Michael Cintolo- The FAQ Issue

During the past few months, through some good marketing, good stock picks and strong performance from our newsletters, we’ve been lucky enough to attract many new subscribers to the Cabot family. (If you’re one of them, welcome!) And that means I’ve also been lucky enough to field a variety of phone calls and e-mails, helping new subscribers get the most out of our Letters.

In those contacts, we’ve covered a variety of topics and questions, many of them applicable to more than just a specific stock or sector. So, instead of going through my usual rant, I thought I would cover a few of the most common questions – and our answers to them. I’m confident that all investors – experienced, novice, or somewhere in between – will find them valuable. As always, feedback is welcome at mike@cabotwealth.com.

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Q. “I’ve seen you’re recommending XYZ stock, but I’ve also noticed the directors and management are selling tons of shares. Why should I buy the stock if the top brass is selling?”

A. Simply put, insider selling in fast-growing companies has never proven to be a reliable predictor of stock performance. Sure, sometimes stocks with lots of insider selling top out quickly … but other times, the stocks soar for more than a year before topping out.

Remember, insiders can sell for a variety of reasons – pre-arranged rebalancing of their portfolio, for one, or simply to book some profit since most of their compensation comes in the form of stock options. Insider buying, on the other hand, is more meaningful, as people buy shares because they think the stock is headed higher.

To be honest, we don’t even consider insider transactions when examining a young growth company – there are far more important metrics to follow, such as sales and earnings growth, profit margins, projected growth, sector performance, and whether the firm has a revolutionary product or service.

Q. “Your stock just crashed after reporting earnings! Why shouldn’t we sell our shares before an earnings report?”

A. You could, if you wanted to, and there’s nothing wrong with that. But remember, there’s good and bad to everything – if you sell every time one of your stocks is going to report, then you’ll never be holding anything longer than three months … and thus you’ll have a hard time landing any really big winners. You’ll miss out on the inevitable couple of stinkers during earnings season, but you’ll also kick yourself for not owning the stock that soars 30% on its report.

I’m definitely sympathetic to those who hate the wild volatility during earnings seasons; Regulation FD (stands for fair disclosure) has prevented any wink-wink, nudge-nudge tactics from management to analysts, leaving investors with little idea how the quarter is really progressing. I don’t like the resulting sharp ups and downs … but as Hyman Roth said in Godfather II (just watched it on TV again this weekend), “This is the business we’ve chosen!”

Because there is no great way to predict how a stock will react to its earnings report, your best game plan during earnings season is, well, to have a game plan. Be consistent in your approach. If you want to sell, say, one-third of every stock before it reports earnings, fine – just realize the benefits and the costs of such an approach. As long as you’ve given it some thought, you’ll do fine.

Q. “My stock reported good earnings, had a good forecast and beat Wall Street estimates – but it collapsed! Should I buy more?”

A. No! Our studies, especially since Regulation FD came into effect, show that big, big earnings-induced moves up or down tend to continue in the weeks to come. By “big,” we’re talking 15% to 20% or more, up or down, the day after an earnings release. As contrary as it seems, those huge moves have momentum; more often than not, they rocket the stock further in either direction.

I’ll even go so far as to say that big earnings gap ups, in a generally bullish market environment, can be bought the day of the gap. But if you see a huge earnings gap down – especially if the stock’s had a major advance the past few months or longer – you should stay away, or if you own some, sell it.

What about the fundamentals? Don’t get too close to those – it’s good to know the general story and the numbers, but if a stock gets crushed after an earnings report, the market is telling you that the report did not live up to expectations. End of discussion!

Besides, I never hear from subscribers saying, “Gee, that report wasn’t so great, but XYZ stock is up 25%. I should short it here!” Of course not – because people want the stock to go up. So when it goes down, it’s a natural tendency to fight against reality. Don’t do it.

Q. “I can’t buy that stock because it’s too expensive; at $200 per share, I can’t buy my normal 100 shares.”

A. I will say this as clearly as possible: The price of a stock means absolutely zero. Do you think the big institutional investors, who manage billions of dollars and, oh, by the way, are the ones that actually move our stocks up and down, care about how many shares of a stock they own? No!

What they care about is the percentage weighting a stock has in their overall portfolio – they might want to have 2% of their total assets in a given stock. Then, given that information, they tell their trading desk to accumulate that amount of stock (usually in a given price zone) over a period of days and weeks.

