Run your winners or take profits? How the pros decide

In the happy event that a stock has gone up a lot, every investor faces an uncomfortable dilemma. Do they stick or twist? Do they ride the momentum in the hope that they have found a company that is truly unique and can continue to outpace expectations?

Or recycle the profits into something that has lagged in the hope that it will catch up?

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It is a difficult balance to strike. In the short term, markets can be distracted by everything from a Trump tweet to a rogue inflation statistic. Deciding whether a company’s share price has reached the limits of its potential, or has further to run, is an art rather than a science.

Investors must also battle their own instincts, which tend to favour inaction. It is very difficult to sell out of an investment that has been a good decision and delivered high returns. It is far easier to cut a holding that has been a persistent disappointment, even though this flies in the face of the cardinal rule of buying low and selling high.

Fund managers tend to use various disciplines to avoid the natural tendency to fall in love with good companies in a way that blinds them to a change in outlook, or high valuations. This may include having price targets that force a review of a holding, regular rebalancing that pushes them to recycle capital from holdings that have done well into holdings that have done badly. They may also have risk parameters that limit the size of individual positions.

The technology giants

The performance of the technology giants is a glaring example of this dilemma in action. NVIDIA Corp (NASDAQ:NVDA), Meta Platforms Inc Class A (NASDAQ:META) or Microsoft Corp (NASDAQ:MSFT) are undoubtedly great companies, with high earnings, plenty of innovation and a foothold in the astonishing growth of artificial intelligence (AI). Yet they are expensive. According to Morningstar data, Nvidia’s share price is currently 66x its annual earnings, while Microsoft’s is 35x.

The problem became clear this summer when Nvidia delivered a 122% rise in revenues and its share price went nowhere. The market had expected astonishing results, so gave Nvidia no credit for achieving them.

The trajectory of high-growth companies always tends to be bouncy. The team on Scottish Mortgage Ord (LSE:SMT), for example, says that while Amazon.com Inc (NASDAQ:AMZN) has had eight drawdowns over 10% during the time they have held it (including losses of over 50%), it has delivered 11x its initial investment. The real skill was to hold on through the tough times.

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The key decision is whether the likely future growth justifies the share price. For Ben Rogoff, manager on the Polar Capital Technology Ord (LSE:PCT), the growth in AI is sufficiently exciting to merit high valuations for technology companies in that area: “The market and stocks around the AI theme have become slightly choppier, and I think to some degree they are victims of their own success. Year-on-year growth comparisons get more difficult against the staggering growth that we have seen over the past 12 months.

“There is a natural volatility that has come into the stocks, but the underlying technology makes huge progress, models are improving, the scaling laws that we think really define the scope of where AI can get to relative to human cognition continue to look incredibly encouraging – so we have not adjusted the portfolios.” Nvidia is still the largest weighting for the trust at 11%. Microsoft, Apple Inc (NASDAQ:AAPL) and Meta are 8%, 8% and 6% respectively.

He adds: “We are early in a technology cycle – elevated volatility is pretty normal at this point. We certainly saw that early in the internet days. It was an incredibly strong period for markets, but it was punctuated by some quite material setbacks along the way.”

The value approach

Hugh Grieves, manager on the Premier Miton US Opportunities fund, is more conscious of valuation and nervous where the growth trajectory appears speculative. He says: “I only invest in companies where I’m reasonably confident I can model and forecast their profits and cash flow. That is a small sub-set of the total market. There are stocks we don’t invest in because it’s too random, they’re too unpredictable and they’re too vulnerable to outside shocks.”

For him, this includes Nvidia, although he admits, “once momentum gets behind a stock, it can go on for a long time”. However, his view is that this is too risky. “When you get to that point, any valuation metric you have has no anchor to reality. You’re just rolling the dice.”

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He is always balancing the potential upside in an individual share with its possible downside. “The share price may reach a point that no longer makes sense. There’s always something that can go wrong that you’ve never thought of. If I look at a stock and say ‘if everything goes right, I could make 10%, but if there’s a problem, I could lose 30%’, that’s not great. We need to recycle that capital into an existing holding that’s done less well, or a new holding.”

Grieves recently took this view with Broadridge Financial Solutions Inc (NYSE:BR). When he bought it, the valuation was depressed because there were specific worries about the company and the outlook. He thought those fears were unfounded. Those issues have subsequently been dispelled and the stock has run up 40%, even though the earnings have only grown 7%. He says: “If the multiple isn’t likely to expand further, the only upside is the earnings growth”.

Jeff Atherton, lead manager of the Man Japan CoreAlpha fund also has a more value-focused philosophy, aiming to buy when a company is out of favour. As such, he will look to take profits once a stock has mean reverted and its valuation has normalised.

He says: “We do not set a precise target price, as so many variables are involved, and therefore the selling zone is a range rather than a single point. In some cases, we sell relatively early into the mean reversion process, typically because our evaluation of the company or industry has been lowered. In other cases, we hold on to the stock for as long as possible, as we see positive developments.

“With the buying process, we look for some signs of capitulation - analyst downgrades, negative sentiment and low relative valuations, and with the selling process it is the opposite: signs of euphoria - heavy volume in the shares, high valuations and very positive commentary. This is ultimately a qualitative judgement, and not a scientific process.”

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Other managers will make use of algorithmic processes to take out the human factor altogether. The Jupiter Merian North Amer Equity fund is rebalanced every day, with the model re-evaluating each stock in the investment universe, using around 40 million data points, to produce a daily forecast of future returns for every stock. Manager Amadeo Alentorn says: “Based on this new forecast, the model will suggest a number of buys and sells. These buys and sells are reviewed by the investment managers and then put on to trade.”

The idea is that the companies with strong prospects are more likely to remain in the portfolio, while those whose prospects have deteriorated will be sold.

He adds: “It is well understood that no single investment style can work across an entire cycle. Therefore, our stock selection criteria are weighted according to which factors are likely to perform better in the prevailing market environment, which will also impact the ‘attractiveness’ of a stock.”

The process has seen them retain positions in areas such as communications services, while real estate holdings have fluctuated. The key is that there is no human bias to influence the decision to buy or sell.

In the thorny question of whether to stick or twist, there is no magic answer. At each stage, investors need to look at what is anticipated in the price and make an honest assessment of the potential upside versus the possible downside. Automatic checks and balances can help overcome natural biases in decision-making, but selling Nvidia is still going to be a tough call.