Can you buy Sub-$15 Stocks?

The simple answer is yes. Some publications suggest that buying stocks less than $12 or $15 is very risky. This is true but it’s not as risky if simple investing rules are implemented such as cutting losses quickly. (Note – I will pound this one rule into your head as long as I run this community – cutting losses quickly is the single most important rule to successful investing).

William O’Neil and IBD recommend buying stocks above the $12-$15 threshold. I also recommend this to novice investors as higher priced stocks usually don’t have the extreme volatility that some lesser priced stocks have, due to smaller floats. Personally, I am comfortable in my philosophy and have strict rules in buying and selling all types of stocks at all price levels so I feel that I can take on the added risk.

If you read MSW closely, you will notice that many sub $15 stocks are highlighted on daily screens, weekly screens and case studies. Even IBD will include sub $15 stocks in their charts, sector highlights and New America articles. Buying stocks under $15 does present higher risk but a closer study into our screens will reveal that a solid chunk of our All-Stars have started their triple digit up-trends when they were still below $15. A closer look at the IBD 100 will also reveal that a good portion of these stocks broke out while they were still under the $15 threshold.

You must do what is most comfortable for you. When I first started teaching this philosophy on the internet, I told new investors to stay above $12 and I still believe that this is good advice. As a novice investor becomes more experienced and has endured a few losses and cut a few losers quickly, they can start to take on positions with more risk. I don’t advocate buying stocks under $5-$6 except in very specific cases.

If you go back and study the weekly screens, you will notice that 7 of the top 10 MSW All-Star stocks of 2004 started their runs below the $15 threshold. I highlighted these stocks on weekly screen over and over as they advanced from these sub-$15 levels. (2004: ALDN, NGPS, ELOS, DHB, ESMC, TRGL, DCAI).

As your investing experience grows and you start to review past trades, only you will be able to determine if sub $15 stocks are right for your portfolio.

Piranha

Don't Buy Stocks based on P/E Ratio alone

...I use the P/E ratio as a secondary indicator for buying and selling stocks but I don't use the ratio in the same a manner as many value investors teach. I will explain the difference in my methodology for using the P/E ratio to your advantage.

Many value investors will pass on a growth stock that has a P/E ratio higher than a predetermined level. For example, they may discard all stocks that have a ratio of 15 or higher, no matter what industry group they come from. Some investors will discard any stocks that have P/E ratios above the industry group averages, concluding that they are grossly overvalued. I am not saying that this method doesn't work, because it does but it will not work when you focus on buying young innovative small cap stocks that are growing at tremendous rates, rates that "big caps" can no longer sustain.

I have never passed on buying a stock due to its P/E ratio being too high. What is too high? Too high to one investor may be low to another investor. This is the same logic that I use when speaking of stock’s prices. One problem that have with some value investors is their lack of understanding of the movement of the P/E ratio line on a chart. As a stock begins to move 100% or 200% from its pivot point, the P/E ratio will also move higher over the course of time. Plotting the P/E ratio on a chart will show you how much of a gain the ratio has made as the stock continues its up-trend.

Value investors that pass on buying stocks with P/E ratio’s above a certain threshold have missed some of the biggest winners of all time (the 10-baggers as Peter Lynch would say). Analysts frequently downgrade stocks when their P/E ratios cross what they believe to be fully valued thresholds.

Some things in life are worth more than other things although they offer the same use, such as a car. I tend to use this example often but I would rather own a Mercedes for $50k over a Pinto for $10k. They will both take me where I want to go but I value the amenities that the Mercedes gives me and the added comfort, quality and style that comes with the luxury vehicle. The same holds true for stocks, certain companies offer greater appeal and are valued at higher ratios than their competitors. The best materialistic things in life, including growth stocks, are usually bought at a premium.

The P-E ratio uses a stock's current price and divides it by total earnings per share over the past four quarters. For example, currently GDP has a P/E ratio 51.06 with a share price of $24.00. Its last four quarters of EPS add up to $0.47. Its P-E ratio is $24.00 divided by $0.47, or 51.06. MSN Money Central has the P/E ratio listed at 51.30.

