Buying Stocks and the Importance of Correct Timing

...An investor can find and research the best stock on the market, one with huge potential but if the general market indices are negative, it will most likely be the wrong time to buy. A stock with tremendous accelerating earnings, rising sales, an up-trending chart pattern and a strong industry group may sound excellent to buy but will mean absolutely nothing if the market is positioned to move in the opposite direction of your expectations. As soon as a stock is purchased, the time comes for an investor to make a decision to hold or to sell. If the position shows a profit, hold as your judgment is correct. If the position shows a loss, cut it quickly and don’t rationalize the situation before it doubles in size. Timing will play an important role in determining if you are right or wrong.

Losers must be cut quickly, long before they materialize into enormous financial disasters. They company and stock may not be a loser but rather your timing may be premature to a strong movement, forcing you to sell on a pullback. After a stock is cut from your portfolio, the transaction must be forgotten about and eliminated from your subconscious mind and/or emotional bank. The trade must be studied to capture the true essence of your mistake but the specific security involved must be blocked from any sentimental attachments, allowing you to consider reinstating the position at a higher level. This repurchase may take place immediately or well into the future but the important fact is that you were wrong with the timing on the initial position. The timing, also known as the ‘M’ in CANSLIM by William O’Neil, may have been wrong even though all fundamental and technical criteria related to the individual stock seemed to be perfect.

A quote from the great Gerald Loeb:
“Cutting losses is the one and only rule of the markets that can be taught with the assurance that it is always the correct thing to do.”

The wisdom shared by Loeb is easier said than done. Humans like to take profits and hate taking losses or admitting that they were wrong. Pride and ego distorts the clear thinking process that every investor must posses when following clear cut rules that provides insurance to their cash stake. Even tougher, humans refuse to repurchase anything at a higher price that they sold it previously. As Loeb states, only logic, reason, information and experience can be listened to if failure is to be avoided.

It is advisable to make a “test buy” in a shaky or unstable market which allows the investor to assess the general conditions with minimal risk but still maintain an emotional attachment. If the position goes bad, a small loss will be realize but the damages will be limited and the investor’s pride and ego can be repaired rather quickly. In a sense, the investor was half right by only initiating a partial position also known as a “test buy”. If the market was trending up, a “test buy” would not have to be established as the market direction would have been clear from the beginning.

When it comes to timing, an uneducated investor may realize better gains during a solid bull market based on pure luck than a seasoned investor will return in a sideways or unstable market. Following the trend will be the most successful route to consistent profits over the long haul. By watching the general market indicators, such as price, volume and daily new highs, an investor should know exactly what type of environment they are trading. The most important factor weighing on the stock market is the presence of public psychology, even more so than any fundamentals that the most intelligent academic analyst can compute. Technical analysis along with confirmation of the market trend allows us to see the combined thought process of the general public and tells us if the timing is right to buy or short a specific stock, regardless of the fundamentals.

In conclusion, we must understand that certain situations are only applicable during specific times. Buying leading stocks during a down trend is a sure way to multiple losses that are cut quickly. Shorting stocks during a raging bull is another sure way to financial disaster and margin calls. Don’t get discouraged if you take a few small losses consecutively as this is your rules telling you to stay out of the market at this time. The timing may be off even though the stock and research is favorable. Why would you swim upstream to reach your destination if you could jump in a boat and row downstream with the current another day? Before you ever start to immerse yourself into researching a stock to purchase, make sure you know the exact environment of the market and determine if it coincides with your objective. If it doesn’t, get ready to get slaughtered, especially if you don’t follow strict rules to cut all losses quickly.

Piranha

What describes a "qualifying" stock for shorting?

...I was asked these series of questions today by a fellow member:

“I am your subscriber and I am wondering about your choices for a short? You wrote on Daily Screen for: 04/18/2005 “We do not recommend buying anything in the current market environment unless you are establishing a short position in a qualifying stock.”

What describes a "qualifying" stock for shorting?

Some stocks you mentioned have good fundamentals. Why would you like to short stocks with good fundamentals at all? Isn't it more logical to short stocks with weak fundamentals and weak technicals?”

To start, please read the two part series on shorting stocks in this blog to understand what the qualifying characteristics are for these types of stocks. These two very informative articles were written last month on March 16th and 18th.

Shorting Stocks – The Basics, Part I of II ...What does it mean to short a stock?
Shorting Stocks – The Basics, Part II of II

Now that you have read or re-read those two articles, I will now refer back to another great article that I wrote back on February 21, 2005, titled: Fundamentals are late to the Party.

In this article I said “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.”

This member is correct by asking the question about solid fundamentals but we all must remember that fundamentals will stay positive much longer than the technical indicators. Ideally, deteriorating fundamentals are preferred over superior fundamentals but it is not as important as we all would like to think. Leaders from six months ago are typically the stocks that will start to fail today (especially in the weak environment), setting up for nice profit opportunities using a shorting strategy. The charts will show us reversals, trend-lines breaking and moving averages being sliced. We also must remember that 75% of all stocks will follow the general trend of the major indices and that has been a pure sideways correction in 2005.

