Editor's note: This story was originally written going into 2023 and has been added to our CNBC Investing Club white paper vault. This is the kind of in-depth reporting on the markets that Club members can expect. Investing for the long term is our mandate at the Investing Club with Jim Cramer. However, in the short term, there can be unfavorable factors that impact a company's fundamentals, and a winning stock can turn into a losing trade. On the other hand, when stocks are rising, investors have a dilemma — albeit a good one: When is it time to pare back winning positions and take some profits? Before taking any action, you need to be informed. "Buy and homework," as Jim likes to say. That's his take on "buy and hold" investing because you never want to be static. You always want to be stress-testing your holdings, whether they're working or not. Unfortunately, there are no hard and fast rules. We often worry about getting too greedy when a stock is rising. But what might be greed to us at the Club could be a comfortable risk-reward calculation for another investor. Each investor must fine-tune her rules of the road. Sometimes, investing is more art than science. Conversely, human nature may tell you to ride the stock down a bit further in hopes of a reversal. But hope is not a strategy. When you must take losses, use them as learning opportunities. Deciding to sell can free up capital for the next possible buying opportunity. You can always make your money back on another stock. It may be tempting to consider selling when a stock is steadily falling well below your cost basis or when it seems to be going up and up. Neither are reasons alone to move on. We don't care about where stocks came from, we care about where they are headed. There are some tell-tale markers that can determine when it's time to start thinking about bowing out rather than hold on to a stock that could cost you further, or when to take your profits. When managing our own portfolio, there are six questions we ask ourselves that could also be beneficial to Club members — three on selling losers and three on selling winners. By no means exhaustive, these questions should be viewed as good starting points to keep us disciplined and check our emotions — which should never play any role in our selling (or buying) decisions. Let's start with the questions to get our minds around how to trim or sell some of those cherished winners and then we'll go through the questions on how to think about dumping a loser with real-world examples from our portfolio and what we learned from taking our medicine. 1 | SELLING A WINNER: HAS THE RISK-REWARD PROFILE BECOME LESS ATTRACTIVE? The stock's current P/E ratio should be compared to its own historical P/E ratio, the P/E ratios of its industry peers, and its earnings growth rate. This comparison can help you determine whether you are overpaying or underpaying for a stock at its current price. A high P/E ratio means investors are paying more for each dollar of company earnings. It also suggests that investors are willing to pay up for what they expect will be higher future earnings. Stocks become overvalued when their prices rise faster than their earnings estimates. A very high P/E compared to a stock's peers could mean that its price may not fully justify its earnings potential. In this scenario, you are taking on more risk with the stock. The stock may be trading at a premium, reducing your risk-reward potential. This could be a chance to lock in some gains and rebuild your cash position. Consider: stock XYZ has a $1-per-share earnings estimate and is trading at $10 per share. This implies a 10 times price-to earnings multiple ($10 share price divided by $1 earnings per share). If the stock jumps to $15 but there is no material news and earnings estimates remain at $1, the stock is now trading at 15 times earnings. In other words, the stock is now 50% more expensive and it could be time to sell for some profit. On the other hand, if Wall Street analysts estimate XYZ company could generate $1.50 in earnings and the stock rises to $15, it is still valued at 10 times earnings ($15 per share dividend by $1.50 eps). In this case, sticking with your position is justified. 2 | SELLING A WINNER: IS THE MARKET OVERBOUGHT? Market data can drive some selling decisions. One specific indicator that Jim uses and one that we often reference in the Investing Club is the S & P 500 Short Range Oscillator . The Oscillator, which is updated every day after the market closes, is a market indicator that shows whether the market is overbought or oversold. A market that is overbought can refer to a market that has had a big move up in a short period of time. The higher the Oscillator gets the more overbought it is. On the flip side, an oversold market occurs when the market takes a big move lower in a short amount of time and may indicate that we have overshot to the downside. In other words, investors may have gotten too negative, and the market could be due for a bounce back. The Oscillator can show whether market levels have strong, weak or neutral averages. If the Oscillator goes up, we tend to get short-term cautious. Typically, a