- After-Hours Trading
After-hours trading, sometimes called extended trading, is trading undertaken on electronic market exchanges either before or after regular trading hours.
In the United States, pre-market trading occurs between 8:00 a.m. and 9:30 a.m. Eastern Time (ET), and after-hours trading typically occurs between 4:00 p.m. and 6:30 p.m. ET. After-hours trading is usually abbreviated on message boards with the acronym AH.
Until recently, after-hours trading volume was relatively low. However, the volume of extended trading has exploded, as online trading and related computer technologies have become more prevalent and the markets have grown more international.
Once the preserve of big institutional investors who had the confidence to deploy unorthodox methods, after-hours trading is increasingly being adopted by retail investors, who are becoming more comfortable with the interconnected electronic communications networks that make it possible to trade at unconventional hours. Online trading is less of a novelty and more commonplace, removing the mystique of after-hours trading.
After-hours trading allows nimble investors to act quickly to major events that are investment "catalysts," such as sudden corporate misfortune, political turmoil overseas, terrorist attacks, etc.
Trading before or after the markets officially open allows instantaneous investment decisions that are pegged to the latest developments. A caveat is that after-hours trading can be subject to the emotional whims and fears of less-seasoned, smaller investors—consequently, veteran pros on Wall Street sometimes derisively refer to after-hours trading as "amateur hour," a play on the AH acronym.
- Average Up
Buying more of your best stocks, also called averaging up or pyramiding, is something most great investors through the years have practiced. However, like any tool, it can also be dangerous if misused.
The most important key is to buy smaller and smaller amounts on the way up—hence the term pyramiding, which obviously starts out with a wide bottom (your initial purchase) and gets narrower and narrower toward the top (your follow-up buys). Averaging up in this fashion ensures that your average cost doesn't run up too fast, yet allows you to funnel more money into a potential big winner.
Some investors prefer to average up any time the stock rises a certain amount from their previous purchase price, while others like to wait for specific chart set-ups. There is no one right way to do it, just be sure that whatever strategy you employ, it works for you—you'll be heavily invested in some stocks using this method, which means the upside and downside will be sharper.
- Bear Market
A bear market is defined as one in which each successive decline carries the market to new lows. Falling prices and growing pessimism characterize a bear market.
- Benjamin Graham
Benjamin Graham (May 8, 1894–September 21, 1976) was an American economist and investor. He was born in London, graduated from Columbia University at the age of 20, and became Warren Buffett’s teacher in 1950.
Graham is the author of The Intelligent Investor, a seminal book on value investing that Warren Buffett called “by far the best book on investing ever written.” Buffett was just one of Graham’s disciples. Graham also taught or influenced Mario Gabelli, John Neff, Michael Price and John Bogle.
Why do we have an investment newsletter named after Benjamin Graham at Cabot? First, Graham is widely celebrated as “The Father of Value Investing.” He created the process of evaluating companies to find their intrinsic value. Graham could thereby purchase companies with undervalued stock prices and avoid buying companies with over-inflated prices.
Cabot Benjamin Graham Value Investor recommends stocks based on the Benjamin Graham investing system. Graham analyzed every company according to seven factors: profitability, stability, earnings growth, financial position, book value, dividends and price history. He analyzed every potential investment based on these factors to determine which companies were clearly undervalued.
A key concept of the Benjamin Graham system is the Margin of Safety, which is achieved by buying a stock only when it falls below its maximum buy price. That price is calculated using the metrics that determine the intrinsic value of a company. Strict adherence to the rule of buying only below the maximum buy price will minimize potential losses while maximizing potential profits.
In essence, Graham developed a whole new approach to investing based on principles of measuring a stock’s price versus its intrinsic value. For nearly a full century, that approach has beaten the market. Since 1926, the Benjamin Graham value investing approach has achieved average annual returns of 20% a year.
- Bull Market
A bull market is defined as one in which each successive advance of the primary trend peaks higher than the one preceding it. A bull market is characterized by rising prices and growing optimism.
- Buy On Stop
A “buy-on-stop” is a trade order used to limit a loss or protect an existing profit. It is a buy order marked to be held until the market price rises to the stop price, then to be entered as a market order to buy at the best available price.
The buy-on-stop price always is set above the existing market price. This type of trade is sometimes called a "suspended market order,” because it remains suspended until a market transaction triggers the stop.
Buy-on-stop orders can be used for long and short positions. For long positions, it allows investors to take advantage of anticipated market upswings, and to minimize risk, without frequently monitoring the investment or the market.
When short selling, the investor can choose implement a buy-on-stop order, as a way to protect against losses if the price shoots too high. When an investor "shorts" a stock, he is betting that the stock price will drop, so he can return the borrowed shares at a lower price (called "covering").
Technically speaking, buy-on-stop orders exemplify a method of engaging in a purchase request for a security that carries the stipulation that the request be held until the current market price for the security is equal to the stop price for that particular asset.
Let's say that for the past several weeks, the price of a stock has risen from 3.00 per share to 5.00, and is now trading within a range of between 4.50-5.00. You've determined that the stock will probably move higher and you'd like to make money on this prediction, but only if the stock actually breaks out of its trading range.
Rather than keeping your eye on the stock every day, you can implement a buy-on-stop order at, say, 5.10. If the stock actually does move higher and break out of its trading range of 4.50-5.00, your order will be triggered once the price reaches 5.10, thereby becoming a market order to buy shares of the stock.
