What to do when the bull stops
The stock market is in one of those phases where it goes up regardless of what happens. Yesterday morning futures were down over 1%, commodities were getting slammed and European indices were collapsing. All in all, the morning looked ugly. Of course, in the land of free money where we currently live it appears real earnings and economic data do not matter. So despite the pessimism going into yesterday's session the market still closed higher.
I was joking around with Trademaster’s Jason Cimpl this morning and we came up with a proprietary trading strategy that is virtually guaranteed to work in this environment. I’d like to share it with you. Here it is:
When great news comes out: buy stocks
When good news comes out: buy stocks
When bad news comes out: buy stocks
Using this highly sophisticated trading system of ours we don't need to figure out if the market will go up, we just need to calculate by how much. That seems easy enough.
Now, obviously I’m joking. But the reality is this strategy would have worked lately. But at some point this strategy won’t work, and it will be much more important to actually time your buy and sell points, especially with small-cap stocks – an equity class that tends to be more volatile than large-caps.
In anticipation of this day, let’s go over a few pointers that will help you time your buy and sell decisions. When investing in small cap stocks, and really any other asset class for that matter, you face two basic levels of decision-making:
First select candidates you believe offer the most value and growth potential.
Secondyou need to timeyour buy and sell decisions.
Let’s assume you’ve already done step one. For step two, remember that to some degree use of limit orders and stop-losseswill help to protect you from big losses. But due to the higher-than-average volatility of small caps, you need to be ready to spot other trends that will impact the success rate of your buy and sell decisions.
Here are six useful tips that will help:
1. Set profit goals and bail-out points. Doing this gives your investment strategy some structure. Buy when trends meet your criterion. Either the price meets your pre-determined range, a trend-line changes direction, or there is some change in the broader market. There are virtually hundreds of criterion to chose from, but remember to use ones that support your particular profit goal. Then sell when you reach your predetermined profit yield - or when the stock price drops to your bail-out point.
2. Decrease your holdings after a big run-up. Often stock prices rise and you reach your goal, but you want to believe that the upward trend is going to continue. You can cut potential losses by selling a portion of your holdings, and letting the balance ride. Your investment time horizon will dictate this to a large degree.
3. Use trailing stop orders to control potential losses. Losses happen a lot faster than gains in most cases. Carefully watch fundamental and technical trends, and look for early signals of change. Protect yourself by using trailing stops to set a floor on your potential losses, or to lock in your predetermined percentage gain.
4. Review fundamentals regularly. Don’t expect to draw a conclusion about a company and then never look at it again. Everything changes. Just think of the company where you work – surely things were different a year ago, and there are plans to change things in the coming year. This is especially true with small caps, where growth trends can be fast. It is critical that you monitor the fundamentals in the companies you invest in for potential game changing developments.
5. Follow financial trends and look for leveling-out of those trends. Every trend levels out at some point, even the ones we wish could go on forever.Be on the lookout for subtle changes in revenue, earnings, and the other trends you monitor. You want to make your sell decisions before the change becomes obvious to everyone else, because by then the price decline has most likely already occurred.
6. Track moving averages and identify buy and sell signals. The use of moving averages is probably the strongest of the technical tools you can use. The averages offset short-term price volatility and show you what is likely to occur in the coming weeks or months. Changes in the moving averages can improve your timing of buy and sell decisions and should be watched closely.
It’s and old question to be sure, and one that every fund manager, stock picker, and independent investor out there wants to find an answer forto.
Sure, you can pick up Peter Lynch’s 1993 best selling novel book ‘Beating the Street’ - the main message in that book is to “buy what you know”. It’s a great read, and I recommend every independent investor take Lynch's message to heart and invest in companies with business models that they understand.
These don't have to be complicated. In fact another investing icon, Warren Buffet once quipped, "I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." I appreciate Buffet’s candid and balanced approach, and that the fact that at a certain level he tries to keep it simple.
We all hear stories about derivative masters, dark pool investing, and algorithm based trading strategies. But if you work a normal job, like most people, these complex investing strategies are unduly complicated – not too mention time consuming. Invest in what you know, and keep it simple, and you're likely to have much more success.
I conducted an informal poll at the office this morning. My employees “bought what they knew” and are invested in well known large-caps like Apple (Nasdaq: AAPL) with a current P/E of 24, IBM (NYSE: IBM), with a current P/E of 13 and McDonalds (NYSE: MCD) with a current P/E of 17.
And that’s good work -- all these companies have made investors money over the last two years. But these aren’t exactly unknown companies and Wall Street is all over them – so if you purchase shares in these companies you would be buying what the Street already owns.
To really beat the Street, you need to get in on small-caps before they become the darlings of Wall Street and owned by everybody - including your annoying neighbor who brags about his investment winnings.
Another informal poll of my employees showed good small cap ownership – and I must admit I love to see team members putting money to work in this sector. It shows they have skin in the game, so to speak. Office member ownership in small caps includes solid names like Del Monte Foods (NYSE: DEL) with a forward PE of 66 and IMAX Corporation (NASDAQ: IMAX) with a forward PE of 21, along with a number of lesser know companies that have yet to reach the upper end of the small-cap spectrum like the above companies.
Ownership of small-cap stocks like those held by member of my team reminds me of another Buffett quote, "Someone's sitting in the shade today because someone planted a tree a long time ago." Small cap stocks are just like that tree seedling - invest in quality ones now, and you'll be rewarded later.
But finding the most fertile seeds is not easy to do, especially if you work full time and want to dedicate free time to spend with your friends and family. How can you beat the Street by buying what you know, if you don’t know about the stocks you should be buying? That circular logic reminds me of my chocolate lab, Pinot – she loves to chase her own tail.
But there is a way…
Here’s what I do for Small Cap Investor PRO subscribers - I look seek outfor overlooked companies we can still buy at reasonable valuations. And for fast growing companies that are on the verge of gaining widespread coverage by Wall Street.
I start by scanning the universe of stocks that fit my particular criteria, and then dig further into the most compelling stocks in the group. I look at quarterly and annual reports, review cash flow models, and determine the likely catalysts that will fuel a company’s future growth.
After deciding which stocks look good, I decide what I’m willing to pay. Then I buy up shares when the window of opportunity is open. The next step is to sit back and let Wall Street (and your neighbor) ‘discover’ these unknown stocks, and allow their buying to propel the share prices higher.
You can use these simple tips to help you beat the pros on Wall Street. Despite what many analysts would have us believe, they simply don’t have the time to follow the small cap universe all that closely. It’s a time consuming endeavor, and the reality is that most analysts are covering a number of stocks. If you pay attention you can get in, and out, of small cap investments before the Street does.
If you’re serious about beating Wall Street at the investment game and want more of my top ideas, I encourage you to try my Small Cap Investor PRO service. Just click here to start your trial membership today. You can preview the service for 30-days at absolutely no risk, and I offer a money back guarantee.