value of 5% or more may not be the ideal buying opportunity because there could be a chance to buy at a lower level, unless the stock is down for some unjustifiable reason. For example, if there is a huge market run in a short amount of time and the Oscillator goes to a positive 7 or 8 reading, we are monitoring the overall market and looking at which of our stocks are up as potential trimming targets. If a stock has rallied 20% in a week, that may be a good candidate to trim off and take some profit. This decision doesn't necessarily relate to the quality of the company, rather it could be an ideal time for us to sell and raise cash, so we are ready to buy into another high-quality company that looks cheaper. In late July 2022, after a market rally, the Oscillator moved to an extreme overbought reading of positive 8. It was then when we decided to trim our position in Salesforce (CRM) , which had risen 15% since we first purchased it in late May 2022. We didn't change our thesis on the company, but we saw an opportunity to secure a profit after the stock and its multiple increased significantly over a short period of time. 3 | SELLING A WINNER: SHOULD WE RIGHT-SIZE A POSITION? This is the most straightforward consideration: We typically don't like to let any stock position grow beyond 5 to 6% of our portfolio. When we start to approach that threshold, we start to sell and take profits because we want to keep the portfolio diversified. Usually, the reason why that position got this large in the first place is due to a recent stretch of outperformance. This sell decision is not a call on the company but rather a risk-management principle that helps us stay true to our discipline Even if you are a staunch supporter of a company and you want to keep building your position without a limit, you are putting yourself at risk because there is always some risk present even in the highest-quality company. This is out of your control as an investor. For example, input costs for a company could get too expensive, consumer demand may weaken, or a company may no longer have access to a certain market. No company can control 100% of the things that impact its business, so a 5% cap is a way to manage our risk associated with a single company or a select few of companies. We decided to trim our position in Danaher (DHR) in late July 2022 after the stock rose almost 14% following its strong second quarter earnings release. This was a discipline over conviction scenario where we needed to take off some of our Danaher position because we had built it up to the largest position in our portfolio. At the time, and still to this day, we think Danaher is one of the best run companies but to keep consistent with our mantra, it was necessary to scale back on the holding. In April 2022, we similarly sold some shares of Apple (APPL) as its weighting in the portfolio was becoming too big. 4 | SELLING A LOSER: HAVE THE FUNDAMENTALS OF A COMPANY CHANGED? A break in a company's fundamentals can come in many forms, including a change in forward guidance, a decline in profits or a shift in a company's strategy that worsened the business. We saw some of these factors at play with the former Club holding American Eagle (AEO), which ultimately led to our decision to part ways with the specialty retailer. When we first bought American Eagle , the retailer recorded a strong performance in the first half of 2021, when it had benefited from consumers spending their Covid pandemic stimulus checks. Strong consumer demand for its loungewear led to sales growth, which improved the retailer's profitability and operating margins. We bought some more into some retail weakness heading into 2022, before the full extent of the inflationary headwinds that came to define this year came into focus. But as economic uncertainties and what turned about to be anything-but-transitory inflation started to kick in, American Eagle was operating in a different environment. The company's quarterly earnings started to shed light on troubles the retailer had been facing. Higher input costs ate into margins, supply chain issues persisted due to factory shutdowns in Asia and consumer preferences started to shift away from what was popular during the pandemic. The retailer took an $80 million loss due to elevated freight costs in its fourth quarter of 2021 reported on March 2. Management provided a cautious forward guide for 2022, expecting a lower operating profit in the range of $550 million to $600 million compared to 2021's adjusted operating profit of $603 million. Rising prices also spurred concerns that consumers would scale back their discretionary apparel purchases. With this, American Eagle no longer had pricing power, or the ability to increase prices on its items without impacting consumer demand. With multiple stressors on the retail sector, we exited the rest of our AEO position on May 19, 2022 , one day after getting rid of half. We took the losses in what we call a high-grading move , shifting money into a stock we felt was right for the time: Johnson & Johnson (JNJ) . Health-care stocks tend to be resistant to economic downturns because people have historically been loath to skimp on their wellness. Again, this goes to the idea that you cut losses and start to build into better names. Lesson learned: From our American Eagle holding, we were reminded that you can't be worried about selling when the original story behind owning a stock changes. As a matter of principle, when you buy a stock for a certain reason, that investment thesis should hold true throughout the time it's in your portfolio. 