Selling The 10-Bagger

WHY SELL?
There are two reasons to sell a potential 10-bagger. The first is to correct a mistake. The second is to maximize profits.

As much as we would like to think that all our buy decisions are on the mark, most aren't. This is especially true of 10-baggers. My early articles on the subject pointed out that leading up to a successful launch, many 10-baggers have very convincing false starts. They can easily increase in price two- or threefold before falling back to their original starting point, or lower. How do you know if those falls are just pullbacks or full-fledged retreats into the abyss of the penny stocks?

Preliminary studies have shown that once a 10-bagger has launched, 93% of them experience at least one price correction during their move, and 13.3% of our sample trigger a monthly moving average convergence/divergence (MACD) during that correction. Using these statistics as a guide, it is reasonable to assume that we have an 86.7% confidence level that a pullback that does not trigger the MACD is just that, a pullback -- not a reversal. There are several interesting twists to that conclusion that we will discuss later. For now, from the standpoint of correcting a mistake and protecting invested capital, waiting for a monthly MACD signal before a stock reaches 10-bag status is a reasonable corrective sell strategy.

However, from the standpoint of maximizing profits, the MACD is seriously flawed. After a stock has achieved 10-bag status, the percentage of stocks that trigger the MACD during a correction actually increases to 50%. Thus, before the 10-bag point the MACD tells you when it's time to sell, but after the 10-bag point the MACD is no better than the flip of a coin. The falling stock is just as likely to go to new highs as it is to tumble into the penny stock pit. This is an especially irritating twist, considering that the average drop in price from its peak price to the MACD signal is approximately 40%. Thus, you could lose more than a third of your gains waiting for a sell signal, which turns out to be not worth the wait.

Can we improve on this dismal result with a different perspective? To answer that, we will look to the fundamentals or maybe our skills as speculators.

FIGURE 1: STOCK PRICE VS. SALES AND EPS

However, we do get a little warning from the fundamentals if we convert them into valuations, in this case the price/earnings ratio (P/E). Figure 2 illustrates the P/E of a 10-bagger along with the revenue growth and calculated price/sales ratio (P/S). During the first half of 2007, the P/E ranged between 30 and 60, and the P/S was above 4.00. Compared to an industry average of just 9.1 for P/E and 0.5 for P/S (as well as an Standard & Poor's 500 P/E between 17 and 18), the price was getting in front of the fundamentals. Something had to give.

FIGURE 2: THE FUNDAMENTALIST'S VIEW. Here you see the stock price vs. sales and P/E. Something changed between February and June that spooked FRPT's shareholders and led them to sell in June.

If we compare what turned out to be a pause in February to the reverse that occurred in June 2007, there is little difference in the fundamentals. Both P/Es are high, as is the P/S, and the EPS and sales are still growing. But something changed between February and June that spooked the shareholders of Force Protection (FRPT) and made June the "when."

THE SPECULATOR'S VIEW
While investors mostly buy history, speculators focus on expectations, and there was a significant change in the expectations for FRPT between February and June 2007. The two biggest were that FRPT was reaching the end of its sales surge, and it reported a management restructuring, which implied it was having trouble handling success.

In a purely market sense, the flattening of the sales curve would be the bigger issue. Stock buyers place a big premium on growth. Take away the growth and the premium disappears. FRPT was approaching $1 billion in sales. With the reported arrival of competitors into their market, speculators would be asking if there was any further sales growth to be had. If they concluded there wasn't, the P/E of 50 would have to fall to 9 or 18, and it could only come from a drop in stock price.

As if the sales issue wasn't enough, the company announced in March 2007 that it would have to restate past earnings. This injected another layer of uncertainty that foreshadowed the stock's decline. Given these new negative developments, a speculator would be inclined to sell at the next weak point in the stock's price rise, which occurred in June 2007.

FIGURE 3: WHEN DO YOU SELL? Deciding when to sell is a combination of fundamentals, speculative foreshadowing, and technical twists and turns.

The February 2007 move (which actually began in January) was preceded by an RSI overbought indication. However, it failed to penetrate the 26-week MA, which according to Justin Mamis in his book, When To Sell, is a significant sell signal, especially if the MA has turned over.

The MACD was triggered, but the DMI was not. Given this indicator set, some traders might decide it was time to get out. However, the monthly chart (Figure 1) was still bullish, and our previous suggestion of selling on the monthly MACD was not met. In addition, the fundamentals were strong, and there were no speculative threats on the horizon. Thus, investors and speculators were probably not motivated to head for the exits along with the early traders.

