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How the Best Investors Buy Growth Stocks

Posted
10/11/2012 2:27:00 PM
By: Cabot Heritage Corporation
Referenced Stocks:COH;KORS

What Most Investing Systems Don't Tell You

Size Matters!

The Next Coach?

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Everyone has an investing system of one kind or another to guide them through the stock market minefield. I'm not talking about a black-box mechanical system, but a simple collection of rules and tools to follow. Even novices have some sort of belief system that guides them into what stocks to buy, and when to buy and sell them. Of course, for beginners, the "rules" are often based on innuendo and falsehoods ... but they make the odds are better than playing roulette.

Most systems, though, are more advanced than that; they offer the investor some structure and guidance for much of what he will see in the market. These systems will usually tell an investor when it's safe to buy and when it's dangerous (market timing), highlight the characteristics a stock should have before being bought (trending up, good sales growth, etc.) and probably include some guidance on entry and exit points for individual stocks (buy on earnings gap, sell on break of the 50-day moving average, etc.).

However, one thing that few systems really cover is position sizing ... how much of a stock to buy, and how to handle that position (buy more, sell some, etc.) as things progress. But that's one of the most important things to know! The reason is rather obvious-if you buy and sell the exact same stocks at the exact same time as another investor, but vary your position size, you'll end up with vastly different results.

I could probably write a 10-page article all about different methods of position sizing; I've studied dozens of methods, tried out a bunch of them myself and have even written a bit about it in past Wealth Advisories. But instead of getting too far into the deep end on the subject, I want to write about one thing that happens to many investors, and yet, hardly anyone ever notices.

I'm talking about the danger of small positions.

While this position-size discussion applies somewhat to all investing styles and systems, it's most applicable to growth stocks. Why? Because growth stock systems are normally more skewed than other styles (fewer of your winners will account for much of your gains), which rely on being correct a higher percentage of the time.

Said another way, with growth stocks, the size of your average winner is what counts most; with other styles, that statistic is important, but your winning percentage is just as vital.

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Most investors have heard many times about the danger of positions that are too big; all that yadda yadda about diversification and "not having too many eggs in one basket" is really another way of talking about the mishap of positions that are too big. And it's true; you shouldn't be putting all of the rent money in one or two low-priced Internet stocks.

But let's be honest-in the current environment, when appetite for risk is ridiculously low, few investors are tempted to get too big. What I've seen is just the opposite ... their positions are too small, which not only costs them profits on the way up, but leads to other problems as well.

For instance, in the Cabot Market Letter's Model Portfolio we have 12 "slots," so each new addition is usually 8% to 9% of the portfolio (speaking in general terms; it can vary more than that). However, I know from my various dealings with investors that many don't think that way-instead, they buy a set number of shares or buy a relatively small dollar amount.

The end result is that many people might have, say, a $100,000 account, but they're only buying $3,000 positions in each stock ... a 3% position. That's too small! Why? There are many reasons.

The first and most obvious: If you actually pick a big winner, owning a 3.0% position isn't going to do you much good. Said another way-why take the risk in the first place if you're not going to make any worthwhile money if you're right? Even if the 3.0% position zooms 50%, you've only made 1.5% in your account ... before any taxes or fees!

And the problems with small positions go further than just not participating on the upside. What I've found is that, if an investor has a bunch of small positions, he'll end up being underinvested if the market really gets going on the upside-he might own seven or eight good stocks but only be 30% invested. So, after a couple of months of buying 3% positions, what does he do? He starts buying bigger stakes-after the market and most stocks have skyrocketed!

In other words, not only does he miss out on much of the upside, he ends up putting on big positions when risk is elevated (after a big run) ... getting the short end of two sticks instead of one.

Another big issue is stock selection. If an investor is taking small positions (and, hence, small risks) on every trade, he's far more likely to talk himself into buying some less-than-stellar set-ups or more speculative companies. That sounds reasonable, but my experience is that investors who do this simply throw money away in three or four small chunks. You shouldn't let your position size tempt you into a poor trade.

As I said above, I could write (or talk) about position sizing for an hour or two; I am convinced that improving their position sizing can be a big help to a lot of struggling investors. If you have any questions, I'm happy to lend some guidance-feel free to email me (mike@cabot.net).

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As for the market environment, it's tough out there-most growth stocks and the major indexes have been consolidating/correcting for a month now, and with earnings season just getting started, volatility is sure to remain high.

That said, I'm not waving the white flag; in fact, by my measures, the intermediate-term trend is still pointed up and, despite plenty of pain in recent days, most leading stocks have thus far found support above or just below their 50-day moving averages.

That doesn't mean the market can't break wide open-anything is possible. But as I frequently write in Cabot Market Letter, it's best not to anticipate what may or may not happen-instead, just go with what has actually happened. To this point, we've seen a tedious retreat that hasn't caused a boatload of breakdowns, and the major (longer-term) trends are still pointed up.

Thus, I've pruned some exposure during the past couple of weeks, but I'm also not burying my head in the sand-I'm keeping up a list of enticing stories and charts for when the selling squall passes. One name in my Model Portfolio that has held up well is Michael Kors ( KORS ) , a company I feel could be an emerging high-end retail giant.

Instead of going into detail about the company's wares, what investors need to focus on is its truly remarkable growth across the board. In the quarter ending in June, Michael Kors' wholesale revenues boomed 66%, while licensing revenues gained 61%; combined, those two made up about half of the firm's quarterly revenue.

But it's Michael Kors' retail segment that really gets us excited-revenues there grew 76%, and at the end of the quarter, Kors had 253 stores compared to 177 one year before. Amazingly, sales at stores open at least one year grew a ridiculous 38%! That might be the biggest number we can ever remember ... except for the current quarter: Kors has already preannounced great results, with same-store sales up 45%!!

Of course, the company doesn't have anything revolutionary; this is no cancer cure or new way of doing business. But we see something akin to Coach ( COH ) circa 2003 ... a company with an outstanding brand name and management that is still early in its growth phase.

Technically, KORS just came public late last year, had a huge run in January, February and March and then based out while the market corrected. A gap higher on earnings in August led to another run, but recently KORS has consolidated, partly because of the market, but also because of a huge 23-million share offering. Those shares came from early investors who wanted to cash out-they were not new shares, so there was no dilution, and not many shares were from management.

The stock has thus far remained above its 50-day line, and it seems to have digested the offering in fine fashion. Obviously, if the market tanks, KORS is likely to get hit, but right here, I think the stock is a decent buy with big upside potential for when the bulls return.

All the best,

Michael Cintolo
Editor of Cabot Market Letter