Contributed by: Neelabh Mishra
Mr. Steven L Birch, the president of William O’Neil + Company, was at the CFA India Society’s Bangalore chapter on 18th October 2016, to talk about ‘Disciplined Selling Rules’ as devised by the great William O’Neil himself. Well known for his CANSLIM approach to stock selection, Willaim O’Neil has written numerous books on Investing and Business. Through his extensive study of stocks, charts and patterns over the years, William O’Neil discerned simple signals one could look out for in order to guess the fate of a position. The approach used is purely technical. Steven argued that through their research they discovered that fundamentals typically lag the technical by almost two to four quarters. Depending on the strength of these warning signs one could either reduce or completely liquidate their position in a timely manner, thus protecting the returns of the portfolio.
While the art of buying is well-established, it is the art of selling that puzzles even the best of us. And it is the latter that determines the effectiveness of the former. And this is where Steven discussed the need to trade in harmony with the general direction of the market. Buying during the Bull markets and selling when the Bears get too loud. Building up positions during the Bull markets helps one ride the wave of optimism fuelling the market. It can be done by using a mix of fundamental and technical factors. However, the trick is to know when to exit. This is where the proponents of fundamental analysis and the contrarian approach to investing would beg to differ from our speakers at William O’ Neil. The former would argue that it is impossible to know, with reasonable certainty and consistency, the time around which one should exit a certain position.
Steven, on the other hand, says that maintaining healthy Sell discipline by recognizing signals can go a long way in optimizing the performance of a portfolio. It can help achieve three objectives of selling; 1) Protect Capital; 2) Lock In Profits; 3) Reduce exposure due to market distribution. These signals are not binary. Some are weak while the others are strong and one must use professional judgment depending on what the daily and weekly charts look like.
Here are the major highlights of the discussion:
A. Keep Your Losses Small: Protecting capital should be the first priority. For this Steven suggests limiting losses to 7-8% of the purchase price. It prevents catastrophic losses at the cost of a potentially mild recovery in the future. It is important to remember that the deeper one climbs into a hole, the harder it gets to crawl out.
B. Avoid Climax Tops: This feature has been noticed for many big winners. A stock that has already had a long run suddenly shoots up due to the euphoria in the market. Soon after, this becomes unsustainable. The investors realize their mistake and the stock tanks rapidly. Climax Tops are typically characterized by:
- A sudden acceleration; a 25-50% rise in just two or three weeks after an eighteen week or longer rally
- Largest daily spreads since the beginning of the move up
- Exhaustion Gaps occur when the stock’s low for the day is higher than the previous day’s high
- One could look for a recent stock split
- The stock is trading 100% or more above the 200-Day Moving Average
C. Read the Signs of Weakness: These signs often indicate a weakening in the quality of the stock. Depending on the strength of these signs, one could either liquidate the position or just reduce the exposure while waiting for more sure signs like the Climax Top
- New highs on Low Volume
- Poor rally on Low Volume
- Lagging performance relative to the market
D. Act on the Change in Trend: These indicate a change in trend for the stock, indicating a corresponding reversal in fortunes
- Stock trades below the 50-Day Moving Average
- Largest one-day price drop
- When the weekly Uptrend is broken
The key here is to maintain consistency in following these rules over a long period without being swayed by emotions or the accompanying noise in the market. It is not possible to determine exactly when the tide would turn but extensive data analysis reveals the presence of these warning signs in varying degrees whenever market corrections have happened in the past. There would be some lost opportunities of course, but stocks that turn to dust, hurt us more!