VERSACE: When to hold ‘em, and when to fold

ANALYSIS/OPINION:

What may come as a surprise to some people is that simply buying stocks and bonds does not make you an investor.

It takes the act of both buying and selling of financial securities, be they stocks, bonds, mutual funds or exchange-traded funds, to make you an astute investor. What separates a buyer of stocks from savvy investor, in my view, is knowing when to exit a position. After all, until you ring the register, the only profits you have are on paper or the computer screen these days. The same is true in knowing when to cut your losses on a losing position and moving on to find a viable opportunity to recoup any losses.

At the outset of this column, I wrote that it takes a lot of work to make a build an investment thesis, narrow the list of related investment candidates and make the investment selection. Knowing when to sell requires a similar thought process but it also has one other common field mine, which is falling in love with or becoming emotionally attached to the company in which you have invested your hard-earned dollars.

Becoming attached with a company and its stock can blind you to what may be really going on with the company or in the industry. It’s easy to say, “be objective” or “remain cold-blooded,” over your investment choices but one of the risks in becoming attached or “holding on too tight” is the inability to let go. That inability may result in not booking profits when you should or remaining in an underperforming position.

For me, I tend to look for inflections in the reward-to-risk profile to determine when to enter or exit.

Let’s look at an example: In the past several weeks, shares of rare-earth-element company Molycorp Inc. have made an impressive move on an absolute basis and a relative one compared with the S&P 500. The vast majority of that share-price increase came in the past few weeks as China cut export quotas for rare-earth elements by 35 percent in the first half of 2011. Subsequent headlines, along with Molycorp being not only one of a few new sources of rare-earth materials in the medium term, but a domestic supplier as well, were the primary drivers in my opinion.

Even though the short- to medium-term fundamentals are intact, I find the reward-to-risk profile in Molycorp shares far more balanced at current levels when several things are considered.

First, on Wednesday, President Obama will meet with Chinese President Hu Jintao with the aim of improving the relationship between the two countries. While I do not expect any immediate shift, the subsequent tone and potential policy changes, as they pertain to rare-earth-element export quotas from China bear watching. Keep in mind, it was the political and trade-related aspects of rare-earth elements, as well as the scarcity factor that drove Molycorp shares up over the past several weeks. Any reversal or softening in China’s position, would likely pressure rare-earth-element companies and their respective share prices.

Second and more specific to Molycorp, the lock-up period associated with Molycorp’s July 2010 initial public offering expires on Thursday. This risk, in my view, given the rapid rise in MCP shares, is that insiders will seek to monetize their positions. Per data from Nasdaq, insiders own approximately 67 million shares, or more than 80 percent of Molycorp’s common-share count.

Lastly, we have to remember that rare-earth-element companies at the end of the day are mining companies. As such, we have to consider the valuation when looking at these types of companies on a price-to-peak-earnings perspective. Other mining companies have peaked at an average of 12 times peak earnings generated over the 2002-2010 period. While factoring in a modest premium to account for scarcity, at the current share price Molycorp would have to deliver peak earnings of $3.75-$4 per share.

Currently, Wall Street expects Molycorp to generate earnings per share of $2.60 in 2012. Aside from keeping our eyes on peak-earnings potential at Molycorp, we will also keep a watch on new production and capacity increases from other rare-earth companies, including Rare Element Resources, Avalon Rare Metals and Lynas Corp.

As I see it, the net view on Molycorp share is this: While long-term fundamentals are in place for rare-earth elements over the short-to-medium term, these factors, the meteoric rise in the shares over the past several weeks coupled with potential change in export policy, the lock-up expiration and peer valuation metrics shift the reward to risk profile to one that is more risk heavy.

Some investors may be swayed by the news flow and keep their positions, but as I mentioned at the outset, savvy investors know when to enter and exit investment positions. There is no shame in booking profits, and few like to talk about losing money in the market.

Good luck and good hunting.

• Chris Versace, the Thematic Investor, is the director of research of Think 20/20, an independent equity-research and corporate access firm located in the Washington, D.C., area. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.