Now Is The Time To Get Out Of Higher-Risk Stocks

The stock market’s rally has been impressive. The major indexes are now up about 40 percent from their recent lows, give or take a few percentage points. And for anyone who scooped up more speculative shares on weakness, the profits could be even higher.

Personally, I don’t ever recommend purchasing shares of companies with shoddy business models, consistently unprofitable operations, poor track records of caring about their shareholders, etc.

But I realize that many investors did buy these kinds of stocks as aggressive ways to play a rebounding market. And that’s why I wanted to make a particular point in today’s column to warn you about holding on to these companies in your portfolio.

Reason: I believe the easy gains have already been made, and the losses on any downside move could be very sharp and swift, erasing any profits that have piled up.

In Fact, the Very Definition of “High-Beta” Stocks Is That They Make Outsized Moves BOTH Ways!

Typically speaking, the less stable a company is fundamentally, the greater the swings in its share price. That makes sense when you think about it …

After all, a firm that has been around for 100 years … posted solid sales and earnings gains … and built a stable of well-known brands is far more likely to survive economic and market cycles than a start-up company running on venture capital fumes.

The measure of an individual stock’s volatility relative to the broad market is called its “beta.” Here’s how it works …

Analysts assume the market (such as the S&P 500 index) has a beta of 1 and cash has a beta of 0.

Thus, if a particular stock’s beta is above 1, the shares are likely to experience swings greater than those of the market. Conversely, a stock with a beta under 1 will probably swing less than its comparable index and is closer to having your investments sitting in cash.

Let me give you an example: If XYZ stock has a beta of 0.5, it should move half as much as the S&P 500. In other words, if the S&P 500 loses 10 percent, XYZ should fall 5 percent. Ditto for up moves - if the market rises 10 percent, the stock should gain 5 percent. Meanwhile, under the same market conditions, a stock with a beta of 4 would be expected to go up or down 40 percent!

For this reason, many investors equate beta with “risk.” And that is largely accurate, though beta is simply a reflection of a stock’s past moves. It doesn’t factor in any recent changes in the company’s business model … shifts in market conditions … or how long a stock has even been around.

The Case for Rotating Back into More Defensive Stocks Right Now

As I said a moment ago, investors have been loading up on higher-beta shares as the recent market rally gained steam.

And in Dividend Superstars, I followed a similar logic, though with a much more conservative spin (and much farther ahead of the curve).

Between October and December of 2008, I told my subscribers to load up on a few companies with rock-solid financials and healthy dividends but operating in what are traditionally higher-beta industries, including:

1. Southern Copper Corp. (PCU: 23.90 +1.11 +4.87%) - a major copper-producing company that was getting hammered as investors focused on the global slowdown and the implied weakness in copper demand. Beta: 1.45
2. Texas Instruments (TXN: 21.02 +1.25 +6.32%) - One of the largest semiconductor makers in the world, and a household name in the technology space. Again, the stock had been beaten down as investors fled to safety and shunned “cyclical” names like TXN. Beta: 0.98
3. Patterson-UTI (PTEN: 14.39 +0.46 +3.30%) - A large land-based drilling company with a major focus on the natural gas market. The shares had gotten pummeled as rig counts fell relentlessly. Beta: 1.49

As you can imagine, all three of these companies have seen their share prices rise substantially since my initial recommendations, especially as other investors started buying up tech companies, natural resource firms, and other stocks that are highly correlated to an economic rebound.

But I recently told subscribers to close out all three of these positions. Why?

Because while I continue to like all three firms, I think they’re vulnerable if the market makes a move back toward lower levels (a high possibility, in my opinion) or once investors come back to the grim reality that economic conditions have not yet improved much at all.

The end result: I’m tracking bagged gains of 23.7 percent (PCU), 24.6 percent (TXN), and 33.8 percent (PTEN) in just a handful of months. (And many of my subscribers likely did MUCH better depending on when they bought and sold!)

Is there the possibility that the shares will keep going higher? Absolutely! Heck, PCU has done just that since my sell recommendation.

That doesn’t upset me much. After all, perfect timing is impossible. And given this brutal bear market, I’d rather pile up money in the bank than watch huge gains get swiftly erased again!

That’s precisely why I’m suggesting that you consider selling off at least some of the higher-risk, higher-beta shares in your own portfolio right now. If you bought these companies on market weakness, you’re likely sitting on similar gains right now. I’d rather see you keep what you so rightfully deserve!

Of course, that begs two important follow-up questions …

“So Are You Saying I Should Dump All My Stocks? If Not, What Stocks Do You Like Now That the Market Has Rallied?”

No, I am absolutely NOT saying you should sell off all your stock holdings, especially your core income-producing dividend shares.

In fact, I am actually saying that, within the equity portion of your portfolio, you should consider taking two steps:

First, book gains on some of your more speculative stocks.

Second, put some of those profits to work in more conservative names that have not enjoyed the kind of returns that higher-risk stocks have gotten during the market rally.

That is the true way to be contrarian within the stock section of your account. And I believe it’s the right approach for a few reasons:

Reason #1: The defensive names are likely to hold up best through what I think will be a long economic slog.

As I’ve argued all the while - tobacco, food, alcohol, prescription drug, and utility companies provide the goods and services that people buy no matter what. And they also happen to be among the biggest dividend-paying firms, too. No coincidence there.

It would be naïve to think that we’re completely out of the woods economically speaking. Therefore, holding less economically-sensitive shares just makes sense.

Reason #2: Since many of these defensive names have not enjoyed much of the rally, their yields are still relatively high … and much nicer than the returns you’d get from CDs, money market funds and other income investments.

Reason #3: By getting ahead of the curve, you will likely enjoy better overall capital gains when other investors rotate back into these tried-and-true names.

Want an example?

On March 30, I told my Dividend Superstars subscribers to scoop up 50 shares of Colgate-Palmolive (CL), one of the most boring companies you can find. I based my recommendation on the fact that CL’s shares hadn’t budged much off their 52-week low even though many other stocks were beginning to rally strongly.

Since then, the stock has started to move, and is up about 19 percent. But there are many other well-known dividend companies that remain bargains in this market and should provide better total returns than higher-risk shares … no matter which way the S&P 500 heads next.

So please use this current rally as an opportunity to re-evaluate the risk in your portfolio, and make some changes if necessary!