Whoopee! In the just completed March quarter, Jubak's Picks beat the
Nasdaq Composite Index. Yep, while the Nasdaq fell 26% for the first quarter of 2001, Jubak's Picks declined
Impressed? I don't expect you are. And neither am I. That performance stinks. The poor ol'
Standard & Poor's 500, itself in a bear market now, was down only 12% during the period. Money market funds beat my record by something close to 23 percentage points for the quarter. I should have been able to do much better.
So why didn't I? When you've turned in a quarter as lousy as this one, you'd better try to learn something from it. And you'd better come up with some strategies for fixing what went wrong. Here's my analysis of the big mistakes that killed me during the last three months, and my plan for improving in the area that most needs it.
The mistakes? First, trying to buck the market by buying technology in late January and early February. Second, going with the traditional wisdom of "Don't fight the
Fed" in the same period. And, third, not limiting my losses by selling more quickly.
The area I'm going to work on? Selling. I'll spend the bulk of this article describing a disciplined approach to selling that I believe will improve my performance going forward -- after I've described the three big mistakes of this quarter in enough detail that we can possibly all learn something from them.
Mistake No. 1: Buying Extreme Networks and Exodus Communications on Jan. 26 and Brocade Communications Systems on Feb. 16.
What can I have been thinking? I had sold sector leader
Oct. 31, 2000, because I thought that, given the way business seemed to be slowing for the networking-equipment companies, the stock was too expensive. So why buy other stocks in the same sector? I suppose because I was seduced by the long-term prospects of these companies. I think they will be among the leaders in the next generation of growth in the communications and networking sector. But by buying these stocks, I was violating a key investing rule: By and large, it's not a good idea to buy any stock in a sector that's in a downtrend as a whole, no matter how good the individual stock and the company. About 50% of my total loss for this quarter came from buying and holding these three stocks. I have to mark this one down to plain and simple stupidity.
Mistake No. 2: Don't fight the Fed?
That's the conventional wisdom: When the Federal Reserve is cutting interest rates, it's time to buy stocks, especially in sectors such as financials, advertising and retail that historically bounce back most rapidly when the central bank acts to stimulate the economy. Not this time, however, for reasons that I laid out in my
March 23 column. The performance of the stocks that I picked to go with the Federal Reserve's interest rate cuts --
-- weren't disasters by and large. But as a group, they still cost me some money; they were responsible for about 8% of my total loss for the quarter. In retrospect, I think I rushed the gun on following the Fed, but still this was what I'd call a well-reasoned mistake. The strategy was based on sound investment principles that have worked most of the time -- even if they didn't this time.
Mistake No. 3: I didn't sell enough or quickly enough to limit my losses.
It's not that I didn't sell at all during the quarter. I sold
, and I've watched it fall another 34% through April 4. I sold McDonald's and it has declined a further 3% to date;
, down another 10%;
, down another 62%;
, down another 16%; and
, down another 11%. But I certainly didn't sell enough. I could have limited my losses from buying Brocade, Exodus and Extreme if I'd dumped them quickly. I could have avoided further declines in
, just to name a few, if I had sold at any point during the quarter. And I could have avoided giving back most or all of my gains in
Wind River Systems
So why didn't I sell? I attribute part of it to my belief that the interest rate cuts by the Federal Reserve would stabilize the market relatively quickly. Part of it I chalk up to a belief that the Nasdaq, down 51% from its March 10, 2000, high as of Dec. 31, had seen the worst of the damage. And part of it I think belongs to a stubborn belief that stock prices should reflect long-term fundamentals. It sounds quaint, I know. But I did believe in January -- and still do -- that much of the technology sector was undervalued on its fundamentals. I overlooked the very real possibility that stocks can trade massively below fundamental value for a long period of time. And that a stock that is undervalued on Jan. 1, can get a whole lot more undervalued by March 31. Given what we've seen of the market in April so far, it's clearly possible that stocks can get even more undervalued still. I think I need an occasional whap upside the head to remind me of this.
A Systematic Whap to the Head
And that's exactly what I've tried to design my new selling system to deliver. If it works as I intend, it will periodically and
remind me to sell -- or at least consider selling -- damaged stocks. And it will give me a set of guidelines for making that decision. I think the system is potentially simple enough for anyone to use, even me, and yet flexible enough so that you can add a considerable amount of sophisticated analysis.
It has just three steps.
First, a mechanical whap on the head. I need something simple that will remind me to consider selling a damaged stock. My very mechanical rule: Whenever a stock has declined either 20% from its purchase price or fallen enough to give back 20% of my profits in the stock, I'll consider selling.
You can tinker with this formula to your heart's content. For example, you could set the limit at a 10% decline for a less volatile stock (because it will take longer to make up the loss due to its lower volatility) and 25% for a highly volatile stock. Traders usually set much tighter limits than investors. Some investors and traders like to use a sliding scale in their profitable positions. For example, if the stock is up 33%, they'll consider selling on a 15% giveback. If it's up 50%, they'll sell on a 20% giveback. Whatever the exact percentages, however, the point is to set a level that prevents a relatively tolerable loss from turning into a truly painful one, and another level that prevents a profit from turning into a loss.
I prefer to keep the system simple at this point because the 20% number doesn't trigger an automatic sell, but instead signals me that I have a stock in my portfolio that needs urgent "selling" analysis.
Second, decide if something is seriously wrong with the fundamentals. Here my job is to figure out if one of the fundamental factors that led me to buy the stock has changed so much that I should consider it broken. If it has, I think the stock becomes a sell no matter what its current price.
I'm clearly not talking about a minor problem, like a quarterly shortfall in sales or a quarter's delay in a product introduction. Stocks beset with that kind of fundamental problem aren't sells regardless of price. For example, the price may have fallen far enough so that the problem is already priced into the shares. Such a stock might even be a buy.
