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After a big runup, many investors bail out of a stock too early // Common practice is to take profits, but one good year can follow another
by Anne Tergesen
Jan 6 1998 12:49AM CST, Star-Tribune Newspaper of the Twin Cities Mpls.-St. Paul
When shares in Cisco Systems doubled in price between April and early December 1997, Libby Olson did what many investors do: She took the money and ran.
"It's pretty tough to get a stock to double again in a year or even in a two-year period," said Olson, an investing consultant who trades for her own portfolio from her home in Pewaukee, Wis. When a stock soars, Olson said, her rule of thumb is to "pocket your profits and look for another investment."
Although Olson's thinking exemplifies the conventional wisdom, it may sometimes shortchange her portfolio. According to several studies, many stocks that do well in one year continue to beat the market for another year.
James P. O'Shaughnessy, a money manager and the author of "What Works on Wall Street" (McGraw-Hill, 1996, $29.95), said his research indicated that one of the best ways to make money in the stock market from 1951 to 1996 was to look at the 50 top-performing stocks in the overall stock market and buy those that are still a good value.
The strategy would have brought an investor compound annual returns of 18.8 percent, compared with a 12.15 percent average for the market during the period.
O'Shaughnessy uses this pattern to guide one of his four mutual funds, O'Shaughnessy Cornerstone Growth. The fund, which is about a year old, was up 26.8 percent for the year through Dec. 22.
A 1993 study of the equities on the New York and American stock exchanges - where many stocks are larger than the average in the overall market - found the same pattern. The researchers said that, from 1965 to 1989, stocks finishing in the top 10 percent on their exchanges during various quarters within each year continued, on average, to outperform the exchange's average in the next year. Over the subsequent two years, these stellar stocks were average performers, said a co-author of the study, Narasimhan Jegadeesh, a finance professor at the University of Illinois at Urbana-Champaign. (Of course, some stocks continue to outperform the market for more than two years.)
Despite this and other research showing similar results, such unconventional wisdom doesn't seem to guide most individual investors.
Terrance Odean, a finance professor at the University of California at Davis, examined the trading records of 10,000 customers of a large discount brokerage firm from 1987 to 1993. He found that investors were more likely to sell stocks that had gained in value than those that had declined.
However, the winners they sold generally outperformed the losers they kept, Odean concluded. And the stocks that replaced those sold lagged behind the latter by 3.2 percentage points a year later. One reason for that result may be that many people sell stocks just as they begin to rebound and replace them with stocks that have risen further and over a longer period.
These investors "buy too late in the cycle and sell too early," Odean said.
Out too soon
People who sold shares in Dell Computer at the end of 1996 clearly got out too early. Although those who had held the stock for all of 1996 realized a 207 percent gain, they missed out on another rise of about 200 percent in 1997. The story is similar for those who bailed out of US Airways Group, Costco, Warner-Lambert, Compaq Computer and Merrill Lynch. All of these stocks finished in the top 50 of the Standard & Poor's 500-stock index for 1996 and were there again in 1997, at least through Dec. 23.
Why are investors inclined to pull the trigger too soon?
"People have the sense that the market has gone up and will continue to go up, but they are nervous," said Meir Statman, a finance professor at Santa Clara University and a leader in the field of behavioral finance, which looks at investor decisions through the lens of psychology. "They say: 'This can't continue. This is too good to be true.' "
The recent turbulence in the market has added to the tendency to take profits fast, said Lewis Altfest, who has an investment advisory firm in New York City.
Psychological forces also may help explain why it takes so long for a stock to reach its full value. "People have a mind-set about a stock" that is hard to break out of, said Josef Lakonishok, a finance professor at the University of Illinois who has written about patterns of stock performance. Thus, even if there is a lot of good news, the stock price may not fully reflect the improvements for some time.
But many experts caution investors not to buy a winning stock only on this or any other psychological theory. Nor should they invest just because a stock is rising - the so-called momentum strategy.
"Would I just use price momentum?" asked Marc R. Reinganum, a finance professor at Southern Methodist University. "The answer is no." Indeed, a company's fundamentals - revenues, profits, rivals' strength and so on - are the most important criteria in assessing a stock, most academics and analysts say.
Finding the winners
To find a winning stock that will keep excelling, some money managers look for rising earnings and a stock price that, despite its climb, is a good value. O'Shaughnessy, for instance, plans to unload the Dell stock held by Cornerstone Growth when the portfolio is rebalanced this month. The stock is too expensive according to O'Shaughnessy's preferred measure, the ratio of stock price to sales per share. At a ratio of 2.4, the stock is pricier than the 1.5 ceiling that O'Shaughnessy has put on his fund's stock purchases.
But he sees some good values among the rest of the top 50 stocks in the S&P 500 in 1997. For instance, he plans to buy shares of US Airways - which has been a stellar performer for the last two years - and Navistar International; the stocks have appreciated 150.5 percent and 152.1 percent, respectively, in 1997, yet they carry price-sales ratios of just 0.47 and 0.22.
Altfest also likes these two stocks. US Airways (formerly USAir) has engineered a turnaround, in part by clearing its balance sheet of debt-like preferred stock, he said. The stock also looks cheap by Altfest's favored measure of value, the price-to-earnings ratio. At 8.9, US Airways' multiple is substantially less than the 13 of the Philadelphia Airline Sector index, which includes 11 carriers. He also says the company's earnings are forecast to rise an impressive 10.7 percent in 1998.
After years of turmoil, Navistar's prospects also have improved, thanks to the sale of its troubled farm-equipment business, the retirement of a lot of debt and an increase in demand for its trucks, Altfest said. He noted that investors have high hopes for Navistar's new generation of trucks and buses, which are scheduled to begin rolling off assembly lines in 2001. With a price-earnings multiple of 14, the stock price is low even though earnings are expected to grow by 24 percent in 1998, Altfest said.
He also said Nacco Industries, a conglomerate that makes forklifts, Hamilton Beach appliances and other items, might be another solid bet. Although Nacco's stock nearly doubled in 1997, it has a P-E multiple of just 17.8, earnings that are expected to rise 9 percent in 1998 and a stock-buyback plan, which should bolster earnings-per-share growth by reducing the number of shares outstanding.
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