If the stock doesn't break out and move higher and instead starts to drop, your order would not get triggered.
Typically, these orders are used when an investor has determined that the market price for a certain type of security is on the verge of entering a period of growing value. This principle works in reverse, when short-selling. A buy-on-stop order is a risk-hedging strategy that allows you to secure an asset when and if the market price begins to rise, but it obviates the need to continually monitor the security's activity.
- Call Options
Call options give the buyer the right to buy 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a call option is obligated to sell the stock at the strike price if the option is exercised. (Also see: options trading)
- Canadian Stocks
Canada often gets overshadowed in the investment world. But there are plenty of reasons to invest in Canadian stocks.
Overall, Canadian stocks have not performed as well as U.S. stocks or many emerging markets in recent years. Nor is its economy growing as fast as America’s, China's or India's, with an average gross domestic product (GDP) growth of less than one percent. But Canada has some unique characteristics that are hard to find in today’s global market.
Here are five that particularly stand out:
Economic stability. What Canada lacks in economic growth it makes up for in reliability. Canada’s banking system is one of the soundest in the world. Its budget deficit is relatively modest compared to America’s, and especially when compared to sovereign debt-ridden Europe. Canada’s economy was less impacted by the 2008-09 recession, and thus didn’t have nearly as steep a recovery. And with a solid monetary policy, Canada faces less inflation risk than most countries.
Trusted banks. Moody’s Investors Services ranks Canada’s banking system No. 1 in the world for financial strength and safety. The World Economic Forum has dubbed Canada’s banking system the best in the world for seven years running. Look no further than the global financial crisis for proof of Canadian banks’ strength. During that time, no Canadian bank or insurance company failed or required a bailout. Canada’s banks operate an oligopoly, leading to higher profit margins and more government protection in times of financial drop-off.
Low volatility. Like its banks, Canadian stocks didn’t experience the same kind of drop-off the other G-7 countries experienced in the wake of the global recession. By early 2011, Canadian stocks were back trading near their pre-recession levels. Though Canadian stocks haven’t risen as fast as U.S. stocks since then, there haven’t been many big dips, either. Absent the huge gains of the U.S. and other emerging-market stocks in recent years, Canadian stocks trade at comparatively fair values.
Cheap currency. The Canadian dollar, also known as the Loonie, is historically cheaper than the U.S. dollar, thus inflating the value of Canadian exports by making them more affordable to U.S. – and other – customers. Combine that with a strong manufacturing sector and budding export presence, and there are plenty of Canadian companies that are – and will be – in strong demand globally for years to come.
Low tax rate. At just 17%, Canada boasts by far the lowest tax rate on new business investment among the G-7. That’s about half the effective tax rate of the U.S. Its corporate tax rates are also low, typically in the 26% to 27% range, depending on the province. America’s corporate tax rate is 35%. That makes Canada attractive to outside companies hoping to cut costs by relocating their operations to countries with lower tax rates. Burger King did just that when it merged with Canadian coffee-and-doughnut giant Tim Hortons in part to achieve a less cumbersome tax bill. Canada’s lower tax rates have an even larger impact on the companies that are actually based there, and less of an obstacle toward profitability.
You wouldn’t want a portfolio full of Canadian stocks. There’s better growth in other parts of the world, including the U.S. But in today’s uncertain global economy, countries with reliable banking systems and stable economies are safe places to invest.
Canadian stocks might not deliver the same returns as China or India. But they’re also less likely to go belly up if another financial crisis strikes. Cabot's Benjamin Graham Value Investor has a section on recommended Canadian stocks.
- Chinese Stocks
When seeking better-than-average growth, many investors flock to emerging markets. In emerging markets investing, Chinese stocks are your best bet.
Emerging-market economies are growing faster than the U.S. economy. Thus, investing in the companies based in those emerging markets – or the ones that derive a large portion of their revenue from emerging market sales – is a good way to earn market-beating returns.
But there’s a catch. You don’t want to invest in just any emerging market. After all, these markets are still “emerging” for a reason. In reality, the word “emerging” is a euphemism for “underdeveloped.” Anytime you invest in an underdeveloped nation, you take on an increased measure of risk – more than you would investing in an American blue-chip company.
Chinese stocks are perhaps the safest way to invest in emerging markets.
The so-called “BRIC” countries – Brazil, Russia, India and China – are considered the most powerful emerging market nations. All four have enormous (and growing) populations, stable governments and fast-expanding economies. Of that group, China has proven to be the most reliable.
China enjoyed more than a decade of double-digit economic growth based on cheap labor and massive exports, and its huge population of industrious people, directed by a powerful central government, has created a booming middle class eager to achieve the prosperity of developed nations. The country has made major investments in infrastructure and looks ready to deliver GDP growth of close to 7% (or more) for the foreseeable future.
Amid China’s economic boom, Chinese stocks have soared. Among the BRICs, only India has posted bigger gains in the last decade. India’s potential in the coming years is undoubtedly immense. However, India suffers from a political system that is chronically susceptible to gridlock, thus making its stocks less predictable – and more volatile – than Chinese stocks.
To be sure, China’s economic growth has slowed. From 2000-2010, China averaged 10% annual GDP growth. The 7% annual growth expected over the next decade-plus amounts to a fairly substantial step back. But no economy – even an emerging one – can grow at 10% a year forever. Besides, 7% is a much faster growth rate than the U.S. economy, which is expected to grow in the low single digits annually over the next 10 years.
