What To Do When Investments Turn Into Great Trades

John from California writes:

"I know you are a long term investor, but given that one of your 2008 Select List picks just went up 30% in a matter of days, I'm stuck as to what to do, sell or hold on? Any thoughts?"

John, thanks for the question. A common answer to this dilemma (feeling compelled to book gains even if your time horizon has not played out yet) is to sell a portion of the position. This gives you the best of both worlds by booking some profits but staying in the stock. Oftentimes I will sell half of a position if I'm really torn about what to do.

However, this works best with large gains (say 100%) because you accomplish both taking a lot off the table and maintaining a sizable position for meaningful further gains. With a 30% gain, however, selling half brings your overall position size down to about one-third less than the level it was less than a week ago, which could very well be too small for your taste.

In that case, I might consider selling 20%-25% rather than 50% in order to keep a full sized position for the long term. After all, the Select List is geared for intermediate to long term investors, even if gains over the first week for one of the picks was unusually high. Hope that helps.

BAC/CFC Baseball Analogy

Sometimes baseball analogies work as well as anything to help explain something. With Bank of America (BAC) buying Countrywide (CFC) for $6.1 billion ($4.1 billion in stock plus the $2 billion in cash they invested last year), one came to mind. I think this is a lot like when a major league pitcher hurts his arm badly and elects to have "Tommy John" surgery. You have to sit out a full year, but the club is banking that an extended period of time off will result in maximum recovery, resulting in the player pitching like this old self when he returns the following year. You sacrifice the near-term in order to maximize long term upside potential.

Bank of America was already the largest mortgage player among the big diversified banks. Adding Countrywide (the largest independent mortgage company) makes them the Goliath in the industry. In the short term, this will hurt them. More losses, more write-downs, more delinquencies until the cycle hits bottom and stabilizes. It won't be pretty. But when the cycle does turn, losses have largely been absorbed, and we (hopefully) get back to a time when you put money down and get a fixed rate mortgage to buy a home, the BAC/CFC combo could be a home run.

To put the purchase price of $6 billion in perspective, Countrywide earned between $2.2 billion and $2.7 billion in profit every year between 2003 and 2006. Obviously the later years were more "bubbly" in nature, but if you look out several years, when the overall mortgage market will be larger in volume terms (despite lower margins most likely as ARMs dissipate), the CFC deal could easily add $2 billion in annual profit to BAC's business after you factor in cost savings from the merger and cross-selling to a new customer base. That puts BAC's cost basis at 3x earnings, even after factoring in the $2 billion convertible preferred investment last year. Clearly that is what Bank of America CEO Ken Lewis is banking on, pun intended.

Full Disclosure: Long shares of Bank of America at the time of writing

Third Time's A Charm?

Earnings season officially kicked off this afternoon, with Alcoa (AA) reporting fourth quarter numbers. Given the worries about the economy, these profit reports obviously carry as much as weight as anything in determining market direction, but they also come at a time when the S&P has once again dropped down to a support area between 1350 and 1400. Since I am not of the belief that the Fed can cure all of our ills on its own, the next few weeks are crucial to whether or not we can maintain these levels again, or if a wider bear market (not just in financials and consumer discretionary stocks) awaits us.