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Why You Should Think About Taking Your Profits and Running

Wednesday, July 18, 2007 | Dylan Jovine

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Editor's Note:  Below is a letter that Fallen Angel Stocks chief Dylan Jovine sent to his members yesterday.  In the context of my article on Monday ("Party Poopers 'R Us?") I thought it would make sense to share this with you directly. 


In lieu of the market's hitting new highs, coupled with the fact that interest rates are moving higher, and there is less money for deals (money is indeed getting tighter), I am recommending that we take profits on the following positions:

1. Sell Hilton Hotels (SYM: HLT):  We own the stock from $32.07 and should be selling it for a 41% profit.

2. Sell American Railcar Industries (SYM: ARII):  We own the stock from $34.85 and should be selling it for roughly a 20% profit.

3. Sell iShares Dow Jones Transportation Average September 2007 $85 Call Options (SYM: IYT.IQ):  We own this call option from $8.60 and the bid is $12.10 giving us a roughly 40% profit.

Under "normal" circumstances (whatever that means), I would recommend holding onto these positions.  For example, if the market were not hitting new highs AND facing the headwinds of less money available for financing deals, I would recommend holding these positions.

But the fact that money is getting tighter (witness the Chrysler deal: financing deals through bonds is getting harder and harder as bond investors demand higher interest payments for their risk) suggests that the market's new highs are more a function of crowd psychology than true fundamentals.

And that brings to mind a lesson of investing that I must share with you.  Whenever financing dries up through an increase in interest rates, that means there is less money available to investors who want to finance deals.

Since this bull market has been turbo-charged by the flurry of multi-billion dollar deals in the private equity arena, a large part of the market's momentum will be stunted when those deals begin to dry up because of lack of available financing.

Witness what happened right before the market's big crash in 1987:  private equity firms made a big offer for UAL, contingent upon debt financing.  But the banks thought there was so much leverage with the deal that they weren't getting the safety you normally get when issuing bonds.  In other words, the deal had so much debt, they began to see themselves almost as shareholders.  When the financiers backed out, the deal fell apart, and within months, the market crashed 22% in one day (October of 1987).

Today, instead of one deal falling apart, there are many cases where financiers are balking at the interest rates they are being paid to buy the debt in these deals.  Take Chrysler, for example.  The banks that originally signed up to do the deal are now asking the buyers for HIGHER interest payments.

If the company agrees to pay higher interest payments, they will be unable to borrow as much to get the deal done as they originally planned.  For example, if the company originally planned to borrow $25 Billion at 7% interest, that means that they planned on paying back $1.75 Billion each year in interest payments.  But if interest rates go up to 10%, that means the company would have to pay back $2.5 Billion each year.

That's a difference of 750 Million bucks a year.  Maybe that's the expected profit.  Or the amount of money it costs to create a new plant every year.  Either way, it is possible that the extra $750 Million means the deal is in danger of falling apart.

Now I won't make a bet as to whether it falls apart or not, but I will say that during times like this, there is more RISK in the market than usual.  And when there is more risk in the market, that means you have to have the potential for higher RETURNS to compensate you for the increase in risk.

Since the potential for higher returns is not there for the three positions mentioned above, it is time to recommend selling them.

One last comment I would like to make.  When I recommend selling something, I am NOT saying that the position will not go higher after we sell it.  In fact, I wouldn't be surprised if any of these positions traded a bit higher in the days and weeks ahead.

What I am saying is that our potential rate of return is simply not good enough for us to take the risk of holding these investments.  And when that happens, that means the music is over (which means it's time to turn out the lights).

Best Regards, and I Hope You Keep Enjoying Your Summer.

Dylan P. Jovine
Cheap Stock Investment Officer
Fallen Angel Stocks


Related Articles:  Party Poopers 'R Us?, Warren Buffett vs. Shaq, Why Stocks Drop When Interest Rates Rise, Profit from the Upcoming Crash: A Trader's Blueprint


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Dylan Jovine
Contributing Editor
The Tycoon Report




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7 Comments

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  1. Dylan (1 year ago) Is this Spam?

    Hi Jester,

    Yeah, taking these profits was unusually quick for me. Normally I'm accused of holding onto positions for far too long. But in this case, I had to re-adjust my risk adjusted rate of return analysis and pull the trigger on the stocks.

    In the end I just decided that the reward wasn't worth the risk. Fortunately, we were able to take profits (albeit small ones) instead of learning that lesson the hard way.

    Cheers,

    Dylan

  2. jester112358 (1 year ago) Is this Spam?

    The profits you mention seem to be quite short term. I would never take profits with such small gains unless a fundamental change in the individual companies occurred. The market is actually being driven by growing corporate earnings (especially international companies like GE, which explains why the DOW is at a record but NASDAC is far from it) and the MA action is basically a distracting sideshow which should be of little or no concern to long term investors. The world economy continues to grow at an acceptable pace. The difference in world stock and bond yields has remained invariant for several years (this is a good measure of differential risk between these two types of financial instruments) Trading in and out of good equities has been shown to be a money losing practice since market timing is basically impossible (i.e. when do you get back it?). And there are trading and tax consequences to this approach. Take profits only when you need to have cash reserves for living /cash flow reasons or have an better investment idea. Never invest with funds you need for living expenses. As Warren Buffet once said, "only buy stocks you would be prepared to own if the markets shut down for 10 years". He's right and has the annualized returns to prove it.

  3. Major (1 year ago) Is this Spam?

    Dylan- Yes! Patience! Risk reward and the time

    factor for options. The more things are repeated, the more it becomes a part of your thinking. Teaching and learning.

    Thanks, Major

  4. Dianne H (1 year ago) Is this Spam?

    Enjoyed the articles, especially about the past researchers. My mother had more experience in watching the indicators and economy. Timing is so important!

  5. Michael O (1 year ago) Is this Spam?

    Dylan,



    Look at the VIX. Somebody in the market agrees with you. The days of complacency (readings of 10 or LESS) went away in Feb. As the DOW climbs and the VIX climbs somebody is going to be right! Oh, and don't forget CRUDE at $74! How many dollars is that sucking out of the economy? Remember when rising crude was seen as a negative for the market?



    The obvious best course of action is for Congress to remove cash from US citizens by raising taxes. Don't worry though, because they PROMISE not to raise taxes on the middle class and this time they really mean it!



    When Congress taxes a corp, does that business pass those taxes on to consumers through higher product prices? Yes, if they can. Sounds like price inflation. Would an oil company do that too? Will any of this affect the stock market? Maybe. Stay tuned! Film at 11!



    I agree with Dylan. It's difficult and dangerous to try and capture 100% of the trend. Dylan is just being a realist in my opinion.



    Thanks

  6. hlevine216 (1 year ago) Is this Spam?

    I generally like what you say, but you used the wrong word here: "In lieu of the market's hitting new highs, coupled with the fact that interest rates are moving higher, and there is less money for deals (money is indeed getting tighter), I am recommending that we take profits on the following positions"



    "In lieu of" means INSTEAD of.



    Keep writing.

    Howard

  7. Harry G (1 year ago) Is this Spam?

    Dylan, I have been thinking the same thing about my stocks. I have been selling off two every week for the last three weeks. Excellant article. Harry Perakis
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