Plus, there’s one other thing Chinese stocks have going for them. Many of them have struggled in recent years. From July 2009 until April 2014, Chinese stocks – as measured by the benchmark Shanghai Stock Exchange (SSE) – actually declined 40%, or more than 8% a year. In the long term, the pullback may have been a good thing.
A derivative is a financial instrument—or, simply put, a contractual agreement between two parties—that has a value, based on the expected future price movements of the "underlying asset" to which it is linked. The underlying asset can be a stock, bond, currency or commodity. Strictly speaking, a derivative has no value of its own. It is not an asset; it is a contract. There are myriad kinds of derivatives; the most common are options and futures.
- Dividend Aristocrats
Dividend Aristocrats are companies that have raised their dividend rates at least once every year, for a minimum of the previous 25 years.
More precisely, they constitute the S&P High Yield Dividend Aristocrats Index, an official index of the 50 highest dividend stocks in the S&P Composite 1500.
Investors can track the performance of the Dividend Aristocrats online, via the Standard & Poor’s Dividend Aristocrats page. Also, an Exchange Traded Fund (ETF) exists—the SPDR S&P Dividend ETF—that's designed to mirror the behavior of the S&P Dividend Aristocrats Index. It trades under the symbol SDY.
Income investors seeking safety and a steady stream of income gravitate toward Dividend Aristocrats. However, these stocks can't be bought and blindly maintained on automatic pilot, because extreme events can cause even the aristocrats to fall out of favor.
For example, during the Great Recession of 2008-09, many financial institutions once considered to be rock-solid dividend plays were dumped from the list. If a company fails to increase its dividends from the previous year, it is removed. This is what happened during the recent economic downturn and financial meltdown, when brand-name companies ordinarily associated with dividend stability were cut, notably Bank of America.
Typically, a so-called Dividend Aristocrat is, by its very nature, a large and relatively stable blue-chip company with a healthy balance sheet. Dividend Aristocrats are considered the "gold standard" for dividend-generating stocks and, as such, income investors seek them out. Many of the companies on the list are household names with storied pasts and ubiquitous brands, such as McDonald's (MCD) and Coca-Cola (KO).
- Dividend Reinvestment Plans
Dividend reinvestment plans, otherwise known as "DRIPs", are a way for income investors to build long-lasting wealth.
Offered by some dividend stocks, dividend reinvestment plans allow you to have your quarterly dividend payments allocated toward buying more shares (or fractions of shares) of that stock instead of being paid directly to you in the form of a check. Thus, the amount of shares you own in a given stock automatically expands every quarter when you enroll in a DRIP, so long as that company keeps paying a dividend.
You’d be amazed at how fast your money accumulates when you reinvest your dividends —especially when dividends and share prices increase over time. Consequently, DRIPs are tailor-made for the long-term investor.
- Dividend Stocks
Investing in stocks can be like buying a lottery ticket. You can have a very good reason to believe that a stock is going to rise. But ultimately, it amounts to speculation.
Investing in dividend stocks is more than speculation. It’s a good way to build long-term wealth.
Dividend stocks aren’t solely dependent on their share price rising or falling. When you buy a dividend stock, you know for sure that you’ll receive a steady stream of income—generally on a quarterly basis. If the market crashes and the share price begins to fall, you at least have a nice 3% or 4% yield (or higher) to soften the blow.
More often than not, you can trust a company that pays a dividend. Dividends are a measure of a company’s success and its commitment to shareholders. The companies that consistently grow their dividends are the ones whose sales and earnings are also growing. Companies that lose money or fail to grow are unable to consistently pay a dividend.
When a company pays a dividend—and especially if it makes an effort to increase that dividend every year—it shows that it cares about rewarding shareholders. Paying a dividend is also a savvy way to attract investors, which is why their share prices typically appreciate over time.
Dividend stocks aren’t going to make you rich overnight. But they can significantly build up your nest egg if you buy and hold them for years, or even decades.
Not all dividend payers build wealth. You need to search for investments with timelessness and longevity—companies that are sure to not only be around 20 or 30 years from now, but still thriving. Dividend stocks become more powerful, and usually make up a larger part of your annual return, the longer you hold on to them.
For example, if you had bought Wal-Mart (WMT) in April 1990, your current yield on cost would be about 19%. That means you’d be collecting 19% of the value of your original investment every year from dividends alone. If you’d invested $10,000, you’d now be collecting $1,921 in dividend payments every year.
With investments like these, it’s best to let your money work for you as long as possible.
That can mean riding out some tough times. Wal-Mart declined 23% during the 2000 bear market, for example. Selling would have saved you some money in the short term, but you also would have forfeited that 19% annual yield.
When buying dividend payers, you have two options. You can either collect the quarterly income or reinvest it to buy more shares. The latter is called a dividend reinvestment, and is an easy way to increase the value of your position without having to do much. You can always start collecting the dividends down the road when you need the income.
- Double Bottom Chart
A double bottom chart pattern is a chart pattern used in technical stock analysis to describe the fall in price of a stock or index, followed by a rebound, then another drop to a level that's roughly similar to the original drop, and finally another rebound. Consequently, the double bottom chart pattern resembles the letter "W".
This "W" pattern forms when prices register two distinct lows on a chart. However, the definition of a true double bottom is only achieved when prices rise above the high end of the point that formed the secondary low.
