Oct 042015
 

Sell your losing positions

Thanks for reading!

Oh I should elaborate a little.

Mistake #1 – Assuming market trends continue indefinitely

Last year I bought into ZUH (BMO Equal Weight U.S. Health Care). I was attracted by the massive gains over the past 3 years…surely they would continue indefinitely? right? right??? (Mistake #1 – assuming the current trend will last forever) But even if the gains relaxed, the aging baby boomer population will surely continue to savage devour healthcare services? Considering these points was enough for me to scoop up some shares.

As you may or may not know the health care index recently got taken out back and savagely tenderized. No doubt helped in part by Mr “lets raise the price of this life saving drug by 5000%“. Naturally my first thought was “If only I had sold at the top I would have made sweet sweet bank!”. Alas if only I could predict the future! Marty Mcfly arrives from 1984 in a couple weeks, maybe he can help.

 

Mistake #2 – Timing the market

My second though was “well this sucks, maybe I should sell my position and cut my losses” (Mistake #2 – Attempting to time the market, also mistake #1 again). I’m not worried though, soon enough I’ll learn what I should have done. But by then it will be too late. Time travelling the slow way!

If you got a lemon of a stock/ETF, you should definitely sell, but how would you know? Well to answer that question we need to go down a dangerous, long, and often boring road called “stock judgement”. Stocks are a little more complicated than my criteria for ETF judgment. And I’m not going to do it for you, read a book you lazy Warren Buffet wannabes!

 

So…. should I sell and cut my losses?

I still need to decide if I should sell my health care ETF position. Really I just want to know if the ETF is overvalued. For that I’ll judge based on the price-to-earnings ratio. The P/E ratio is simply comparing the current stock price to the company’s profit. A lower P/E ratio means the stock is less expensive (since you can get a larger piece of the company’s profits for a lower price). Lets look at the P/E ratio for the top holdings in ZUH:

ZUH Top Holdings

Seems there are 3 P/E ranges: Low (15-20), Medium (~40), Outrageous (>100). We also have the average P/E ratio for the entire ETF, which is 25.41.

But wait! What’s a good P/E ratio? is 100 good? Well the entire S&P 500 has an average of 20.52 according to this website, so ZUH is about 5 point higher. But comparing healthcare to the entire market is like comparing a doctor’s salary to everyone who works at Walmart. We need to zoom in on the greater healthcare industry and see how ZUH compares! I’ve listed the P/E ratio and market cap (the total monetary value of their collective stocks) for the subsectors of health care in the table below:

Health Care Industry

Average P/E for all health care is 44.87 (source)

As you can see the drug manufacturers and biotech people dominate the industry according to their market cap. And look at those crazy biotech people with their P/E ratios of nearly 200! Meanwhile drug makers are pretty cheap with their P/E of 20.2. And in case you were wondering this particular source didn’t have data for the first 4 listed industries.

Biotech likes to hang out at these high P/E ratios because they are normally research based around a single drug. They will make no money until they have a breakthrough drug for cancer/aids/heart disease/death and sell it for billions! It’s a great place if you like to gamble on high risk stocks.

Meanwhile drug manufacturers have slow and steady profits. They are like bonds, your shares won’t suddenly jump by 50% overnight, but you can normally count on them for steady gains over the long term.

ZUH has a good sprinkling of companies from all these sectors with a slight emphasis towards drug manufacturers. Thus a P/E ratio of 25.41.

 

Wait a minute, didn’t you just compare the index to itself?

Good catch dear reader. All I did was confirm that ZUH is tracking the healthcare index with the bulk of holdings in more reliable drug companies than biotechs. Although interesting, I shouldn’t act on the P/E data alone. Really I just subtly taught you something about stocks! Take that! You can never unlearn that knowledge!

The only conclusion I can really draw from the P/E analysis is that the ETF isn’t horrifically overpriced. What I really want to know is what every single person wants to know about their stock:

Is the intrinsic value higher or lower than the price? Is it overvalued or discounted at its current price and should I buy/sell?

If I knew how to get a reliable answer to that question I’d be filthy rich by now. But alas here I am trying to come up with a justification that I can live with. Time to ask the internet!

 

My quick and dirty method for market evaluation

Find a resource with easy to understand metrics and evaluate the stock/ETF yourself.

Lets look at Morningstar’s Market Fair Value estimates. It doesn’t get much simpler than this, if their ratio is less than 1, it’s undervalued and you should buy, and greater than 1 is overvalued, sell. As of this writing the total market’s ratio is 0.91, which makes sense since the sell off over the past couple weeks is making stocks cheaper. What about health care though?

The health care ratio for today is 0.93. Pretty good right? Well let’s take a look at the historic:

Health Care Ratio

Historic data for the health care industry valuation. Pretty colours!

We can clearly see the dot com crash in 2002 (even though this is healthcare) and the 2008 crash.

Now before we start panicking remember Mistake #2 (timing the market).  Sure we could be at the start of a great chasm like 2008, but what if it’s just a small blip like the one midway through 2004? One fact we can gleam from this is that we aren’t at the top of an overvalued spike and I feel confident now that I’d be a fool to sell.

One final question to remember before selling anything:

Would I buy at this price?

Obviously it wouldn’t make sense to sell if you would also buy at the same price! My answer for ZUH is yes. Sure it might drop another 10% tomorrow but it doesn’t matter since I plan on hanging on to this guy for another decade at least.

Spam your friends:

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