Growth stocks usually sport higher P/E ratios than the rest of the general market, even at the start of up-trends. A high P/E ratio typically means that the stock is enjoying strong demand. If a stock climbs in price from 40 to 60, its P/E ratio also gains 50%. Even though the P/E ratio may be high according to some analysts and value investors, the stock may be about to breakout from a cup-with-handle and go on to double from this point. Would you want to miss out on a possible 100% gain because the P/E ratio is too high?

Investor’s Business Daily conducted an excellent case study in 1996-97: “The 95 best small- and mid-cap stocks of 1996-97 had an average P-E of 39 at their pivot and 87 at the peak of their run-ups. The 25 best large caps of those years began with an average P-E of 20 and rose to 37. To get a piece of these big winners, you had to pay a premium.”

When I purchase a stock, I note the current P/E ratio and chart it along with the price. Historically, P/E's that move up 100%-200% or more while the stock is advancing, usually become vulnerable stocks and can start to become extended and flash sell signals. It holds true for a stock with a P/E starting at 15 and going to 40 or a stock with a P/E of 50 and going to 115. Don't skip over EXCELLENT companies that are growing at amazing clips because of a high P/E ratio. What may seem high now, may be low later on! Earnings and Sales are much more important. Price and volume are the most important. The P/E ratio is just a secondary indicator that can be used to further analyze the stocks in your portfolio.

Always use price and volume as your first line of offense and defense. From this point, turn to some dependable secondary indicators to confirm your original analysis and then make a decision. I would never throw out a stock because its P/E ratio is too high. Take GOOG for example, every value investor missed the 100% gain that this stock boasted after the release of its IPO. Growth stocks are expensive for a reason, don’t forget the analogy to a Mercedes.

Enjoy the Weekend,
Piranha

A Common Misconception about Stock Prices

…I cringe every time I hear a novice investor tell me that they only purchase low priced stocks because they offer higher potential gains. A common phase I hear is “I like to buy $1 and $2 stocks because they can double easily and I will make a 100% profit”.

My reaction is to always let these people know that “stocks are priced low for a reason, just as stocks priced high are there for a reason”.

Like anything in life, quality is never offered at a discount. When I am in the market for a car, I don’t expect to purchase a Mercedes for the price of a Pinto. No pun directed towards Pinto car owners as I am just providing an example.

Stocks are valued at their current market value or perceived value under the current situations. A $1.00 stock is trading at this level because it is only worth this much in investor’s eyes. A stock priced at $50 or $100 is trading at these levels because of a quality that the lower priced stock does not have. Institutions, such as mutual funds, will not purchase a stock at $1 based on strict internal rules and fund guidelines. Stocks, similar to the ones on our All-Star list move based on vast amounts of support from institutions that have the buying power to propel prices 100%, 200% or more in less than 12 months.

A quick study of stock market history will prove that the majority of stocks priced at $2 or less will be de-listed or bankrupt before they ever give an investor a triple digit return. High quality stocks are typically representative of high quality companies that usually have innovative products or services that are increasing revenues and earnings thus peaking institutional interest. I have seen more stocks double or triple from the $20-$50 range than any other price level during the past five years.

A stock going up 25% in one month’s time is the same whether it is from $5 to $6.25 or $60 to $75. It happens every year. The novice investor is usually hesitant to buy a stock that is priced at $50 or more as it looks too expensive to the untrained eye. What’s expensive to an uneducated investor may be a bargain to an educated investor.

Always buy the stock that presents the highest probability of success based on both fundamental and technical analysis. The price should never matter nor should the lot size. A 25% gain will always be the same whether you buy a $2 stock with 5000 shares or a $100 stock with 100 shares.

I agree that the chances for a quick 25% gain on a $5 stock seems greater than a 25% gain for a $100 stock but it's also much greater for a 25% slide on the $5 stock than it is for the $100 stock. Your downside protection is limited with a low priced stock as it can move quickly and present you with an illiquid position that a higher quality stock may not present.

Here is a very basic example:
If you buy a $2 stock and it gains $1 in two months, you now have a 50% gain. But, if the stock falls $1 in two weeks, you now have a huge 50% loss in your portfolio, a number that usually devastates most traders.