Put another way, the double bottom is a "reversal pattern" in an equity price's downward trend. The price drops to a floor—a "support level"—before rallying, pulling back up, and then falling to the support level again, before rising. A double bottom is characterized by two well-defined lows at roughly the same price level. Double bottoms are among the most commonly occurring chart patterns.
Double bottom patterns can be discerned within charts that are intra-day, daily, weekly, monthly, yearly and longer-term. The two lows should be distinct. According to technical analysts or "chartists," the second bottom can be rounded while the first should be distinct and sharp. The pattern is complete when prices rise above the highest high in the formation. The highest high is termed the confirmation point.
Typically, a double bottom's volume is greater on the left of the bottom than on the right. Volume usually is downward as the pattern forms and accelerates as the pattern hits its lows. Volume increases again when the pattern completes, punching through the confirmation point.
If accurately identified, the double bottom can signal a fortunate entry point for investors. To chartists, the double bottom formation indicates that the stock has reached a crucial support level and is encountering difficulty moving lower. That implies the stock has formed a low and is now positioned for an upward move.
- Emerging Markets
Emerging markets are economies whose gross domestic product (GDP) is growing at a much faster rate than more developed markets such as the U.S., Germany and Japan. Consequently, the stocks in those countries often grow at a faster clip than the average stock in a more mature market.
Brazil, Russia, India and China—the so-called “BRIC” nations—garner the most attention. But good stocks can be found in other, less populous corners of the globe, including South Korea, Mexico, Turkey, Saudi Arabia and South Africa. The options are numerous for investors willing to explore outside their American bubble.
There are myriad reasons to do so. Investing in emerging markets allows you to invest in countries with double-digit GDP growth—or close to it. At a time when America’s economy is expanding in the low single digits, Japan’s economy is struggling and much of Europe is still buried under a mountain of sovereign debt, emerging markets hold more appeal than ever.
Of course, all emerging markets investing comes with its fair share of risk. The term emerging is really a euphemism for “underdeveloped.”
Many emerging markets are plagued by political instability, inferior infrastructure, volatile currencies and limited equity opportunities. In addition, some of the largest companies in emerging markets are either state-run or private. There are simply more unknowns when investing in a market that is still developing. And the less you know about a company, the more risk you take on when you invest in it.
One way to curb the risk is to invest in American Depository Receipts (ADRs) traded on U.S. exchanges, which subjects the stocks to strict U.S. requirements.
For some, emerging markets are simply too risky. But for many, the potential for massive rewards is worth the extra risk.
An exchange-traded fund--or ETF, for short--is an investment fund that trades on a public stock exchange just like a stock. But unlike individual stocks, ETFs hold dozens and even hundreds of stocks, commodities or bonds, so you get the safety of diversification. In that way, they're like mutual funds.
Because they are "unmanaged," however—you might say they run on autopilot—ETFs entail lower annual fees than comparable index-based mutual funds, and far lower fees than actively managed mutual funds. And unlike mutual funds, which are priced once a day after the market closes, ETFs are traded throughout the day just like regular stocks, so you can buy or sell them whenever you want, and when you buy, you get exactly the price quoted when you buy.
At Cabot Wealth Network, we are stock pickers at heart. That said, there are some instances when investing in ETFs makes sense—whether it be gaining maximum exposure to a red-hot sector, gaining access to an entire country’s stock market, or simply taking advantage of a bull market. In general, we don’t recommend buying and holding ETFs the way you would a stock with long-term growth potential. But there’s money to made in ETFs if you time it right.
- Ex-dividend Date
It’s important for investors who buy dividend-paying stocks to understand what “ex-dividend” means and how the various dates related to dividend payments really work.
The Ex-Dividend Date is the first day the stock trades without its dividend, thus ex-dividend. It's the date by which you have to own the stock to get the payment. That means you have to buy before the end of the day before the ex-dividend date to get the next dividend.
The day before the ex-dividend date is really the all-important date for investors to know.
So if a stock’s ex-dividend date is February 28, only those who own it on February 27 will receive the dividend.
But there are a few other dividend-related dates you should know.
The Record Date is the day the company announces when a dividend will be paid to “shareholders of record as of” some date. Because it takes two days to reliably become a shareholder of record, the ex-dividend date falls two days before this day declared by the company.
The Payment Date is the day the dividend will actually be transferred into your brokerage account. It’s usually about a month after the ex-dividend date, although for some funds, it’s as little as two days after the ex- date. When a stock is trading ex-dividend that means its ex-dividend date has already passed but the dividend payment has not been made yet.
- Forever Stocks
The word “forever” is often hyperbole.
What do you say if you’ve been waiting a long time in line at the DMV or on hold with your cable provider? “I’ve been waiting forever!”
The term “forever stocks” is a similar exaggeration. You don’t necessarily hold on to these stocks “forever.” But you do hold onto them at least until retirement.Forever stocks are stocks that are fairly evergreen. Typically they are industry leaders that have been growing for a while and should continue to grow for decades to come. They're stocks you can count on to be viable not only today, but 20 or 30 years from now.There are five key attributes you want in forever stocks:
- A product or service or business model that is revolutionary.
- A mass market.
- A company that’s still small enough to grow rapidly.
- A company that is not respected—perhaps not even known—by the majority.
