How to handle a 'high-class problem' with a stock like Nvidia

In yesterday's e-mail, I repeated my warning about Nvidia's (NVDA) stock at current levels, concluding:

To be sure, Nvidia is a great company with a bright future...

But given its size – more than $120 billion in run-rate annual revenue and a $2.6 trillion market cap (even after yesterday's big drop) – and valuation – more than 22 times run-rate revenue (not earnings) – it would take unprecedented (and unlikely) performance for the stock to be a good investment at these levels.

As I said in Thursday's e-mail, "this is the kind of stock I like to pound the table on when it's down at least 50% (if not 75%)."

This led one of my readers, John M., to send me this excellent question:

I'm seeing your post on NVDA. I'm a lifetime subscriber to the old Empire Stock Investor letter, now with Stansberry. Your advice got me in to NVDA, and it has done incredibly well.

In recent months, you wrote about lessons learned, one being to ride your winners – and so I have with NVDA.

But today, I see your post on NVDA which makes me think you are saying to sell. True?

Is selling your advice, as I was otherwise thinking to buy more if it goes to mid-90's.

Thank you.

To be clear, I can't give personalized investment advice to individual readers. However, I'll address this issue publicly today because this is one of the trickiest questions investors face...

What should you do if you own the stock of a great company, it's firing on all cylinders, and the stock has skyrocketed?

Keep in mind that this is a "high-class problem" – it's one that all investors hope to have often!

One the one hand, as I wrote on June 11:

... the key to long-term investment success isn't just being smart – and lucky – enough to own a few huge winners. You must let your winners run.

Looking at the math behind long-term investment success, take any portfolio of 20 stocks or more, and you'll see that it isn't usually driven by a high batting average (e.g., 80% of the stocks go up), but a high slugging percentage (a few huge winners) instead.

But of course, this math doesn't work if you sell those winners – that cuts off the long right tail of the distribution.

But what if such a stock becomes such an outsized portion of your portfolio that you're losing sleep at night?

An easy answer is to trim it – but not too much. As I also wrote in my June 11 e-mail, using my investment in Netflix (NFLX) a decade ago as an example:

It would have been terrible risk management to let such a richly valued, speculative stock become 20% of my portfolio – let's be clear, this was never something safe like Berkshire Hathaway (BRK-B), which could be 50% of my net worth and I wouldn't lose a wink of sleep.

But I was far too conservative deciding to keep the position size in the 3% to 5% range, given how cheap it was on an [enterprise value ("EV")]-to-subscriber basis during nearly the entire run-up.

Instead, I should have kept it in the 8% to 10% range.

But what if position size isn't an issue – rather, you're just worried that the stock has gotten ahead of itself and don't want to give back your big gains?

Here, the answer requires some investment judgement. Just because a stock has run up a lot doesn't mean it's overvalued.

As I noted in the case of Netflix, I had purchased the stock when it was a 10-cent dollar – that's right, it was 90% undervalued using a market-cap-per-paid-subscriber metric – so I didn't need to have sold half when it doubled, and then sold another half after it doubled again.

But a stock like Nvidia today is a very different situation. As I wrote on June 11:

In July 2014, Netflix still only had a tiny market cap of less than $30 billion, only 1% of Nvidia's $3 trillion market cap today, meaning it had far more room to run.

And keep in mind that Netflix was still trading at a huge discount to Hulu, based on an EV-to-subscriber basis.

So what's the answer today for folks like John who have big gains in Nvidia's stock?

Keep in mind that there's no "right" answer – or a one-size-fits-all solution – here...

But if I had this high-class problem, I would want to let the stock run, but have a series of stop losses in place – let's say, starting with selling 20% of my position if the stock fell 20%. Then, if it dropped 30% from its peak, I could sell another 10%... down 40%, another 10%... and finally another 10% if the stock got cut in half.

So, using Nvidia's all-time closing high price of $135.58 per share on June 18 and this potential series of stops and sells, the first stop loss would be at $108.46 per share (down 20%), which it hit on July 30.

Then, in less than three weeks, NVDA shares rallied back to $130 on August 19... but have since pulled back to close yesterday at $106.21.

Here's the stock chart over the past three years so you can put the recent moves in context:

Then, the next stops in the series would be $94.91 (down 30% from the peak), $81.35 (down 40%), and $67.79 (down 50%) – in each case, selling 10% of my original position, such that, if the stock was cut in half, I would have taken half my money off the table and locked in huge gains.

At that point, I would stop selling, even if it fell 60%, 70%, or more – which isn't at all out of the realm of possibility given Nvidia's extreme market cap and valuation.

Just look at Netflix and Meta Platforms (META), which both fell more than 75% from late 2021 to late 2022, as you can see in the charts below:

"But wait," you might ask... "If Nvidia could fall 75%, why wouldn't you keep selling two more 10% chunks if it dropped 60% and 70%?"

I don't have a firm answer, other than saying it's a judgement call. I think Nvidia is a great company with a bright future – the type of stock to hold for the long run – so I would be more inclined to be a buyer than a seller if it fell more than 50%.

Those who held on to Netflix and Meta after they fell 50% (or, better yet, had the courage to buy more, as I discussed in a series of e-mails starting on November 1, 2022) have done extremely well – even though they had to suffer the pain of another 50% decline – as you can see in the charts above.

Another variable to keep in mind when deciding when and how much to trim is the reason for a stock's decline...

If Nvidia's stock fell due to general market weakness – perhaps because of an economic slowdown or recession – I would have wider stop losses and/or sell less.

But if the decline were due to company-specific issues – missing revenue or earnings guidance due to lower demand for its chips, perhaps due to rising competition – I would sell much more aggressively.

In conclusion, I want to emphasize that there is no formula here, as this is more art than science.

This hypothetical stop-loss strategy for Nvidia I've outlined here could be different a month from now – and would certainly be different for another stock. Each situation is unique.

And of course, all investors have different appetites for risk and how much money they're willing to potentially lose... Again, there's no one-size-fits-all perfect answer.

But I hope I've given John and other readers some food for thought on ideas for how to let winners run, while also protecting against giving back big gains.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.