For example, EBAY still has solid earnings and sales but the stock price has dropped almost 50% since December and 33% over the past couple of months since placed on our Red Flag screens. The market is usually priced into a stock approximately six months in advance. The market anticipates what the stock will be doing six months from now and that is why you must use both fundamental and technical analysis when making decisions based on future movements. If you go back and see some of the best shorts of all time, their fundamentals were still great as they were breaking down and becoming prime short candidates.

The only way we can assess the direction of a stock is by the underlying trend that is established on the charts. We confirm these trends with volume because we know that only institutions can develop moves powerful enough to spike volume levels above average on a daily and weekly basis. What individual investor do you know that trades millions of shares a day, every day in eBay? No one! The institutions drove down eBay’s stock over the past 5 months based on future expectations and speculation of slowing sales. They were right and the stock dropped.

Recently I have screened the builder stocks as red flags even though their fundamentals are still superior. With recent drops below their 50-d moving averages and breakdowns on the point and figure charts, I calculated that something is changing within this industry. Since making our red flag screens last month, they have all recorded double digit losses. There are two reasons for this:
The market is very weak and the ‘M’ in CANSLIM is negative
The industry is boasting late stage bases while interest rates are rising and fears of inflation are growing.

If anyone has more questions on this subject, please post them to the comment link below on this blog article and this discussion and lesson will continue.

Piranha

PEG Ratio

I have been using PEG ratio for the past several years with great success. It cannot be used alone but is a very powerful tool when integrated with the basics (price, volume and chart reading). I am going to use the definition form investopedia.com as it makes complete sense and doesn’t get too confusing:

What the PEG Ratio is:
“The PEG ratio compares a stock's price/earnings ("P/E") ratio to its expected EPS growth rate. If the PEG ratio is equal to one, it means that the market is pricing the stock to fully reflect the stock's EPS growth. This is "normal" in theory because, in a rational and efficient market, the P/E is supposed to reflect a stock's future earnings growth.

If the PEG ratio is greater than one, it indicates that the stock is possibly overvalued or that the market expects future EPS growth to be greater than what is currently in the Street consensus number. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for a stock that is expected to grow rapidly (otherwise known as "growth at any price"). It could also be that the earnings forecasts have been lowered while the stock price remains relatively stable for other reasons.

If the PEG ratio is less than one, it is a sign of a possibly undervalued stock or that the market does not expect the company to achieve the earnings growth that is reflected in the Street estimates. Value stocks usually have a PEG ratio less than one because the stock's earnings expectations have risen and the market has not yet recognized the growth potential. On the other hand, it could also indicate that earnings expectations have fallen faster than the Street could issue new forecasts.

It is important to note that the PEG ratio cannot be used in isolation. Like all financial ratios, to properly use PEG ratios, investors must use additional information to get a clear perspective of the investment potential of a company. Investors must understand the company's operating trends, fundamentals, and what the expected EPS growth rate reflects. Additionally, to determine if the stock is overvalued or undervalued, investors must analyze the company's P/E and PEG ratios in relation to its peer group and the overall market.” - provided by www.Investopedia.com


This is the first time that I will try to teach PEG ratio to an extended audience without face to face interaction or a very detailed personal e-mail. I have noticed that people can get confused with my explanation when I try to generalize the procedure that I use.

You must enjoy crunching numbers and have a calculator handy to estimate your own PEG ratio. You also must have access to quality statistical information from the web (past earnings and future earning estimates). A variety of websites produce a PEG ratio but I have not found one site that has a reliable PEG ratio that I can use for my own research, so I calculate it myself, ensuring accuracy with the final number. You will start to realize why I spend so much money making sure that I always have accurate numbers rather than using the free internet sites for my statistics. The free sites work but always cross reference your numbers; this is your hard earned cash that you are dealing with, we wouldn’t want to throw it away because of careless mistakes.

Using Paincare Holdings (PRZ – see the recent case study), I will demonstrate why this stock looks so attractive during this sideways market.

First, you will need to gather the past earnings numbers; going back at least 2 years and going forward two years.

PRZ:
2003: 0.05
2004: 0.14
2005: 0.25 (E)
2006: 0.34 (E)

Now we need to calculate the growth from year to year.
Subtract the earnings of 2004 by 2003 and then divide by 2003.
Repeat the process to determine the growth rate for the following years:

2004: (0.14-0.05)/0.05 x 100 = 180% growth rate

2005: (0.25-0.14)/0.14 x 100 = 78% growth rate

2006: (0.34-0.25)/0.25 x 100 = 36% growth rate

Now, take the current price (we will use the close from Monday night - $5.10) and divide it by 2004 earnings and then by the 2004 growth rate:
2004: 5.10 / 0.14 / 180 = .20 PEG Ratio
2005: 5.10 / 0.25 / 78 = .26 PEG Ratio
2006: 5.10 / 0.34 / 36 = .41 PEG Ratio

Now, I take all three and add them up and divide by the total number:
.20 + .26 + .41 = 0.87

0.87 / 3 = 0.29 PEG Ratio (Very Positive).