- And last but not least, a stock that’s trending up, indicating that investors’ perceptions of the company are improving. This is important because perceptions are always at least as important as reality, at least on Wall Street.
Forever stocks aren’t synonymous with safety stocks or even dividend stocks, necessarily. You’re not searching for the next Procter & Gamble (PG) or Johnson & Johnson (JNJ)—reliable, low-beta dividend growers that will deliver a steady stream of income and decent, if unspectacular, returns. Their purpose is to make you rich.
You want to find the next Apple (AAPL), Google (GOOG) or Amazon (AMZN)—stocks that if you had bought them 10 years ago (or more), you would have earned 10, 20, even 100 times your initial investment. Those are life-changing investments. And that’s what forever stocks are supposed to be.
Not every forever stock will deliver those kinds of returns, of course. In fact, you’ll be lucky to find a single buy-and-hold stock that will provide the same kind of return as you would have gotten by investing early in Apple or Amazon. But if one or two of these stocks can gain half the long-term return of an Apple or an Amazon, you can position yourself for a nice financial windfall by the time you retire.
Futures are contracts to buy or sell stocks or bonds, or commodities, at a stated price at a stated time in the future. These commodities include pork bellies, gold, currency, corn, wheat, orange juice, etc.
Most commodity futures contracts come due within three or six months. You can buy and sell single stock futures or stock index futures, which are contracts based on the performance of a broad index such as the Standard & Poor's 500.
When you purchase or sell a stock future, you're not buying or selling the underlying stock. You never really own the stock. You're engaging in a futures contract, which is an agreement to buy or sell the stock certificate on a certain date at a fixed price.
A futures contract essentially entails one of two positions: long or short.
If you've entered into a long position, you've agreed to purchase the stock when the contract expires. A short position stipulates the inverse: you've agreed to sell the stock when the contract expires. So, if you're convinced that the price of your stock will be higher in three months than it is today, you take a long position. If you think the stock price will be lower in three months, you choose to go short.
Futures contracts are traded in freewheeling "trading pits" at exchanges worldwide. It's in these frenetic environments where traders determine futures prices, which change from moment to moment. Established in 1848, the Chicago Board of Trade (CBOT) is the world's oldest futures and options exchange. More than 3,600 CBOT members trade in excess of 50 different futures and options contracts.
Most commodity and currency futures have a margin of 5%, which means to make a trade, you only have to put up 5% of the contract value. That's a small stake, because prices can easily and quickly move by much more than 5% in only a day's time.
However, a leveraged bet of 5% is much smaller than the margin debt with which you're allowed to buy stocks. A percentage that small doesn’t allow you to ride out ephemeral fluctuations. It's possible to bet hideously wrong.
As with options, a futures contract uses leverage that can turn a small bet into a very large win or loss. In fact, futures are even riskier than options, because with the latter, an options buyer's worst-case scenario is losing the original investment. An investor in the futures market can lose a lot more. Then again, a single futures contract can rise in value by several thousands of dollars each day.
- Growth Investing
Growth Investing involves a greater degree of volatility than dividend investing or even value investing. But it also has the potential for much bigger rewards.
Growth investing involves investing in fast-growing companies that are typically less established than blue-chip companies such as General Electric (GE), Caterpillar (CAT) and Exxon (XOM). Those global behemoths were once growth stocks themselves, but their period of rapid growth is behind them. The best growth stocks are smaller companies whose best is ahead of them.
In searching for growth stocks, you generally want to invest in companies that are growing – or projected to grow – earnings at a faster rate than the overall market. Companies growing at triple-digit rates, 100% or better, are among our favorites. (In fact, triple-digit growth has been a factor in most big winning stocks over the years).
That kind of rapid growth can overcome a number of smaller deficiencies: inexperienced management, competition, weak patent positions, etc. Furthermore, fast growth typically attracts the attention of institutional investors, who push share prices higher as they buy their way in.
Of course, the risk in growth investing is that you’re buying less mature companies that usually don’t pay a dividend. If the share price declines, you don’t have a quarterly dividend payment to cushion the fall. And these stocks can very volatile, especially during earnings season.
While fast-growing companies have a good chance to outpace the market—sometimes by a considerable amount—they also have the potential to fall flat. Some high-growth companies are so under the radar, or so misunderstood, that the share price appreciation doesn’t match the financial growth.
The key to successful growth investing is identifying fast-growing companies before the masses do. That can be tricky, since some of the best growth-stock candidates are relatively obscure. There’s a reason, after all, that the market hasn’t fully discovered them yet.
But keep things simple. Look for companies with accelerating sales, better-than-average earnings growth, and strong profit margins. More often than not, the combination of those three characteristics eventually grabs the market’s attention.
When it does, the rewards can be astonishing.
- Growth Stocks
Growth stocks are the glamor investments on Wall Street.
They are the reason all those talking heads on CNBC have jobs, and what makes Jim Cramer ramble on as if he’s just chugged five Red Bulls (maybe he has). Growth stocks often outpace the market, and the best ones can earn triple-digit returns in a short amount of time. So it’s no surprise they generate so much excitement and endless chatter.
Of course, there’s a caveat to investing in growth stocks. Unlike time-tested dividend growers or bargain-basement value plays, growth stocks carry plenty of risk. The companies are less mature, often are subject to greater potential competition, and typically don’t pay a dividend. Thus, the stocks can be very volatile, especially around earnings season.
