Eat Here and Smile

This column was originally published on RealMoney on July 27 at 2:04 p.m. EDT. It's being republished as a bonus for readers.

Too many investors use strong markets as an assessment of their skills. It really should be the opposite. As in golf, it is how good your bad shots are that makes the difference.

In a bull market, everyone is a genius. In general, people are hesitant to admit mistakes, but a realistic evaluation of your actions over good and bad times can save you a good deal of money. In this column, I'll examine some mistakes I made during the recent carnage and some good things that, while they don't have me jumping up and down, have left me in a position to outperform over the medium to longer term.

Let's start off on a positive note with two restaurant stocks I recently bought that are cheap and generally unloved: P.F. Chang's ( PFCB) and CheeseCake Factory ( CAKE).

As David Lee Roth said, eat 'em and smile. I think the opportunities and merits are remarkably similar for these two companies: They are both tremendous brands that offer good products and experiences for customers.

For me, these also fall into the old buy-what-you-know angle. I like to eat, and judging from my last trip to Vegas, so do the majority of Americans. Both of these companies are still relatively small, with strong growth prospects. I know we could sure use one of each up here in Toronto.

Both stocks are roughly 50% off their highs of the last 52 weeks. There are some headwinds for these companies, such as high gas prices and a stretched consumer, but I believe that at these prices you have a very low-risk entry into two strong long-term growth stories. That is something you normally have to pay up for.

S&P expects both companies to maintain at least high double-digit growth rates over the next several years. At those growth rates, earnings and revenue should double over the next 36 to 48 months, as should the stocks. From these depressed levels, an unexpected fall in the price of oil or improvement in consumer prospects would add extra juice to these positions.

P.F. Chang's CheeseCake Factory
Combined Locations 208 112
2007 P/E 20X 17X
Growth Rate 20% 18%
PEG 1 1
Source: Steven Bulwa

Now I'd like to share some of the poor decisions that I've made over the past few weeks.

During these somber times, I like to listen to Wilco's A Ghost Is Born.

Too Much Leverage

My accounts are generally down 6% to 7% on the year. I'm primarily exposed to small-cap technology stocks, and I'm margined to the max.

I'm a margin junkie -- if I have buying power, I use it. There is no such thing as too much exposure for me. That said, I usually maintain at least 25% of my portfolio value short individual stocks. I believe now that the 25% short level should be the minimum, regardless of assessment of risk.

For a short period of time, I was exclusively long when the market was unhappy -- basically, my entire negative performance was generated in those two to three weeks. There are too many unknowns, such as war, that cannot be gamed, hence the value of maintaining a short position as a hedge. This is especially valuable if fully margined.

Too Quick to Take Profits

I had an amazingly profitable group of shorts on the books that included Trident ( TRID), Multi-Fineline Electronix ( MFLX), SanDisk ( SNDK) and Monster Worldwide ( MNST). With all four, I left at least 25% on the table.

As Rev and others have said, market moves tend to go on much longer than anyone thinks. I was hasty to cover these positions; in the case of Multi-Fineline, I left a good 50% on the table.

There is never a rush to do anything in the market. If you feel there is, go have a smoke and come back in two weeks.

Averaging Down Too Quickly

Whether you choose to average down or not is an individual strategic preference. I believe in my assessment of stock valuations and prospects. Short-term moves can be extreme, especially in smaller-cap names, and adding to positions that are being hurt unnecessarily can be very profitable.

However, I exhibited too much haste adding to positions on the long side. I was so busy adding to names that I liked on the basis of longer-term valuation assessments, I was forcing myself to create room by covering shorts that were imploding. In retrospect, in the spirit of overall portfolio protection, if the indices are only down 10% after a four-year bull market and a war is breaking out, keep your shorts on (literally) and come back in two weeks.

OK, enough of this self-examination. Let's change the music to reflect some strength, throw on some Rage Against the Machine, and look at some strategies that have kept losses manageable and set us up for the next 24 months.

Don't Overpay for Keepers

I don't buy a stock unless I believe that, looking out 24 months, the company is potentially 100% undervalued. Buying momentum stocks is fine if you recognize you are just renting them. When Qualcomm ( QCOM) was at $50 and 10 times revenue, I said that no one could really justify the stock price by any historical standard.

Same went for Broadcom ( BRCM) and Marvell ( MRVL), which were 50% higher than they are now. Discipline keeps you away from these problems, either through abstinence or tight stops. I choose abstinence.

If you suffered through some of these momentum unwindings, hopefully you won't make the same mistake twice. Strict adherence to these valuation standards means I had only a few stinkers such as O2 Micro ( OIIM) and WorldSpace ( WRSP) in my portfolio. The majority of my stocks held up fairly well, and some, like Viisage ( VISG), actually went up.


Jim Cramer says it every night: You need to diversify, not just across sectors but also in the number of positions. I own anywhere from 30 to 40 positions at any given time, and none represents more than 8% of the portfolio. So while I've had some blowups like Packeteer ( PKTR), which I believe was a major overreaction, no major damage was done.

Buy 'Em When They're Down

This strategy works in a variety of ways. Averaging into positions that were getting oversold deep into multiple-day selloffs paid off on the few up days recently as those positions rebounded and I removed the extra stock weighting. If I can buy into a good long-term story on sale, it is certainly reducing downside risk.

I like stocks people hate. Buying Martek Biosciences ( MATK) in the low $20s on the way down helped performance tremendously last quarter when I dumped it out at $29 and change.

At the time of publication, Bulwa was long P.F. Chang's, CheeseCake Factory, O2 Micro, WorldSpace and Packeteer, although holdings can change at any time.

Steven Bulwa is an independent portfolio manager based in Toronto. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bulwa appreciates your feedback; click here to send him an email.

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