Continued from last week’s post (note, I’ll only provide a “couple” of applications to the meaning of taking a profit if you believe a stock might take a turn for the worse):

First, if a company I’ve bought cheaply has risen in price, having garnered attention due to seeing steady earnings growth but then something occurs to make me believe that the earnings will pause or decline in the foreseeable future, I’ll sell and move to another situation. So, this is a scenario where my belief in things becoming worse is defined by a negative shift in the company’s business outlook. Such a shift is thus consequential in my judgment, moving me to take profits and look elsewhere. For sake of clarity, so long as the outlook for earnings growth is being sustained by management commentary included in the latest earnings report and via earnings follow-up conference calls (not every small company does quarterly earnings conference calls but many do), I have no reason to conclude things may take a turn for the worse. So, I tend to hold my position unless the stock has moved well above my adjusted floor price and has “also” become overpriced relative to earnings growth (beyond theme of this post).

Second, let me use the oil service stocks environment of today. A short while ago, oil started dropping. There’s a phrase in the investing world that says “don’t try and catch a falling knife.” I think this applies well in the commodity world. So even though oil service stocks quickly declined to deep value prices, the oil price per barrel kept falling; in turn, the stock prices got even cheaper. Oil eventually reached around $43 a barrel before starting to show life again. Let’s say I observe the oil price firming for several days; and I decide to buy a given stock, hoping I’ve found a low price for my investment.

Since commodity pricing for the next several years is beyond my ability to predict and commodity companies are dependent on commodity prices for their success, my stock pick had to be one where the balance sheet revealed not only a lot of equity for the money (most oil service companies carry a lot of fixed assets on the balance sheet), but especially a very strong working capital (current assets less current liabilities) position. Strong working capital helps a company survive a prolonged downturn.

Assuming that the oil price seems to have found its bottom, at least temporarily, I next reason that I’ll buy (add) some “trading” shares in addition to my investment “core” position. Since I’m uncertain about whether oil has really bottomed for good, that means I believe it could improve temporarily but get worse again. Thus, if the stock price of my selected company bounces say, 15 to 25% in short order (due to oil bouncing back from its relentless selling pressure), I’ll bank profits on my “trading” shares. I’ll also rinse and repeat on the “trading” notion if the situation permits. If oil goes back up and just keeps going, well, I’ve got my “core” position still. If it goes back down and remains for a time, my company reflects a very healthy balance sheet to weather a prolonged storm. If it didn’t, I would not have bought in the first place.

So in this second scenario, I’m believing oil will definitely come back at “some time” in the future; I just don’t have a clue as to when. So, I’m therefore believing it could get worse, perhaps repetitively until higher oil prices are in place again. By including “trading shares” in my portfolio, as the situation may present itself, I can bank profits during the bottoming process for the underlying commodity.

This two part post has ventured into the realm of selling stocks; I’ve said before, selling is far more abstract than buying in my view, and much more a learned art. I believe my post today hardly scratches the surface. But its intention was not to focus on “selling” but rather to address Steve’s interest in reacting, profit-taking-wise, to a belief of “taking a turn for the worse.”

Thanks to Steve for the note and the question.