Stop Orders, Targets Don't Help Us

1/4/2010


Have you ever wondered why we don’t typically use target prices or stop-loss orders as part of our selling strategy? If so, you’re not alone.

While in the past we’ve answered these questions one subscriber at a time, we hope this story will explain our procedures to everyone.

Q Why don’t you use stop orders to limit your losses when stocks go down?
A Because selling losers may not boost portfolio returns.

If you purchase a stock at $50 and do not want to risk a drop of more than 10%, you can place a stop-loss order that kicks in and sells the stock if it drops to $45, 10% below the purchase price. Admittedly, the idea of controlling losses sounds good. And in cases where a stock’s share-price action is a central reason you own it, a stop order can make sense. But, for our purposes we see two main weaknesses with the stop-loss:

First, stocks often bounce back. Suppose you own a portfolio of high-quality stocks during a down market. The market could fall 10% and many of your stocks could get stopped out (sold at the stop price). Most stocks tend to move with the pack, at least in the short term. All too often, stop-loss orders get you out near the bottom, and you miss the subsequent rally.

Second, if a stock falls sharply you may not get out at your stop-loss price. Suppose your $50 stock declares disastrous earnings after close and opens at $38 the next day. Your order would be executed at or near the open, most likely well below the $45 you had hoped to get. You could use a stop-limit order that sells only at $45, but in this case a stop-limit order would result in no sale.

For a more specific look at the effect of stop-loss orders, check out the table below. Last year, we added 14 stocks to the Buy List, all of which are still rated Buy. If you set a stop-loss order at 10% below the price at which the Forecasts added the stock, you’d have sold 12 of them at a roughly 10% loss. However, 10 of those 12 stocks currently trade above the price at which we purchased them. Even a looser stop set at 20% would have gotten you out of seven of the stocks at a loss of roughly 20%, missing out on the gains six of them have since tacked on.

STOPS WOULD HAVE WEAKENED RETURNS
Of the 14 stocks added to the Buy List in 2009, a stop-loss order set at 10% below the purchase price would have sold 12 at a loss. Most of the stocks are now trading above their purchase price.
— Added To Buy List —
Would
Have Sold
— Using . . . —
Price
Chg.
on Buy
List
(%)
Company (Price; Ticker)
Date
Price
($)
10%
Stop
20%
Stop
Current
Rating
Laboratory Corp. of Amer.
($76; LH)
11/27/2009
73.29
Yes
No
4
Buy †
Travelers ($50; TRV)
11/5/2009
50.64
No
No
(2)
Buy †
General Mills ($72; GIS)
10/22/2009
65.55
Yes
No
10
Buy †
Aflac ($47; AFL)
9/24/2009
41.00
No
No
14
Focus
Buy †
Hewitt Associates
($43; HEW)
9/24/2009
36.16
Yes
No
20
Buy
AmerisourceBergen
($26; ABC)
8/13/2009
20.58
Yes
No
28
Focus
Buy †
CA ($23; CA)
8/6/2009
21.53
Yes
Yes
7
Focus
Buy †
Hospira ($51; HSP)
6/4/2009
35.46
Yes
No
43
Focus
Buy †
Comcast ($17; CMCSA)
5/14/2009
14.79
Yes
Yes
15
Focus
Buy †
CVS Caremark ($32; CVS)
5/14/2009
31.55
Yes
Yes
3
Focus
Buy †
GameStop ($22; GME)
4/9/2009
32.42
Yes
Yes
(31)
Buy
BMC Software ($40; BMC)
3/26/2009
33.90
Yes
Yes
19
Focus
Buy †
Dolby Laboratories
($47; DLB)
2/12/2009
32.90
Yes
Yes
44
Focus
Buy
Stryker ($51; SYK)
2/5/2009
42.00
Yes
Yes
22
Buy †
† Also qualifies as a Long-Term Buy

If the goal of a stop-loss order is to limit losses by selling losers before they dip even lower, the strategy would have worked on only one of the 14 stocks. In all the other cases, subscribers would have been better off holding the stocks through the price decline.

This phenomenon is not simply an anomaly for Forecasts stocks or a fast-rising market. A strategy of selling S&P 1500 Index stocks after they declined 10% or 20% lagged the return generated by simply buying and holding all the stocks in the index since 1995.

Q Why don’t you use target prices?
A We get this one a lot, and the answer is simple — the target is always moving.

When we recommend a stock as a Buy, we aren’t implying a certain return, but rather that the stock will outperform the market over the next 12 months. Target prices interfere with that strategy in two ways:

First, suppose you set a target price 30% above the purchase price. Sure, a 30% return sounds good. But what if the broader market then rises 30% and the stock matches that move, while the catalysts that caused you to recommend the stock remain intact? Do you sell a stock with potential to outperform the market just because it has hit a prearranged price? Not if you trust the reasons you recommended the stock in the first place.

Second, consider the example of Cognizant Technology Solutions ($46; CTSH). When we added the outsourcer and consultant to the Buy List on Dec. 11, 2008, we saw an attractive valuation and the potential for profits higher than market expectations. In this case, we got in at just the right time. We could have sold the shares at a 30% profit in April, but the reasons we purchased the stock were still valid. The shares are now up 157% from the purchase price, and we still haven’t set a target price. Our strategy with Cognizant has not changed despite the big gain — we will sell when we no longer believe the stock represents a top pick for 12-month returns.


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