If you buy a $60 stock and it gains $30 in two months, you will have a 50% gain. Now, if the stock starts to fall rapidly and is now down $10 in a few days, you still have a chance to sell the stock within 10% of your purchase price and prevent further loss and devastation to your portfolio. You, the investor will most likely be able to spot negative action or red flags and get out quickly enough without the sudden 50% drop that the lower priced stock could blindside you with.

Don’t buy a stock based on low prices or a quantity of shares. Always buy a stock based on quality looking towards the fundamentals and technicals and the price and volume action. Study our archives and look at the number of stocks that have gone on to tremendous gains from the $20, $30 and $40+ levels.

As you can see on every weekly screen, we don’t discriminate against $10 stocks or $100 stocks. We list every stock that has the highest potential to present a gain.

Piranha

Fundamentals are late to the Party

...Most members of this community already know the differences between fundamental and technical analysis. Some prospective members may still be confused and that is completely understandable since main stream analysts still focus on “the numbers” rather than the charts. Turn on any major network news station and you will become bombarded by fundamental analysis and strong opinions based on these numbers and nothing else. Occasionally I will see a basic line chart posted on the screen without any study or analysis from the “talking head”. In addition to not focusing on charts, these analysts tend to concentrate on the same 5-10 stocks each and every day (the most famous large blue chip stocks). It disturbs me that the “buy and hold” strategy is still the predominate scenario discussed on the major news networks and newspapers across the nation.

Reading corporate financial statements is an excellent skill for every investor but making short term buy and sell decisions based from this information can be costly. In my opinion, a short term trade is less than one year. A stock usually breaks down well before the actual fundamentals turn negative and official news hits the street. Insiders always start to sell when things are looking down or sales are not expanding. This poses a problem for the individual investor because they won't know about poor sales or earnings until the official news is published or the company changes their outlook in a conference call, months after the problem has already developed.

You now ask: How can I sell before the fundamentals crash?

It's called technical analysis, a study of chart patterns that allows the investor to see if a company may be heading in the wrong direction or sideways pattern after an extended up-trend. Fundamentals make you aware of a particular stock to purchase as sales and earnings are rising quarter over quarter and year over year but they don’t get you out of the stock before the floor drops. Just because a company has excellent earnings or a perfect track record, doesn't mean you buy immediately. You may be buying after an extended up-trend while the stock is due for a correction before its next up-trend. Nobody knows how long a correction will last; it can be 8 weeks, 8 months or 18 months. Why would you park your money in an investment that is stagnant or can possibly lose money for an extended period of time? This is the typical buy and hold strategy that the analysts tout to novice investors.

For example, if you bought Microsoft exactly five years ago today at $47.21, you would be down 54%. Yet, every network TV and radio broadcast mentions MSFT’s ticker price every night as a highlighted stock. Many analysts have said to buy as MSFT has fallen over the years. This seems to be dead money to me. I have found a lot more success buying young innovative stocks that are growing at clips similar to the numbers Microsoft boasted in the late 1980’s and 1990’s. A few other nightly favorites include MRK, CSCO, INTC and so on, take a look at their five year charts – I wouldn’t touch them with a 10 foot pole!

Technical analysis can help you spot red flags such as distribution days, breaking of support lines or slicing of moving averages. The most recent fundamentals may still be stellar but the charts will be well ahead of the numbers, flashing multiple sell signals. It is imperative that the intelligent investor sells based on the information coming from chart analysis. The buy and hold investor will not sell or even be aware of the current situation on the charts leaving them vulnerable to costly drops in price that may take years to recuperate. The talking head on TV may still recommend the stock but that is because they don’t understand that fundamentals are priced into stocks six months in advance. The technical investor will see the trouble arising and can take action well before the “bad news” hits the street. The technical investor won’t know what this bad news will be but they know it won’t be good and that is the most important fact.

