Here’s a common complaint I hear from subscribers: “You just recommended XYZ after it had already gone up from 13 to 38. Why the [heck] didn’t you recommend it at 23?”
The question is a fair one, but I have a fair answer. Our growth disciplines at Cabot tell us that, in most cases, we should look for stocks that have been in uptrends for at least 13 weeks, which means there is a momentum component to our strategy. We use a rising price chart as evidence that investor perception about the company is improving. And the higher the trading volume during the advance, the more likely it is that large, institutional investors are providing the fuel for the advance.
Why 13 weeks? Mostly it’s just that our experience with growth stocks tells us that a stock that’s been advancing for 13 weeks puts the odds of gains in your favor because the stock has a better chance of going up than a stock that’s only been in an uptrend for 12 weeks, or 11, or less.
Reasons? Well, a 13-week advance requires that a stock successfully weather at least one quarterly earnings season. So surviving at least one opportunity to disappoint investors is all to the good.
Also, 13 weeks up usually give a stock a chance to correct a couple of times, which will often cause pure short-term investors to bail out. We call a significant correction to the 25-day moving average (or sometimes even the 50-day) a shakeout, because it scares away (shakes out) those who lack conviction in the stock (the weak hands).
If you want an example of how the process works, just go to your favorite online chart facility (like http://www.stockcharts.com/) and pull up the chart for China Life Insurance (LFC). Look back to October 2005 when the stock was trading at 11 on very low volume. There had been a little movement in July and August that pushed LFC up to 12, but it quieted down quickly.
The real action started on December 1, 2005, with a push above 12. Thirteen weeks later on March 2, the stock closed at 17, down a little from its high of 18 earlier in the month. At that point, the Cabot growth system would have put its stamp of approval on the stock despite its advance of over 40%. And those who had jumped on the stock and held on until the top (107 in October 2007) would have reaped a reward of 530%.
At least in a perfect world, that’s what would have happened.
In the imperfect world that we really live in, I didn’t actually recommend LFC until it was trading at 25. And that, to return to the original point of the story I’m telling, is when I received a spate of notes from subscribers asking why the [heck] I hadn’t recommended the stock back at 12?!
LFC hit a climax top at 58 in January 2007 and the portfolio sold for a nice profit. The correction following the climax took a nearly 40% bite out of the stock, dropping it to 36 before it got back on track. It later made a nice run and peaked at 107 and the Cabot China & Emerging Markets Report portfolio made another nice profit on that upleg as well.
The takeaway from all this is that buying a stock that has already enjoyed a big advance may seem counter-intuitive. But in fact, the circumstances that have been pushing a stock up are exactly the ones that will keep pushing. Now all you have to do is figure out the actual buy point, which is something I’ll discuss in a future issue.