5 | SELLING A LOSER: WERE PROMISES MADE AND NEVER DELIVERED? We lost conviction in payment processing company PayPal (PYPL) because management was doing a poor job at setting expectations around business growth as it was transitioning out of a pandemic economy driven by e-commerce. We sold our last bit of PayPal and exited the position fully in May 2022. One of PayPal's pressure points was its longer-than-anticipated separation from eBay (EBAY) , which eventually revealed a much larger impact on growth than what management had reported. After eBay and PayPal separated into two independent companies in 2015, eBay started to transition to its own payments system and away from using PayPal's platform. This was a nastier separation than expected, making it unclear how it could impact PayPal's growth rate. At the time we held PayPal, management had promised growth after the separation — but revenue excluding eBay actually declined. PayPal CEO Dan Schulman provided upbeat comments in a November 2021 "Mad Money" interview with Jim, leading us to believe that its problems were behind the company. But that was followed by earnings misses and weak forward guidance, which made us question management's credibility. In the fourth quarter of 2021 , which reported in February, PayPal provided mixed results and lower-than-expected estimates for the first quarter. PayPal delivered $1.11 earnings per share versus $1.12 consensus estimates and forecasted 2022 revenue growth of 15% to 17% when analysts had expected 17.9% growth in 2022. In the first quarter of 2022 released in April, we were discouraged by PayPal's lower net revenues of $6.5 billion versus the previous quarter's net revenues of $6.9 billion. Another red flag was PayPal's speculation around acquiring social media platform Pinterest (PINS) . What would have been the biggest acquisition of a social media platform ended in PayPal addressing what it called "market rumors." PayPal announced in an October 2021 press release that it wasn't pursuing an acquisition with Pinterest, sparking concerns of how it would increase new active accounts. Apart from PayPal's multiple execution problems, we also considered how macro challenges could weigh on the company. PayPal's post-pandemic business had trouble keeping up with its strong pandemic performance. We were concerned about a slowdown in e-commerce growth, supply chain challenges, and the broader market turning against tech stocks. We also weren't too keen on PayPal's exposure to cryptocurrency through its crypto platform. In the first half of the year, crypto had been selling off, so there was uncertainty around how much PayPal could be impacted. Lesson learned: When a company reports a number of bad quarters in a row, even if management says everything is OK, it's time to move on from the situation because the stock will likely sit in the penalty box for an extended period. 6 | SELLING LOSERS: ARE THE FED AND THE MARKET WORKING AGAINST YOU? The phrase, "don't fight the Fed," refers to positioning your investment portfolio with companies that could benefit from the Federal Reserve's monetary policy, or at least not get crushed by it. We think this is a good mantra to follow because the direction interest rates take can have a considerable influence on the market. In 2020, the Fed lowered interest rates to near zero and took other extraordinary steps to try to stimulate the economy in the early days of the Covid pandemic. This created liquidity, much of which made its way into the stock market. When Wall Street anticipated a change in the Fed's monetary policy at the start of 2022, stocks steadily sold off, eventually going into a bear market. In early April 2022, two of the most dovish Fed governors gave separate speeches describing the harmful effects of inflation. We took their comments seriously and viewed this event as a sell , sell , sell moment for higher multiple and economically sensitive stocks. Their words meant that the Fed had finally gotten serious about raising interest rates and slowing the economy down to combat inflation. Over two days back then, April 5, 2022 and April 6, 2022, we exited Nucor, lightened up on Microsoft (MSFT) twice, and trimmed Amazon (AMZN) , Ford (F) and Marvell Technology (MRVL) . Lesson learned: In the midst of a Fed policy change, you can't be afraid to sell a stock that has fallen because of a shift toward a tightening cycle that originally benefitted from a loose monetary policy. The Fed's fight against inflation remains the story in 2023, which started off strong after a terrible 2022. The market made a 2023 high in February and then ran into some trouble. In fits and starts, the S & P 500 have been trying to get back to those February levels ever since.