June 2007 presented a different profile and further sell signals. The valuations were skyrocketing, and there were storm clouds forming on the speculator's horizon. The stock was repeating its February decline from a new overbought position (RSI), but this time it had an additional confirmation from Mamis and the DMI in July. And while the monthly MACD did not provide firm support until September-October, it was trending downward (Figure 1).

The June-July price decline gave both traders and speculators plenty of reasons to sell. Of course, a trader along the lines of John Magee would ignore the context and focus on the chart. So let's do that before we leave the trader's point of view.

Let's summarize some chart observations that can be made using our entire sample of 10-baggers. These observations relate to a monthly chart. Of the 10-baggers, 29 were observed for a total of 972 months from launch to peak price. The medium number of months between launch and peak price was 36. The average was 33.5 months.

Of the 972 total months:

• 305 were down months, 31.4%.
• 246 were months that opened, closed, or had lows below the SMA, 25.3%.
• 68 of the months would have triggered a sell signal, according to Mamis's theory.

Of the 29 10-baggers studied:

• 23 triggered the Mamis signal before their peak price, 79.3%.
• 4 triggered the MACD before achieving 10-bag status, 13.8%.
• 15 triggered the MACD after achieving 10-bag status and then went on to new highs, 51.7%.

If anything, the preceding summaries illustrate that selling is not a simple formula. The key to selling is in the narrative. It's a story, one composed of fundamentals, speculative foreshadowing, and technical twists and turns. Each 10-bagger has its own unique tale, and each shareholder must be in tune with and react to that narrative.

THE FRPT STORY
FRPT provides an excellent example of that dynamic. With FRPT, the high fundamental valuations were warning signs that something had to give, in this case the price. In addition, from a speculative view, we know that there are limits to growth that are defined by market size and competitive restraints. As FRPT approached its limit, the growth premium afforded it evaporated, and its price fell to comport with industry norms. That is FRPT's story.

So when do you sell? An aggressive trader would have been out in February (using the weekly chart), but the more conservative trader might wait until June, July, or October to bail. With all these exit points, the trader gives back as much as 40% of his profits. However, the speculator, with one eye on the chart and the other on the newspaper, might have moved when he saw the bearish engulfing candlestick in June. Such a quick response would have put an extra $4.00 per share in his pocket. By trading within the context of the story, the speculator can maximize his profits.

The fundamentalist might still be holding the stock. After all, FRPT is, at its latest reporting, fundamentally strong. Its last reported quarterly sales were actually higher than its last reported annual sales. Unfortunately, the reports are old -- September 2007 for the quarter and December 2006 for the annual, which is a troublesome sign. Its latest P/E has fallen below the industry average and its P/S is now in line with its competitors. In addition, it continues to report large contracts for its products, and there is no reason to assume this will abate anytime soon.

Given these fundamentals, it is possible that the fundamentalists held through the collapse. And as bad as that sounds, at $4.50 a share (its current price), they still have a three-bagger, which is a 45% annual return over three and a half years.

IT'S A MYSTERY
So when do you sell? The answer is in the narrative. While each narrative presents a unique mystery, they share some common clues, which are:

1. Market: Companies grow within a market. In the case of FRPT, the market was for bomb-resistant vehicles. These are primarily sold to the military. It is possible to determine the size of the market by calculating the current number of armored vehicles in the military's inventory. This gives a clue as to how big the company can grow.
2. Competition: Most companies don't get all the market. They share it with competitors. The greater the competition, the smaller their share and the lower the price they can command. This limits both their sales and profits.
3. Management: Some management teams can handle the explosive growth, but some can't. Watch the operating leverage metrics such as gross profit and S&GA expenses. If the management is getting sloppy or building an empire, it will show up in these measures.
4. Legal: Always be aware of legal threats. Shareholders lawsuits, patent infringements, environmental transgressions, and so on. In the case of FRPT, a slew of shareholder class actions have been filed that could reduce future earnings.
5. Financial: Remember, presence of profits grow the company; lack of cash bankrupts it. Companies with high debt or low current ratios do not command (or will lose) valuation premiums.
6. Chart: Watch the chart and follow the crowd even if the fundamentals are still sound. Ten-baggers are longer-term trades, but they are still trades. They are not buy and hold investments. This is a critical point that fundamentalists must keep in mind.

Selling the 10-bagger is the end of a story. Anytime after it has reached 10-bag status is a good time, but the optimal time depends on its unique story and the skills of its reader.

Thomas Maskell is a retired engineer and MBA with a modest nest egg, 45 years of experience managing large and small businesses, and a fundamental curiosity about the workings of the stock market. Direct comments and questions on this article to Brdgames33@aol.com. Be sure to include "10-bagger" in the subject line to avoid the tyranny of the delete key. In addition, look for Maskell's first book, The Complete Guide to Investing During Retirement, in October 2008 from Adams Media.