Don't Fall in Love With Your Winners

 | May 16, 2013 | 4:00 PM EDT
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We have been bullish on the stock market and on our 2013 outlook. The market has had robust gains to date, and we look for stocks to trade even higher by year-end. However, we do expect some volatility and pullbacks along the way.

If you have been on the sidelines, it's not too late to buy stocks, but we would take partial positions and add to them during any pullbacks. We continue to believe there is still good opportunity in select financial, technology, industrial and energy names.

On the other hand, we are more wary about the strong pace of gains in consumer staples, telecom and utilities, and we do expect a slowdown. 

Since many stocks are up sharply from their lows, it's very important to not fall in love with your winners. In light of the sharp gains for the market overall and for a number of individual stocks, it makes sense to review your conviction in some of the strongest gainers, compare current prices with your targets and review the stock's valuation metrics against its historical ranges. In some cases, it will make sense to start taking some money off the table.

We would not be taking that money out of the market unless you have too much committed in the event of a decline. But consider moving out of names where you have less conviction and into others that you believe are ready for the next leg up or which would be more protective in a pullback. 

The following is a simple road map to use in deciding whether it's time to declare victory in some of the biggest gainers. Also, remember that it's not an all-or-nothing decision. In many cases, you can do well by slowly scaling out of these stocks into their gains.

1)    As stocks have shown sharp gains, look at a particular stock's 2013 and 2014 projected price-to-earnings ratios compared with the overall market (the S&P 500 sells at about 15.0x 2013 earnings and 13.5x 2014 estimated earnings) and relative to where it has sold over the past 10 years. If the P/E is well above the market and is at extremes to the company's historical relationship, consider scaling back.

2)    Use a similar analysis to compare the stock with its peer group. If a stock is selling at the high end of its peer group's valuation on P/E ratios and the low end on its dividend yield, unless you believe it's warranted, you might consider that as a flag to scale back as well.

3)    Has the stock's investment thesis played out? If you bought a stock with certain expectations of a turn in business or as an acquisition target, and if this event has occurred and the stock prices in this information, then the stock should be a candidate for sale. A few names that we have either recommended as takeover candidates or that were ultimately acquired fall into this basket. If you own BMC Software (BMC), H.J. Heinz (HNZ) or Life Technologies (LIFE), we would be sellers.

4)    If a business continues to struggle but the stock price has been lifted by the better overall market, you should consider moving on. This is especially the case if you believe the market is temporarily overlooking overhangs or upcoming business risks. Some defense names may fit into this category. Defense spending will be under pressure in the next few years, yet the stocks have rallied with the market. Be sure you understand what you own in this area.

5)    Finally, don't just sell a position because it's up a lot. Compare the stock price relative to earnings, valuation and outlook. A lot of financials have had great runs but are still are cheap relative to earnings or their book value. In many cases there should be a lot more to come. We have highlighted JPMorgan (JPM), Wells Fargo (WFC), BB&T (BBT), MetLife (MET) and Morgan Stanley (MS) as names to own. They have all had sharp gains, but we feel they are reasonably valued and have a lot more upside in the future. Cisco Systems (CSCO) was up nicely today and is up sharply from its lows, but it still sells at a very reasonable 12x earnings. We believe the stock will continue to trade higher in the upcoming weeks and months.

While market psychology and momentum might carry all stocks even higher, locking in profits as winners reach fair valuation or over-valuation and redeploying the money into new more reasonable priced investments is a prudent way to protect capital and position your portfolio for future gains. Similarly, take an honest look at your losing investments and ask yourself if further patience is warranted or if this an opportune time to move on.

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