If you’re “old school” and you have always bought round lots, get over it. I can tell you personally that I can count my round-lot purchases on one hand; I always figure out how much money I want in a stock, and from there, decide how many shares to purchase.

Q. “The company you recommended sounds nice, but it has a P/E ratio of 128! How can you possibly justify owning such a thing?”

A. P/E ratios might have some predictive ability when looking at the broad stock market, or a segment of stocks. But in terms of evaluating growth stocks, they’re not too useful.

Here’s something we read from William O’Neil, founder of Investors Business Daily, that makes sense to us: Elevated P/E ratios are the result of great stock performance, not the cause of it.

Think of it this way – in any market cycle, there are only a few dozen true, institutional-quality leading stocks out there. And thousands of mutual funds, hedge funds and pension funds are trying to accumulate stakes in them! So it’s only natural the valuations of these select stocks get stretched beyond “traditional” comparisons.

In my own history, all of my big winners, and most of my smaller ones, have come in stocks that had huge P/E ratios when I bought them.

Q. “The market usually does well in November, so should I buy stocks here?”

A. In my opinion, “usually” is a dangerous word on Wall Street. It gives you a sense of control, a sense that the odds are clearly in your favor … even if they’re not.

Generally speaking, yes, November through January are the three best months of the year for the market. But not always! And sometimes, those exceptions can be painful (year 2000 comes to mind). You’re better off following the trend of the general market – currently questionable at best – and staying in tune with that.

Q. “I bought a stock at 50, and within a week, it had gapped down to 40! I stink at investing!”

A. Let me share a secret with you: Even the very best investors, those that churn out great results year after year, buy a large amount of losers. I’d say that, if half your picks are winners, you’re going to make an awful lot of money! (I’m assuming you cut losses short while letting winners run.) And sometimes those losers are bad ones.

Thus, you shouldn’t get down on yourself – investing is very difficult to do successfully. Even the best are often humbled by Mr. Market. You’re not stupid if you pick a stinker … just like you’re not suddenly a genius if you pick a couple of winners. That’s just how the game goes.

The goal is, over time, to put the odds in your favor by learning what actually works in the marketplace. It’s like being a casino – in any given month or even two, you might lose money, but over time, if you follow sound rules and learn from your mistakes, you’ll come out well ahead of the game.

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Of course, I couldn’t finish this weekend’s Wealth Advisory without at least mentioning the overall market. In case you missed it … the sellers have taken control. But the most important thing is that the sellers had taken control of most stocks before this week – I wrote two weeks ago about how there was a growing divergence between the few leading glamour stocks and the broad market.

And that divergence had worsened since. In fact, on the NYSE, more than 200 stocks reached new 52-week lows last Friday … and again on Monday … and on Tuesday, too. On Wednesday the figure jumped above 300. And Thursday there were more than 400 new lows! All this while the Dow is just a few percent below its all-time peak.

My point: Such a divergence, while fun if you’re invested in the leaders, usually has a result like we saw this week – the leaders follow the broad market lower, not the other way around.

Does this mean the bull market is over? Not really. It’s certainly time for a correction, possibly a re-test of the major, panicky August low. But these days, there’s already a TON of bad news – the sub-prime issue is so well known that I have a hard time believing that’s going to be the thing to drag the market down.

And leaders like Research in Motion, Baidu, Apple, Google et al, while taking their lumps this week, have yet to even break down through their 50-day moving averages. That’s highly unusual; the common thing is for the leaders to break and then the market to follow, not the other way around.

Still, I don’t advise fighting the market – it’s bigger than you! Now’s a time to raise cash, and importantly, to monitor what stocks with great stories are building bases, and resisting the market’s carnage. The cash raised today will be invested in new, fresh, vibrant leaders when the bulls re-take control of the market.

All the best,

Mike Cintolo

Editors Note: Mike Cintolo is Vice President of Investments for Cabot Heritage Corp., as well as Editor of Cabot Top Ten. Mike’s OptiMo proprietary stock screening system, used in Top Ten, uncovers the market’s strongest stocks – the stocks the institutions are accumulating day in and day out. But he doesn’t just give you a list of ten strong stocks; you’ll also find out the ruling reason behind the stock’s strength, what price you should buy each stock, and sage market commentary, letting you know which trends are emerging (or submerging). As Mike would say, “If you fish in the pool of Top Ten stocks, you’re guaranteed to be invested in the leaders of any market advance.” It’s all delivered to your e-mail inbox every Monday evening. Interested? Try it at our special charter rate.

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