think of the stick-to-it spirit as a sign of character, and it’s a good thing to be called tenacious, persistent, tough, steady or steadfast.
A good thing, that is, if you’re not a growth stock investor.
The rules say that growth investors should stick with a winning stock for as long as it continues to rise. The problem arises when a stock starts to lose value but the investor has faith in the stock and demonstrates that conviction by holding it all the way to financial disaster.
Let’s consider at the action of one amazing stock that had a long, profitable run and is now being dragged through the weeds.
Starbucks (SBUX) came public at about 70 cents a share (adjusted for many, many stock splits) back in mid-1992. Investors who bought it then and held it through its eventual high at 40 in November 2006 would have scored a 98 bagger, earning 98 times their original investment! It looks like the perfect example of the benefits of conviction.
There are a couple of problems with this rosy scenario. During SBUX’s climb to legendary status, it suffered several corrections and consolidations, some of them substantial.
For example, in the 15 months that began in January 1993 and ended in April 1995, SBUX roared from 1.3 to 1.5. Not really very hot. Similarly, you could have bought the stock at the end of January 2001 at 12.8 and sold it in July 2003 (29 months later!) at 12.4. This is deep in the Nothin’ Happenin’ Zone. If you had needed an income tax loss, you also could have sold Starbucks during that period for as little as 6.7 immediately following the September 11 attack.
The positive run that everyone remembers from SBUX actually began during that period in August 2002, when the stock bounced from its July correction, beginning at 9 and winding up at the end of 2004 at 32 handing the lucky investor a 256% gain! That remarkable stretch of 28 months included only five months in which the stock actually declined, and only once did it decline for two months in a row.
But the fact remains that you would have to be crazy to hold Starbucks straight through from its IPO to yesterday. In addition to some sickening corrections, you would have had to endure the double top at 40 in May and November 2006 and the subsequent long slide to 14.
There is a truism in law that applies to stock investing as well. It’s that “Good cases make bad laws.” It means that making the right decision in a particular case may yield a legal principle that’s really harmful.
It happens in stock investing, too. Just think about the last person you talked to who bought a penny stock for, say, $0.18 and then sold it three days later for $4.00. This kind of thing happens all the time, but if you try to make it your investing principle, you’ll lose your shirt, pants, skivvies, accessories and the gold crown your dentist gave you back in the ’80s.
Buying stocks that you believe in and holding them essentially forever is a valid strategy if you either pick a stable dividend-paying blue chip or grab a hugely undervalued fallen angel that’s selling at a discount.
But if you’re trying to play in the growth stock league, you need to temper your conviction with humility. My main example here is the case of a friend who was convinced that Crocs (CROX) was oversold. Just last Halloween the stock was trading at 75 and everything was right with the world. Then the wheels came off, and by last Thursday the stock was trading at about 10, having recovered from as low as 7. This friend decided that the move from 7 to 10 was the first leg of a big recovery, and he had conviction that the health of the company and the continuing appeal of its plastic sandals was enough to warrant a renewed position.
Last Thursday evening, however, company management warned that second quarter revenue and earnings would be substantially lower than previously expected. On Friday the stock opened at 5 and has since plowed a little deeper into the mud on the bottom of the lake.
Moral: Forget conviction. Follow the rules. Look for stocks in sustained uptrends and limit losses to 20%–max! As the killjoy lifeguard at the pool used to say, these rules are for your protection.
This is taken from the July 30 issue of Cabot Wealth Advisory written by Paul Goodwin.