I am often asked the question “Do you have any rules regarding investment in shares?” When this was first put to me, I thought long and hard before attempting to answer. After a few minutes of drawing on all my own experiences, I started to compile a list. But the list became longer and longer, rather like the famous question in Monty Python’s Life of Brian, “What have the Romans done for us?”! But I have subsequently managed to whittle the list down to four golden rules.
- Know how to select probable winners.
- Cut losses and run profits.
- Never invest ‘scared’ money.
- Keep reminding yourself of the first three rules.
When it comes to selecting probable winners, let The Fleet Street Letter do all the donkey-work
The first rule is self-evident. It requires analysing the financial position of the company. It requires understanding what the company actually does and determining whether the company represents good value. There is a lot of work involved. But fortunately for The Fleet Street Letter subscribers, we do the donkey-work for you.
You will have noticed that newspapers and magazines devoted to the stock market produce heaps of ‘buy’ recommendations week after week. It would be impossible to manage a portfolio if you acted on all of the advice. Meanwhile, little indication is given as to which ‘buy’ is the strongest.
At The Fleet Street Letter, we separate the wheat from the chaff and only produce just over 20 new recommendations a year. We consider each company that we pick to be the best and most suitable for the medium-term investor at that particular time. Sometimes an issue can include two recommendations, if they are both very strong candidates, but occasionally there are no recommendations at all. And this is the situation we find ourselves in this week.
After scouring the markets, we could not find a single recommendation contender that we were entirely happy with for this issue. Certainly, the fact that the second half of August tends to be a very quiet period for the stock markets, with many market participants on holiday, can result in thinner and more illiquid markets in certain stocks. This can lead to share prices being squeezed excessively high by market-makers if many investors follow our recommendation.
Cut losses and run profits – water the flowers and pull up the weeds!
The second rule is also obvious. The oldest and best axiom in investment is to run profits and cut losses – that way profits are likely to be large and losses are bound to be small. But, human nature being what it is, never has there been a rule more honoured in the breach than the observance.
Sadly, the average punter tends to sell what he/she should have kept and keeps what he/she should have sold. Another way of describing this investment behaviour is ‘pulling up the flowers while watering the weeds’.
So why is the average investor so reluctant to cut losses early? One reason is obstinacy; some of us refuse to admit that our initial purchase was a mistake and regard taking a loss as an admission of failure. We’ve all done it. We’ve all found ourselves staring at a screen hoping that something will turn up that will change a loss-making position.
Remember Marconi? The more the share price fell, the more investors said: “It’s a blue chip company, it can’t possibly go any lower.” But it did. Right down the tubes.
The lesson: if you are in a loss-making position with the only reason for holding the share is the HOPE that something will turn up, the odds are that you are holding a sure-fire loser.
Allow your profits to run – and treat targets as a rough price objective, nothing more
Running profits is in some senses a less obvious piece of advice. You will have often heard people say: “No one ever lost taking a profit.” But nothing could be further from the truth. Simple arithmetic will tell you if you take profits in shares every time you are 10% in profit and you do not cut losses until they halve, then you will need to have a five to one success rate in picking stocks just to break even.
Many investors get very jittery when a stock moves into profit; they are itching to get out on the FEAR that the profit will soon evaporate. Ask yourself: if you are that uncomfortable with a stock in profit why go into it in the first place?
When we recommend a stock, we set an original target. This is the standard practice of stockbroker research. The target is an objective, a guide as to roughly where one might expect the share price to go. What a target is not is an explicit piece of advice to sell the stock at that price. When The Fleet Street Letter advises selling a share or taking profits we give explicit and clear advice there and then.
If, for instance, the underlying reason for buying the stock is enhanced by subsequent developments, it is logical to raise our objective. For example, if we recommended an oil exploration stock when oil prices were at $20 a barrel the case for upping the target when prices reach $60 a barrel, as they are now, is clear cut.
Don’t risk money you can’t afford to lose
The third rule is never to invest ‘scared’ money. In other words, do not risk money you cannot afford to lose. If you trade the markets to pay your rent, it will end in tears. The pressure of having to perform month in month out will lead to the wrong decisions being made. Typically, you are inactive in the face of mounting losses and not confident about holding on to winning positions. On the other hand, if the individual sets aside funds he can afford to lose, he can be detached, objective and unemotional about his investment strategy. It is no surprise in the world of investment that the rich tend to get richer and the poor stay poor.
However, you will appreciate that these investment axioms are easier said than done. Nobody is perfect. Indeed, if we look at the The Fleet Street Letter equity list we have from time to time allowed loss-making positions to run longer than, with the benefit of hindsight, we should have. Bioprogress is a good case in point. But we have been more ruthless with McCarthy and Stone (see updates) and with Centaur, which we sold for a 7% loss late last month.
In recent weeks, we have also taken profits in some stocks for good reasons. Centrica’s retail margins and customer base were under threat from rising energy prices; Hays had underperformed the market and was subject to broker downgrades; and there was no reason to extend our price objective for James Fisher & Sons. We have also opted to take profits in T Clarke as we believe that the share price rally, following the successful London bid for the 2012 Olympics, has rendered the company fully valued at this juncture.
There’s no recommendation this month, but don’t get complacent – we’ll be back soon with more exciting investment opportunities
The fact that we do not provide a recommendation this week in no way reflects a bearish view on the UK equity market. Indeed, explosive money growth in the UK is underpinning an asset price boom in most sectors other than residential property. There is a raft of company announcements and results coming out early next month and we feel confident that we will have some exciting investment opportunities to offer you.
In the meantime, we will continue to try to water the flowers and remove the weeds.
Brian Durrant is the Investment Director of The Fleet Street Letter . A Cambridge economics graduate with nearly 25 years experience in the City, Brian has worked in stockbroking, the foreign exchange markets and headed the research department at one of London's leading futures and options brokers.
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