For many investors, however, the risks of investing in growth stocks are worth the potential rewards. Apple (AAPL), Amazon.com (AMZN), Netflix (NFLX)—all of them started off as growth stocks before they became some of the market’s most coveted stocks. Those who got in early earned triple-digit, even quadruple-digit, returns.
There are several keys to finding the right growth stocks:
- Invest in fast-growing companies. It’s a rather obvious prerequisite. But it’s important to know what fast-growing means. It means investing in fast-growing industries, where revolutionary ideas and services are being created. Any little-known stock that provides a product that is essential to that budding industry makes for a good growth stock. Rapid sales and earning growth is seen among most big winners before their stocks take off.
- Buy stocks that are outperforming the market. Companies can promise all kinds of financial growth. But is that growth potential translating to a rising share price? The best investing tips come from the performance of the stocks themselves; a rising stock tells you the smart money is accumulating shares.
- Use market timing. Never underestimate the power of the market to move stocks. You don’t want to invest in a growth stock just as the market is topping out, as three out of four growth stocks will follow the trend of the overall market. If you’re in a bull market, you can afford to be aggressive in buying stocks that are more speculative.
- Be patient. Not every growth stock will advance exactly when you want it to. Very few will, in fact. Even Apple had plenty of fits and starts on its way to becoming the most valuable company in the U.S. In the investment world, time is your friend. If you get out of a stock too early, you may miss out on some big gains months down the road.
Investing in growth stocks can be tricky. Finding a hidden gem that has yet to be fully discovered by the market is exciting, but requires lots of discipline to handle it correctly. Look for up-trending earnings growth, improving profit margins, and booming industries. If done right, investing in growth stocks can be both highly satisfying and highly profitable.
- Micro Cap Stocks
Micro cap stocks are publicly traded companies with market capitalizations of less than $300 million but greater than $50 million. Like small cap stocks, micro cap stocks have the potential to net very high returns, but because of their even smaller size, micro caps carry even greater risk than small caps.
- Mid Cap Stocks
Mid cap stocks are middle-sized publicly traded companies: larger than small cap stocks but smaller than large cap stocks. Mid cap stocks have a market capitalization between $2 billion and $10 billion. Mid caps aren't as risky as small cap stocks, but aren't as "safe" as large cap stocks. However, the advantage they have over many of the biggest large caps stocks is that their greatest period of growth is often ahead of them.
Founded in 1971 by the National Association of Securities Dealers (NASD), the Nasdaq Stock Market is the second-largest exchange in the world by market capitalization, after the New York Stock Exchange. It officially separated from the NASD and began to operate as a national securities exchange in 2006.
NASDAQ, the "National Association of Securities Dealers Automated Quotations”, was at first just a quotation system and didn’t actually trade stocks. As the Nasdaq Stock Market got going, it included a lot of stocks that traded as speculative over-the-counter (OTC) issues.
But as the Exchange became the first U.S. stock market to start trading online, it attracted new tech companies who saw it as a more modern, more dynamic place to list their stocks. Those companies included, Apple, Cisco, Dell, Microsoft and Oracle and a host of others.
The exchange’s heavy weighting toward tech and other “riskier” issues lets investors use it as a barometer of how much risk investors are willing to take on at any one time.
The Nasdaq Stock Market has a pre-market session from 4:00 am to 9:30 am Eastern, a normal trading session from 9:30 am to 4:00 pm, and a post-market session from 4:00 pm to 8:00 pm.
It has three market tiers: Capital Market (small-cap) is an equity market for companies that have relatively small levels of market capitalization; Global Market (mid-cap) is made up of stocks that represent the Nasdaq Global Market, consisting of 1,450 stocks that meet Nasdaq's strict financial and liquidity requirements; and Global Select Market (NASDAQ-GS large cap), consisting of 1,200 stocks and more exclusive than the Global Market.
- Net Current Asset Value
One of Benjamin Graham’s earliest analyses, created and tested 75 years ago, is the Net Current Asset Value (NCAV) approach. The objective of the NCAV formula is to find the minimum value a company would fetch if it was liquidated. The formula is:
Net Current Asset Value (NCAV) = cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities – preferred stock
The resulting value can then be divided by the number of common shares outstanding to find the NCAV per share. If the current stock price is less than the NCAV per share, the stock is a bargain. However, further analysis is necessary to determine if the company is prosperous.
Companies with earnings deficits or with erratic earnings histories are likely to become less prosperous and should be avoided. Companies in the financial sector should also be avoided, because their balance sheets are not comparable to those of other companies.
Finding profitable companies selling below their NCAV is a simple process. However, not many companies are selling below their Net Current Asset Values.
Most stocks that qualify as NCAV bargain stocks are small companies, which usually are risky investments. However, Benjamin Graham surmised that any companies selling below their NCAV values carry lower risk: “They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of principal.”
An option is a binding, specifically worded contract that gives its owner the right to buy or sell an underlying asset at a specific price, on or before a certain date. The investor has the right—but not the obligation—to buy.
The right, but not the obligation, to take action is a key distinction. Upon the expiration date, you could always decide to take no action, at which point the option becomes worthless. If you make this decision, the option becomes worthless and you lose all of your investment, which is the money that you used to buy the option.
An option is only a contract that's tied to an underlying asset (such as, say, a stock or stock market index). Hence, it is categorized as a "derivative," because an option derives its value from something else. Derivatives have acquired a pejorative reputation of late, because incredibly complex derivatives helped fuel the financial calamities of 2008.