Using the definition from above, Investopedia states that a stock is evenly valued at a PEG ratio of 1 in a rational and efficient market. Please note that the stock market is not very rational or efficient so we only use this number as a secondary indicator and tool, after our fundamental and technical analysis is complete. PRZ’s PEG Ratio of 0.29 leads me to believe that the stock is undervalued, compared to its peers and overall market.

To determine a price target going forward, using today’s numbers, we can conclude that $12.50 and $19.50 could be achievable in a rational and efficient market. Remember, we don’t work with rational and efficient markets!

How do I get those numbers?

Use this calculation for 2005
$19.50 / 0.25 / 78 = 1 PEG Ratio

Use this calculation for 2006
$12.50 / 0.34 / 36 = 1 PEG Ratio

I now have an exercise for everyone:
Calculate and determine the PEG ratio and some price targets for LaBarge (LB) going forward. I will upload my results tomorrow during the day to allow everyone to complete the exercise. This is where the education will get fun! This is a nice tool to determine possible price targets and stock valuations. As time moves on, I will introduce another tool to help determine price targets, using charts.

Finally, once you determine the PEG ratio of the stock you are looking to buy, take the time to calculate the PEG ratio for the “sister stocks” in the industry group to see if they have higher or lower PEG ratios. Keep in mind, PEG ratios don’t work for companies with negative or non-existent earnings numbers.

Enjoy,
Piranha

Focus when Investing

...I recently started an interesting conversation on a forum on the web about CANSLIM and my method. I consider my philosophy a modified version of CANSLIM with my foundation coming directly from William O’Neil’s teachings. Over the years I have branched out and used various methods from other authors such as Gerald Loeb, Bernard Baruch, Jesse Livermore and Stan Weinstein. Each of these authors differed in their approaches but they always relied heavily on price and volume.

As you read my recent case study explaining my screening methods and fundamental research breakdowns, you will notice that I do follow and study many of the same statistics that CANSLIM uses. The difference is that I don’t require a stock to meet every standard of a CANSLIM stocks. During a bear market, it is near impossible to find a stock that meets the CANSLIM criteria perfectly. I focus on the most important numbers such as earnings and sales and institutional support.

My latest purchase would never make the CANSLIM criteria based on price alone. I have an article written about stocks that are priced lower than $12, something that O’Neil suggests that we stay away from. I don’t agree and I have made good money on stocks coming out of bases from the $8-$10 area over the past few years. A further study will reveal that most great CANSLIM stocks start their initial runs in the single digits, well before making the newspaper at $15 per share.

I buy with the trend more so than the actual base that CANSLIM suggests. I rather buy a stock that is taking a breather to the 50-d moving average during a solid up-trend than a stock that is acting funny, coming out of a cup with handle base. This is not to say that I don’t buy cup with handle patterns because I do but I prefer the long term trend which is explained deeply in Stan Weinstein’s book. See our recommendations page for books to read, including Weinstein.

I always say, my foundation is deeply rooted with CANSLIM and O'Neil.
It works!

Why would I ever confuse myself with anything else until this stops working and it hasn't stopped in all the years I have been using. Sometimes it doesn't work as well or sometimes I am not as sharp but I don't switch my system. This is something that 99% of all individual investors will do. They become frustrated and quit one system to search for a new one, only to be disappointed when that one fails.

Too many people that I meet switch from book to book to book and system to system to system and never understand why they don’t make consistent money. They are too confused, looking at too many things, complicating the entire process. A great statement: Keep it Simple Stupid. It hangs above my desk in my office and I read it everyday. Why complicate things when simplicity works.

I don’t need stochastics, bollinger bands, MACD, MFI and expensive technology to determine and place my trades or any of that “waste of time” crap.

I need fundamentals, price, volume and a chart and that is it. I can make money any year if I am provided with those 4 things. As Livermore, O’Neil, Darvas, Baruch, Loeb and Weinstein all teach: Price and volume are the most important things one will ever need in the stock market. It will NEVER change, ever!

In the end, it is never the systems that fail. Thousands of different systems work in the stock market; it's the user that ultimately fails because of lack of concentration and motivation to stay the course. It is hard work to play in Wall Street and not many people can hang! I see people come and go every day. They are motivated for weeks, months and sometimes a year but most fizzle away after they fail and can’t figure the market out. Some people try to copy a system from a so-called guru and may find success for a while but if they don’t learn the system themselves and tailor it to their personality and investing style, it will become obsolete and they will fail. Work, work hard and you can be successful in the market. Do the work yourself. Learn how to do the work and then do it yourself or you will never learn to be truly successful.

The mission of MSW is to teach you how to develop a system by showing you what to look for and how to research stocks on both the fundamental and technical side. When you finally create your own system, you will be able to be successful without my help. Heck, you may be better than me at that point, the sky is the limit if you only put your mind and heart into it. Money is not easy on Wall Street although most people think it is; I hope the members that go through my community will be the few that actually get the big picture and become successful!