When red flags are flashing in every direction, sell and wait to see how the stock is going to react and what news is on the horizon. Sooner, rather than later, negative news will come out from the company stating that sales have slowed, a contract was lost, a drug was not approved, or maybe the CEO is resigning. Whatever the negative news may be, as soon as it hits the headlines, fundamental analysts will be talking their heads off at how it may be time to sell (even though the stock is now many percentage points below the key sell signals flashed on the charts). The stock has usually dropped dramatically by this point but the numbers have not been updated until now, the time the whole free world can now sell for a significant loss. On the other hand, the buy and hold investor will usually just hold and claim that they broke even or made a profit several years in the future. Who cares if you make 25% or 50% over a 5 or 10 year period. Don’t allow a loss of 10% snowball into a 50% drop in your portfolio. It might take Microsoft another 5 years or more just to break even to the $47 level. That would make 10 years or more for the poor sole that bought exactly 5 years ago today.

The point of this blog is to promote heavy use of technical analysis while investing and deciding to sell on red flags! I use both fundamental and technical analysis to make decisions in the market and believe that both tools give you an advantage over the investor that only uses one of these tools.

Piranha

Top Incomes in 2003 for Hedge Fund Managers

Just an interesting article that I would like to add to the blog:

George Soros of New York-based Soros Fund Management earned an estimated $750 million in 2003, making him No. 1 in the latest ranking by Institutional Investor's Alpha of the world's most highly paid hedge fund managers.

Junk-bond specialist David Tepper of Chatham, New Jersey-based Appaloosa Management takes second place, earning an estimated $510 million in 2003, followed by James Simons of Renaissance Technologies Corp. in East Setauket, New York, who pulled down $500 million.

Soros regains the top spot in Alpha's third annual ranking of top hedge fund earners after falling off the list last year, when Bruce Kovner of New York-based Caxton Associates led the pack. This year Kovner ties for fifth place with Steven Cohen of SAC Capital Advisors in Stamford, Connecticut.

Both earned $350 million in 2003, according to Alpha estimates. They trailed fourth-ranked Edward Lampert of ESL Investments in Greenwich, Connecticut, who earned $420 million last year by Alpha's reckoning.

The wealth being created by hedge fund managers is simply staggering. Never have so few made so much so fast. The lowest earner on Alpha's 2003 ranking took home $65 million in 2003. Seventeen managers pulled down nine figures -- $100 million or more -- compared with just seven in 2002. The average take-home pay for the top 25 in 2003 was $207 million, nearly double 2002's $110 million.

The top ten earners in the hedge fund industry in 2003 were:
1. $750 million George Soros, SOROS FUND MANAGEMENT
2. $510 million David Tepper, APPALOOSA MANAGEMENT
3. $500 million James Simons, RENAISSANCE TECHNOLOGIES CORP.
4. $420 million Edward Lampert, ESL INVESTMENTS
5. $350 million Steven Cohen, SAC CAPITAL ADVISORS
5. $350 million Bruce Kovner, CAXTON ASSOCIATES
7. $300 million Paul Tudor Jones II, TUDOR INVESTMENT CORP.
8. $230 million Kenneth Griffin, CITADEL INVESTMENT GROUP
9. $150 million Daniel Och, OCH-ZIFF CAPITAL MANAGEMENT GROUP
10. $145 million Leon Cooperman, OMEGA ADVISORS

Hedge fund managers overwhelmingly run private operations and guard their secrecy. Alpha's formula for determining which hedge fund managers earned the most was based on two key factors: their share of the fees generated by the funds they managed, and their gains on their own capital in the funds.
These numbers were arrived at based on knowledge or estimates of the firms' capital at the beginning of the year, their performances, their fee structures and managers' ownership stakes. Publicly available sources were used, as well as the Institutional Investor's Alpha Hedge Fund 100 ranking of the biggest hedge funds (April/May 2004), which lists capital positions and fund performances. In making these judgments, II tried to choose conservative estimates.

Where do I get Institutional Numbers?