Options come in two flavors: calls and puts.
If you think a certain asset will increase substantially before the option expires, you'd purchase a call option, because it gives you the right to buy an underlying asset at a specific price within a specific period of time.
If you think a stock will dramatically drop in value, you'd purchase a put, which would give you the right to sell the asset at a certain price within a specific period of time. Think of a put option as a form of leveraged short selling.
Accordingly, there are four types of players in options markets: buyers of calls; sellers of calls; buyers of puts; sellers of puts. The "strike price" is the price at which an underlying asset can be purchased or sold. For calls, this is the price at which an asset must rise above; for puts, it's the price at which it must go below. These events must occur prior to the expiration date.
A "listed option" is traded on a nationwide options exchange, such as the Chicago Board Options Exchange (CBOE). These options are listed with fixed strike prices and expiration dates. The options are named based on their strike price and expiration date. For example, an ADSK January 45 Call is a call option on Autodesk stock at $45 per share that expires in January.
Call options are referred to as "in the money" if the share price is above the strike price. Put options are "in the money" when the share price is below the strike price.
- Put And Call Options
In options trading, there are both put and call options.
A call option gives the buyer the right to buy 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a call option is obligated to sell the stock at the strike price if the option is exercised.
A put option gives the buyer the right to sell 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a put option is obligated to purchase the stock at the strike price if exercised.
- Relative Performance
Relative Performance (RP) measures how a stock is performing relative to a specific market or index. Momentum analysis of a stock’s RP is one of our favorite ways to measure a stock’s health. A stock that holds its value during a declining market often soars once the market turns higher. In a strong bull market, most stocks will rise, even the stocks of weak companies! But you should concentrate your efforts on the best companies with the strongest stocks, the market’s leaders. The way to find them is by analyzing RP lines.
When a Relative Performance line is moving upward, the stock is outperforming the market. When it’s moving downward, the stock is underperforming the market. A flat RP line indicates the stock’s performance is equal to the market’s. Each issue of the Cabot Growth Investor shows the RP lines of the stocks we’re recommending and following.
In general, we like to see a minimum of 13 weeks of outperformance (an uptrending RP line) before we consider buying a stock. Once this condition has been met, we conclude the stock has positive momentum. If a company has a compelling fundamental story and strong positive momentum, it’s a candidate for purchase.
What constitutes strong momentum? When a stock has a powerful RP line, its corrections will be brief, lasting just a week or two. The longer the Relative Performance correction, the weaker the situation. There’s nothing more positive than an RP line that’s hitting new highs!
In general we’ll consider selling a stock if it underperforms the market for eight weeks or longer. But there are other considerations. How deep (or shallow) has the correction been? Has the stock been declining on heavy trading volume (a big negative)? Is it holding up in an area of price support? Relative Performance analysis is extremely important, but it’s not done in a vacuum. There are other considerations.
Interpreting Relative Performance lines is as much an art as it is a science. But to any serious investor, it’s worth the effort. It gives you the conviction to stay with a stock rather than selling for a quick profit. It helps you identify the strongest stocks in both weak and strong markets. And it gives you advance notice that a stock is weakening.
- Small Cap Stocks
Investing in small cap stocks is a good way to earn huge returns. The smaller companies often have the most potential for growth. They also carry plenty of risk for investors.
Anytime you buy shares of a small, little-known company, there are a bevy of unknowns. Some small cap stocks are clinical-stage biotechs whose drugs have yet to be approved for commercial use. Others are chipmakers or cloud-computing companies that have plenty of promise but have been simply misunderstood by the market.
It’s impossible to take the risk completely out of small-cap investing. But there are ways to minimize those risks without sacrificing potential profits. For starters, set up a clearly established set of rules ahead of time, and stick to them.
Our small-cap expert, Tyler Laundon, has a very specific set of rules for identifying the right small cap stocks. Those are:
- Search for paradigm shifts in any field of business that requires a unique, new solution that will be provided by a stand-alone company. Then seek a niche supplier that will become an equal benefactor to that pioneering company.
- Invest only when the market opportunity is huge—and quantifiable. Only invest in small companies that serve large, burgeoning markets because you can realize tremendous growth with even small shares of the market.
- Get into a small-cap stock before institutional investors become aware of it. Sometimes it takes a while for the big hedge funds or mutual funds to discover small yet promising companies. Once they do, it quickly drives up the price.
- Invest in stocks that offer both growth and value. Look for relatively young companies with growing sales, yet is undervalued based on the company’s market potential versus its total market capitalization. A balance sheet with little to no debt is also a big plus.
- Invest at the right time in the product cycle. There is a direct correlation between the time of investment and the degree of risk and rate of return you can expect. The time period after venture capital investors come aboard is generally the most promising.
- Lastly, concentrate on the very best ideas. Look for industries that have hit a roadblock and need new technologies to keep growing. The small companies that provide those breakthrough technologies make for the best small cap stocks.
These rules won’t help you pick all winners. But they should give you a leg up in selecting the right stocks.
- Technical Analysis
When selecting stocks, fundamental analysis is important, but technical analysis is of equal or greater importance. Stocks trade based on what the future holds (or is expected to hold), not on last quarter’s financial results. A stock’s share price reflects the future prospects of and expectations for the company.
