Philip Fisher Articles: Switching Stocks

Posted on Wallstraits: Switching Stocks

Switching Stocks

Out with the old, In with the new

We seem to have several lively discussions (e-mail and forums) this week about selling stocks. One of the topics that I believe is particularly important is the idea of switching, or selling one stock in order to buy another, nearly simultaneously. The switch is usually predicated on the belief that the stock being sold is overvalued, while the stock about to be purchased (with sale proceeds) is more undervalued (and/or has brighter future prospects). I was writing a recent review of legendary growth stock investor Philip Fisher's little known book Conservative Investors Sleep Well, when I came across this quote about switching:

Philip Fisher (1975, as discussing when to sell stocks that meet his stringent screens): "In my opinion there are important reasons such stocks should usually be retained, even though their prices seem too high: If the fundamentals are genuinely strong, these companies will in time increase earnings not only enough to justify present prices but to justify considerably higher prices. Meanwhile, the number of truly attractive companies in regard to the first three dimensions is fairly small. Undervalued ones are not easy to find."

"The risk of making a mistake and switching into one that seems to meet all of the first three dimensions but actually does not is probably considerably greater for the average investor than the temporary risk of staying with a thoroughly sound but currently overvalued situation until genuine value catches up with current prices. Investors who agree with me on this particular point must be prepared for occasional sharp contractions in the market value of these temporarily overvalued stocks."

"On the other hand, it is my observation that those who sell such stocks to wait for a more suitable time to buy back these same shares seldom attain their objective. They usually wait for a decline to be bigger than it actually turns out to be. The result is that some years later when this fundamentally strong stock has reached peaks of value considerably higher than the point at which they sold, they have missed all of this later move and may have gone into a situation of considerably inferior intrinsic quality."

Fisher raises some interesting and important ideas. First, it is no easy task to find the perfect stock. Actually, there is no perfect stock, so when one comes anywhere close to perfection you should think long and hard before selling it, even when it appears temporarily richly valued after a strong price runup.

We have faced this issue in our Wallstraits 8 Portfolio with core holding Osim International. Our original (split-adjusted) May 2001 purchase price was 28 cents/share, with a total investment of about S$88,000. Today, Osim has risen to 72 cents/share, and our $88,000 has grown to $238,000, or a 168% total return (including dividends). That's an almost frightful gain in just a little over one year. Fisher's advice is... "even though their prices seem too high: If the fundamentals are genuinely strong, these companies will in time increase earnings not only enough to justify present prices but to justify considerably higher prices.

Thankfully, we avoided the sell instinct as Osim was rising over the last year. How? By taking Fisher's advice and going back to our 8 Screens. Osim's fundamentals were not only genuinely strong, but were improving quarter by quarter. Without this logical and rational switch-check process in place, I'm quite sure we would have been strongly tempted to bag a profit somewhere along the way... maybe 25%, maybe 50%, maybe 100%...

Fisher's second keen insight deals directly with switching from one stock already in your portfolio to another that looks attractive. He seems to advise against the switch with the reasoning: "The risk of making a mistake and switching into one that seems to meet all of the first three dimensions (Fisher's screens) but actually does not is probably considerably greater for the average investor than the temporary risk of staying with a thoroughly sound but currently overvalued situation until genuine value catches up with current prices."

Switching from a proven core holding to a unknown new holding is dangerous stuff according to Fisher (and he was drawing on decades of knowledge and a very strong track record). Not all holdings in your portfolio may be "core" holdings. Some of these minor holdings, or holdings that are showing a decay in fundamentals may reasonably be considered switching candidates when a newcomer scores very high on your screens. I think the key is to stay as unemotional as possible, rely on and trust your screens, and stick with your rare winners as long as they continue to show good business progress. Patience and logic.

------------------

Previous Philip Fisher articles

1. Philip Fisher Articles: Finding Growth Stock
2. Philip Fisher Articles: Investing in Growth
3. Philip Fisher Articles: Conservative Investors Sleep Well