The Staggering Heights of Annualized Returns

A reader comments:
“Perhaps your ideas have evolved further, matured, but I'm not sure what the fair profit is from reading this article (“Seeking Fair Profits”). Is it 5%, 16% or your current strategy of 10 percent?
"I hold treasuries from 1 - 20 year in exchanged traded funds and about 10 different dividend paying equities. One has capital gains of 19%. That same stock, Suburban Propane (SPH) has beat the S&P by 60% over the last three years. I wonder why the 60% would not be a fair profit. To be "fair" would one have sold when there was a 10% profit three years ago or a 10% profit this year? What is wrong with the 19% gain my stock now has? How does one figure companies like Apple (AAPL)?"
Our response:
The literal interpretation of “fair profit”, according to Charles H. Dow, is between 5% to 10% per transaction. Personally, our benchmark is what you can obtain compared to the historical returns that the market can provide, something in the range of 9%-12%. You could be right that fair profit is more and the NLO team has been known to accept higher amounts when possible.
Unfortunately, the longer you hold a position the less you’re getting out of it unless the stock pays a dividend. Apple (AAPL) is the perfect example. Unless you believe that trees can grow to the sky, the stock has to revert to the mean at the very least. In doing so, each year, month and day that passes dilutes the gains that have been made. This is not a wish, it just happens to be the nature of the time value of money. All the while, there are alternative investments that are waiting to be obtained, like on our Dividend Achiever and Nasdaq 100 Watch Lists, that are waiting to set a torrid pace that few are willing to pay attention to.
The best approximation at an answer to your question as it relates to Suburban Propane (SPH) is found in our March 18, 2010 article titled "Gaining More by Limiting Our Gains." That article points out that sitting on a single position for an extended period of time could result in a complete reversal of gains. In that same article we pointed out the alternative investments that were accrued after we issued a sell recommendation for Meridian Biosciences (VIVO). Individually, we were able to take advantage of the gains provided by the alternative opportunities made available at or near a new low. Therefore, 60% gains in one year with any amount of our portfolio beats 20% a year with the same representative portion of the portfolio.
In order to achieve a 20% annualized gain when selling a stock at 10%, you only need the stock to reach 10% on day 183 of your investment. If you take the time to review our Sell Recommendations, 75% of the names on our list achieved 10% or more in less than 183 days. The secret is to view investment performance is viewing it from an annualized basis.
Suffice to say, when we invest our funds, during Dow Theory bull markets, we allocate at least 25% of our portfolio to each position we enter (during bear markets we allocate 12%) therefore, our initial investment has a greater impact on the entire portfolio. On a $100 portfolio, a ten percent gain on 25% of the portfolio equals a gain of $2.50 or 2.5%. In the same portfolio, a ten percent gain on 3% of the portfolio equals a gain of $0.30 or 0.003%.
  • $25 x .10= $2.50 $2.50/$100= 2.50% (based on 10% gain)
  • $3 x .10= $0.30 $0.30/$100= 0.003% (based on 10% gain)
Under the 3% of portfolio scenario, it would take a gain of 83% before the $3 position could match a 10% increase in a 25% allocation. Because we don’t subscribe to the mantra of diversification as described in our article “Diversification Doesn’t Matter,” we’re more flexible with what we acquire and vigilant about how long we hold each position.
Upon final analysis, the point of our New Low Watch List is that you can investigate quality companies at relatively undervalued levels. Once an acquisition is made you can selectively choose the time to sell with a significantly lower risk adjusted basis. Being cognizant of annualized returns as opposed to absolute returns will change any reasonable person’s mind about whether or not it is worth holding a stock longer than necessary.

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