I have received almost two dozen e-mails asking where institutional numbers can be found such as the ones I placed on the most recent case study. These numbers can be obtained by any investor on numerous websites on the internet for a fee to that specific research house. I personally use the numbers from Vickers Research as I have told many of you individually through e-mail. Several types of accounts can be purchased through Vickers Research depending on the amount of information that the individual investor is looking for. The fees vary greatly and can become quiet expensive for the novice investor. A standard research plan for their services can range between $100-$200 per month and higher. I do not have any affiliation with Vickers and have never endorsed their products. I am just spreading the knowledge and allowing everyone in the community to research one of the many research houses in the country that collects institutional data each year.

Daily Graphs, a sister company of Investor’s Business Daily, also offers basic institutional sponsorship numbers on their charts but they lack in expanded detail. The complete package for Daily Graphs does cost over $1000 per year. Each tool can be purchased a la carte for a smaller fee but I don’t have the details in front of me at the moment. You all can venture to their website for the price structure.

Research tools can become very expensive for the novice investor that is not making a significant amount of money in the market. I would suggest to hold off and not purchase these tools until you are making a consistent profit using the tools on the web that are currently free such as earnings and sales on numerous websites. This additional information will be overwhelming if you have not mastered the basics of investing taught through our philosophy. I made consistent profits early on in my investing career without ever looking at institutional numbers but I now study these numbers and use them to help me make buy and sell decisions. I suggest one step at a time. I added that case study to let you know that the learning process never ends and you will always find new tools to add to your arsenal.

As I say on the FAQ page of our website, MSW is not affiliated with any company within the financial industry or any company in any industry for that matter. We use several tools from many companies around the country to produce our screens and case studies but we do not interact or corroborate with anyone at these companies. I do not accept links on this website and I do not want banner ads plastered on any of my pages as I would like to keep the site clean of any outside influence. The only links that I do provide are for books that I strongly recommend or free websites that allow you to use financial data or charts.

Piranha

Money Management Skills

…Let’s start by saying: “You can’t be afraid to take a loss”. The investors that are the most successful in the stock market are the people who are willing to lose money.

Having a strategy and/or a specific philosophy is an excellent starting point to investing but it won’t mean a thing if you can’t manage your money. As I have said a million times: “without cash, you can’t invest”.

Most investors spend far too much time trying to figure out the exact pivot point or perfect entry strategy and too little time on money management. The most important aspect to investing is cutting your losses, 90% of the battle is won by protecting your capital, regardless of the strategy.

Most successful money managers only make money 50-55% of time. This means that successful individual investors are going to be wrong about half the time. Since this is the case, you better be ready to accept your losses and cut them while they are small. By cutting losses quickly and allowing your winners to ride the up-trend, you will consistently finish the year with black ink.

Here are some methods that can help you with money management:

• Set a predetermined stop loss (you must know where to cut the loss before it happens – this will help control emotions when the time comes). A 7-10% stop loss insurance policy is best. Tighten the stop loss range in down markets and loosen the range in strong bull markets.

• Establish smaller positions if your account has had a recent losing streak (the losses may be telling you important information such as a critical turning point, it may be time to sell and get out).

• If you think you are wrong or if the market is moving against you, cut your position in half – this is the best insurance policy on Wall Street.

• If you cut your position in half two times, you will be left with only 25% of the original position – the remaining stock is no longer a big deal as your risk is very low.

• If you sell out of a trade prematurely based on a minor correction, you can always reestablish the position again.

• Initial position sizing plays a big part in money management – don’t take on too big of a position relative to your portfolio size. Novice investors should never use their entire account on one trade no matter how small the account.

• Know when you would like to get out of a position after a considerable profit has been made. Signs of topping could be a climax run, a spinning top or higher highs on lower volume.

• Finally, cut any trade that doesn’t act the way you originally analyzed it to act.

With these guidelines, you will be well on your way to solid money management skills that will help you profit in Wall Street year in and year out. Always remember, you are going to take-on losing trades at least half of the time. This is a tough concept to accept for most novice investors but it a fact. If you don’t cut losses, you won’t be investing for very long as you will run out of cash and the desire to continue to invest.

Piranha

Tight Weekly Closes

…I was recently asked about a chart pattern that boasts tight closes at some point in an uptrend. William O’Neil actually named a pattern after this type of market action “three weeks tight”. As I mentioned, the pattern usually forms as the stock has already broken out of the original base. The pivot point is usually long gone but this pattern allows the investor to establish a new position or add to the first position.