But stocks also have memories. The stock market is simply a collection of investors who buy and sell stocks. These investors remember a stock’s past, which influences their buying and selling behavior.
This is where the technical analysis of stock trends comes into play. It can be a powerful tool to identify trend reversals and entry and exit points. The best way to analyze the trading pattern of a stock is to look at its chart.
As you read Cabot newsletters and listen to investing news, you will probably hear terms like ‘head-and-shoulders pattern,’ ‘trendline,’ ‘support and resistance,’ ‘double top’ or ‘double bottom,’ “triangle,’ and ‘gap.’
Understanding these basic formations and how to read stock charts will make you a better, more profitable investor. Timing is everything, and even a basic understanding of technical analysis will greatly improve the timing of your entry and exit points. And that can be the difference between a successful and a failed investment.
No technical indicator or system is perfect. There will be times when the signal that is given by the charts turns out to be wrong. But in most cases, when technical stock analysis leads you to a certain conclusion, the stock will behave in a way that is similar to what would be expected.
- Trading Volume
Trading volume reflects the overall activity of the market, indicating the sheer amount of buying and selling of securities. Next to price, it is one of the most closely watched indicators.
Specifically, trading volume represents the total number of stock shares, bonds, or commodities futures contracts traded during a certain period of time.
The major exchanges report trading volume figures on a daily basis, both for individual issues trading and for the total amount of trading executed on the exchange. Trading volume indicates market liquidity and the supply and demand for securities.
Trading volume also reflects pricing momentum. When stock market activity—i.e., volume—is low, investors anticipate slower moving (or declining) prices. When market activity goes up, pricing typically moves in the same direction.
Low volume of a security, even if it's rising in price, can indicate a lack of conviction among investors. Conversely, high volume of a particular security can indicate that traders are placing their long-term confidence in the investment.
Certain types of investors who subscribe to the "technical analysis" school of thought place enormous importance on the amount of volume that occurs in the trading of a security or commodity futures contract.
Trading volume also serves as a warning as to whether a stock is on the verge of breaking into upside territory (high volume) or into a downside trend (low volume). High volume also gives investors more time to determine when it's the right time to sell for a profit.
A dramatic rise in volume is interpreted to signify future sharp rises or drops in price, because it reflects increased investor interest and sustained momentum. Low volume can generate price volatility and mirror factors that, from an investment standpoint, are ephemeral and untrustworthy.
Take note: Extremely low volume sometimes attracts scam artists who are determined to manipulate the price of the stock, because their trading will exert an outsized influence.
- Value Investing
Finding value is all about buying something at a discount to what it’s actually worth. The same is true of value investing.
Sometimes factors can cause a stock to get beaten down to the point of being undervalued. Value investing is about finding stocks that are worth more than their current share price.
Investment legends like Sir John Templeton, Benjamin Graham and Warren Buffett realized decades before behavioral finance became a respected academic discipline that systematic psychological errors tend to create market inefficiencies. Templeton, Graham and Buffett reasoned that herding behavior (including momentum traders and short-term speculators that chase price trends) and overreaction bias (the tendency of people to overreact to bad news) are strong forces in the market that can push stocks far below their fair value.
Based on these observations, many of the world’s greatest investors look for stocks that are beaten down by the market due to bad news or negative rumors. Benjamin Graham, the father of value investing, constantly searched for companies that once fetched sky-high valuations but that crashed when the companies were unable to deliver on investors’ expectations.
Warren Buffett famously said, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Value investing is about recognizing opportunities and spotting deep discounts. One way some investors measure a company’s value is its price-to-earnings ratio, or P/E. But P/E is a very simplistic measure of a stock’s value. Experts dig deeper, examining a company’s sales, cash flow, dividend, book value, debt levels, historical valuation patterns and more to determine if a stock is undervalued.
- Value Stocks
Notice any stocks that are getting pummeled as a result of embarrassing headlines or negative rumors? They might be the next great value stocks.
Value investing isn’t as simple as that. But that’s sort of the mentality.
“Be greedy when others are fearful,” legendary value investor Warren Buffett once said. His advice still rings true.
Sometimes good companies get wrongly punished by the stock market, often to the point where they become undervalued. But not just any company receiving a bit of bad news qualifies as a good value play. Instead, value stocks typically share a couple of key characteristics.
- Strong growth prospects. Every stock takes it on the chin at one point or another. The companies whose sales and earnings to grow through it all are the ones that consistently bounce back. It doesn’t take much for a stock to get knocked down—a disappointing new product, a scandal involving one of its executives, a bad Super Bowl ad. Those are temporary problems. For savvy value investors, they’re also prime buying opportunities.
- Cheap multiples. There are ways to actually measure value stocks. And it’s not as simple as looking at the price to earnings (P/E) ratio, as some analysts might have you believe. Price to earnings is just one of six valuation benchmarks we use. The others are price to book value, price to cash flow, price to dividends, price to sales and the PEG ratio, which is calculated by dividing the current stock price by the last four quarters of earnings per share growth. For a company to be considered a strong value stock candidate, at least one of those ratios needs to be low. If several of those valuation multiples are low, and earnings are projected to grow, then you may have found a stock that is trading well below its intrinsic value.
Even with those characteristics in place, successful value investing still depends a lot on timing. You don’t want to invest in a strong value candidate while it’s still in free fall. You want to buy value stocks right around the time they’ve hit rock bottom—or at least close to it.