No, the kind of fundamental breakdown that I'm talking about here is much more serious. You might define it as something that changes the company's business model for the worse so profoundly that it severely reduces the potential upside for the stock, or it significantly increases the risk to the investor without letting the investor readily quantify that increased risk.
For example, I'd say that Ariba is now a fundamental sell, and I will be selling it out of Jubak's Picks with this column. It's not a fundamental sell because of its recent earnings warning for the just-completed March quarter, although that's serious enough. I do sit up and listen when a company reduces its revenue projections for a quarter to $90 million from $180 million. But if that were all that were going on at Ariba, I'd be analyzing the stock to see if at $4.88 cents a share, the fundamental bad news was in the price.
But I think that's an irrelevant exercise at this point because Ariba's most recent announcement also indicated that its entire business model is broken. The company had told analysts and investors that its road plan was to expand from its niche in business-to-business procurement to become a total solutions provider for electronic commerce. The deal to acquire
, a maker of software that allows the integration of product design with manufacturing, was the first important step in that direction. But the collapse in Ariba's share price has killed that deal, and with it, the entire strategy that Ariba laid out in the past year to compete with companies such as
. The issue for Ariba right now isn't whether it can sell more software next quarter, but whether the company has a viable business model at all.
Much of the time, fundamental selling reviews won't be this clear-cut. For example, do you want to sell Nokia on news that it is extending massive credit to wireless systems operators in order to sell them new networking equipment? On April 2, Nokia,
extended $1.1 billion to the wireless subsidiary of
so that the company could buy third-generation wireless gear. On April 3, the same trio stepped up to loan $2 billion to the wireless unit of
for the same purpose.
Your reaction to that likely depends on how seriously you take the debt problems of European wireless companies. If you believe, as I do, that the entire sector is seriously overextended and is ordering equipment that it can't pay for, then this news does raise the risk of owning Nokia. A significant amount of the remaining value in the wireless-equipment sector is based on the promised rollout of third-generation networks. If this rollout is significantly delayed, the current model for industry growth goes up in smoke. Under the circumstances, it's hard for investors to estimate exactly what risk they are taking on with Nokia.
I know that it's hard to sell a stock such as Nokia on something seemingly as trivial as a big increase in loans to customers. That's what makes fundamental sell analysis so difficult -- the telltale signs of huge future problems are often seemingly minor details on balance sheets and income statements. Do remember, though, when making your decision on Nokia and other wireless equipment stocks that rising levels of loans to customers were among of the first signs of trouble at
and Cisco Systems . I take the news from Nokia seriously, and I'm selling the shares out of Jubak's Picks with this column.
Watch the Tapes
Third, visit the charts. Remember, you're looking at this stock because it has already fallen significantly. It's up to you to decide if that trend is about to reverse or if it's still running full force against your portfolio.
It's worth taking a look at the trends from top to bottom. What's the trend in the market as a whole? In the sector? For the individual stock? The adage "Don't fight the tape" certainly applies, but it's important to realize that you need to look at more than one tape.
For example, take a look at
Transocean Sedco Forex
. Despite a pop April 4 on an analyst upgrade, the stock is still down more than 20% from my purchase price. The stock's price chart over the past three months seems to show that the shares are locked in a downtrend. Switch over to the Oil and Gas Drilling and Exploration index on
and you'll see the same pattern. The group is in the midst of a steep downtrend that shows no signs of bottoming. Maybe, given the relatively low volatility of Transocean Sedco Forex, I should have set my sell limit tighter than 20%. But at the moment, there's really no point to holding onto these shares and taking what is likely to be further punishment. I will be selling this stock out of Jubak's Picks with this column.
Charts aren't always so clear. Interpublic Group is, like Transocean Sedco Forex, down more than 20%. But from its chart, it looks like it may have bottomed and may actually be in the process of reversing the trend. In reading a situation like this, I try to pull in what I know about the environment surrounding the stock. In the case of Transocean Sedco Forex, I know that
is having trouble keeping to production targets and the price of oil has been under pressure due to worries about the depth of the economic slowdown. In the case of Interpublic Group, I know that the recent interest rate cuts from the Federal Reserve are still working their way through the economy and that there is the strong possibility of a fourth cut in May. With that in mind, I'll give Interpublic Group a little more time.
So that's the system and a sample of the kinds of decisions that come out of it. If you want to make it more sophisticated, you can certainly add better technical indicators than the simple eyeballing of price charts that I've used here, for instance. If you have ideas about better selling systems, in fact, please post them in my community, Market Talk with Jim Jubak, in the thread named "How to Sell."
A final word of context for all this. I know that some of you are likely to object to the idea of selling when the market is so depressed in price. Let me take a look at that for the moment. If stocks continue to drop, of course, you'll be glad that you sold these. If the market reverses, I think you'll be in a good position to buy stocks with better prospects for gains than these. My selling here isn't a market call at all. Like all of you, I don't know when or how the bottom will occur in Nasdaq or
NYSE stocks. Instead, these sells are an attempt to move out of stocks that are, in my opinion, less likely to go up when the market does turn, so that we can move into stocks with more potential. I think of the stocks that I've sold here as stocks that are dragging heavy baggage behind them, in the form of questions about their business or their market, that is likely to keep investors from rushing to buy them whenever anybody starts buying anything again.
At the moment, I'm also going to follow the first rule of holes: When you find yourself in one, the first thing to do is stop digging. I'll leave the money from these sells in cash until I have a better sense of how the various parts of the stock market are trending.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Ariba, Brocade Communications Systems, Exodus Communications, Extreme Networks, Global Crossing, Globespan, Home Depot, Nokia, Oracle and Wind River Systems.