You must use a weekly chart to see this pattern as the daily charts will have too much volatility and unnecessary noise that will only confuse you. Look for a stock that has strong fundamentals and has started to stall, closing in a very tight range for at least three weeks. The price will close at almost the exact same point each of the three weeks.

The stock may swing from its weekly high to its weekly low intraday but the most important number is the close at the end of the day on Friday. Make sure the stock doesn’t break any long term support lines such as the 50-d or 200-d moving averages. If the volatility is not excessive, the buy can be considered. After the stock closes the final week (week #3), you may add a new position but make sure you buy a smaller amount of shares than you would at the proper pivot point. If the trade turns bad, always sell and sell fast, cut all losses at a maximum of 7% on this pattern.

Always keep in mind that tight closes in both the daily and weekly charts may provide a clue that institutional investors are buying up shares as the weak investors bail. These institutional investors are holding up the stock as the three week pattern forms.

Another similar pattern is the “railroad-track pattern” which typically occurs near the top of a climax run. If the stock closes the week slightly higher on above average volume, issue a mental red flag. On the weekly chart, this pattern will resemble railroad tracks by closing with two parallel vertical lines. The three week tight pattern is positive while the railroad track pattern is usually negative.

Piranha

How to Calculate the Pivot Point

…The pivot point can be calculated as the stock is forming the handle on a cup-with-handle base. The ideal buy price would be $0.10 higher than the highest spot during the handle, also know as the top of the right side of the base. The highest point can be the intraday high and not always the closing price of the stock. If the stock closes at the high for the day, then we will use this number. We look for the ultimate high on the beginning stages of the handle.

The exact methods used for finding pivot points vary depending on the base that is forming.

On a flat base, you would look for a move $0.10 higher than the top point on the left side of the base or the start of the formation.

A saucer-with-handle would follow the same rules as the cup-with-handle.

A double-bottom formation would set the pivot point at $0.10 higher than the middle peak in the “W”.

As I mentioned in the previous blog post, we do not buy until the stock triggers the pivot point on above average volume also known as qualifying volume. This is the area where the stock faces the least amount of resistance as all overhead sellers are gone as we break into new high territory. The pivot point usually comes within 5% to 15% of the stock’s old high. Try not to buy a stock after it is 5% above the proper pivot point. This does not mean that we can’t buy on normal corrections and pullbacks as the stock remains in an uptrend. The rule only applies to the pivot point area as the stock becomes extended.

Piranha

Can I buy in the Base?

A great question was asked through e-mail by one of our fellow members:
Why wouldn’t you purchase ELOS now before the right side of the base is finished forming?

A stock must finish the base before it is bought because most stocks that don’t finish the base continue to trade sideways for months or years or start to breakdown as the speculators bail by selling their positions. The line of least resistance or the pivot point is the best place to buy as the stock is breaking out to new highs. Remember, many people bought ELOS at the top of the left side of the base near $39.

These investors have suffered through paper losses waiting months to sell at break even which would be at or near the top of the right side. When the price nears the old high, most weak holders will sell out happy that they broke even. This selling action usually occurs in a week’s time thus forming the handle and shaking out weak investors on lower volume.

After the institutions see that these weak holders have sold, the real party starts with a breakout on above average volume – the pivot point. Once the stock breaks out and goes on to a new high, there are no more sellers because the stock has never been in this territory. There is no resistance above this pivot point.

This is why we wait to allow the stock to prove itself and buy properly at the pivot point. ELOS may never complete the base but if it does, I will post the precise pivot point and volume levels needed to qualify.

Finally, if you buy ELOS now, it would be pure speculation and your risk levels would be raised based on history. I would prefer to buy higher when there is lower risk of a breakdown because stock holders might want to sell old positions from the left side of the base. In addition, the current market is in correction mode giving us more reason to wait for this base to form properly, keeping our risk lower than it is today.

This was an excellent question and I hope many of you learn and study past breakouts to understand this rule better.
Piranha

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