Wednesday, May 9, 2007

Using "Stops": Are You Stopping Gains?

I got a great email from a subscriber a few weeks ago. He asked me about the use of "stop-loss orders". To paraphrase:

"Do you use stops to protect yourself from a drop in stock prices and protect profits? If you do, where do you set them 10%, 20%?"

Let go to the basics. What is a "stop-loss order"? In its simplest form, it is a standing sell order place for a security you own at a set price below its current price. The theory is that they enable you to avoid a "meltdown" in the stock and protects you from a lost, or if you have a profit in the stock, preserve it. We need to look closer at this strategy though to see if it really delivers.

Investing vs. Trading
First things first. I am a value investor, not a trader. I only buy stocks in stable, fiscally strong companies that have a history of success. I have no use for fad stocks or 90% of technology stocks (I adhere to Warren Buffets thought process, "how can I invest in something that two 18 year olds writing code in their parent’s garage can destroy"?). Because of that, I have no use for stops. The reason is simple. When I buy stock in a company, whether it be 100 or 10,000 shares, I do it with the thought in mind that I am now buying a part of, and becoming an owner in, the company. This is no different than were I to buy a Dairy Queen franchise for example. I only consider selling my shares if there is a fundamental negative change in the company's prospects or share prices become irrationally overvalued. This causes my outlook and perspective to differ dramatically from the trader who buys shares in the morning with the thought in mind to get rid of them in the afternoon. I fully expect the prices of my shares to fluctuate in value throughout my ownership period which in most cases is several years. Because if this thought process, dips in the price of my shares are for me, great opportunities to purchase more shares at a now discounted price. I always find it funny that Wall the only place in America where buyers get upset when the things they want to purchase go on sale. If you consider yourself a long term owner of a company, think of a drop in the price of the stock simply as a "sale" and not a loss of money.

The "Stop Effect":
Let's do a real life example to see how stops can negatively affect our long term results. Our investor owns shares in Archer Daniel's Midland (ADM) and has a 10% trailing stop in the shares. This means that the stop "trails" the price of the shares up so that it automatically adjust up to preserve profits. Here is the chart:

To give the investor full credit let's say he bought shares at their lowest point at $15 a share in August, 2004. He set a trailing stop at 10% and watched as shares slowly increased to $25 a share in mid February, 2005. In the third week of February, shares dropped from $25 to $21 a share for no reason. There was no earnings released, no warning, nothing. Now, because the investor had a 10% stop in place, his shares were sold at $22.50 (10% of $25 is $2.50 below the $25 price). He was right to have the stop in right because he saved himself the extra $1.50 a share they dropped, correct ? No, and here is why. Taxes. Since the investor owned his shares for less that a year he is not eligible for the long term holdings tax rate of 15%. He has to pay his effective rate and we will assume that to be 28% (most investors fall into this rate). His gains were $22.50 -$15= $7.50. He now must pay taxes on that $7.50 which equal $2.10. This reduces his gains to $5.40. Now, if we add his realized gain to his purchase price, he effectively sold his shares at $20.40 or a full $2.10 BELOW his stop price. To rub more salt in his wounds, AMD shares traded back up at $25 a share the next week, so he effectively lost $5 in potential gains.

Wait, there is more....

Our investor has learned from his mistake but still believes in "stops." He rubbed his wounds and bought into ADM the following week but this time moved his stop to 20%. This way he will be saved from "disaster" but not hurt by normal price fluctuations. At the end of March 2005 ADM announces earnings and they fall 9%. The stock sells off from $25 to $17 over the next few weeks. Now, the earning miss was just due to short term commodity price issues and not long term problems with the company or its businesses. In fact, cash flow increased, debt decreased and the company reiterated the results were short term in nature. Our investor though, because he had a 20% stop, sold his shares at $20 (20% of $25 is $5) avoiding the extra $3 a share loss as the share sunk to $17. Smart? Not so much....

Let's look closer. In the first transaction he ended up with a profit of $5.40 a share and after the second one, a $5 loss, his profit was reduce to a total of 40 cents. Now, if he had never had a stop placed on the shares, he would be at this point sitting on a $2 profit ($15 purchase price- $17 current price). Our investor is undoubtedly frustrated with ADM and like most investors gives up on it and tries another stock. In doing this he then ends up missing the greatest run in the history of the stock to the $39 a share it sits at today.

Without the “stops“, this frustration would not have been present and he most likely would have still be in ADM and wondering what to do with the over 200% profit he is now sitting on.

Who was our "investor" in ADM? None other than yours truly. I was lucky enough to learn from my mistake(s), purchase more shares at the $17 level and have held on for the very profitable ride since then. I have no stops in place for ADM currently (nor do I in any of my investments) because the stock is a long term pick based on two things, food and fuel and until the world need neither, I will be a shareholder.

Lessoned Learned: Sears Holdings:

I bought shares in Sears Holding (SHLD) in December 2005 for $120 a share. I bought them because of Edward Lampert and his ability to make is investors money and having been to Sears and seen the changes there (the Land's End "store in a store" concept is a sure winner), believed in his direction for the retailer. Another fact that did not hurt was his hedge fund, ESL Investments, sports a 28% annual return for investors. Remembering my ADM experience I did not place a "stop" order on the shares. They rose to their peak of $169 in early June 2006 and then plunged 20% over the next 7 weeks to $134 a share at the end of July. Had I placed another 20% "stop" on the shares, I would have sold them for a profit of $14 a share ($10.08 after taxes) or 8.4%. I also would have missed out on the immediate reversal of the shares as they then climbed to $180 by Halloween.

There was no reason to sell the shares in July. Eddie Lampert did not loose his ability to make money and Sears Holdings did not suffer a deterioration of the metrics he uses to measure its success. Do you know what the Summer 2006 prices were? A "Sears Sales Event". I did take my other advice and bought more shares while they were "on sale" and at their current level of $180 a share I am sitting on a very nice 9 month return of 30%.

If you are an investor buying quality companies for the log haul, it is my opinion that "stops" will do you more harm than good in most cases. If you are a gambler just trading stock symbols with no real idea of how the underlying company operates, placing a stop on those trades may save you from the inevitable terrible trade you will make.

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