Investing in the Third and Fourth Dimensions
Taking Some Heat
I’m going to start with a quote I re-read last weekend from Hedgehogging, one of my favorite investment books. But author Barton Biggs didn’t write the quote; it was actually a passage from another book that Biggs included. Here it is:
“No discussion of the interrelation of stock prices and business conditions would be complete without emphasizing that in the clash of speculative forces on the exchange, the emotions play a part which is not paralleled in the normal process of commerce and industry. The golden mean is non-existent in Wall Street, because the speculative mechanism does all things to excess; even the reactions from the heights of phantasy (sic) and from the depths of despair are accompanied by convulsions which are distinct from the calmer tenor of business. Those who seek to relate stock movements to the current statistics of business, or who ignore the strongly imaginative taint of stock operations, or who overlook the technical basis of advances and declines, must meet with disaster, because their judgment is based on the humdrum dimensions of fact and figures in a game which is actually played in a third dimension of the emotions and a fourth dimension of dreams.”—from Ten Years of Wall Street by Barnie Winkelman
Over the years, I’ve received literally hundreds of questions asking why a stock fell when the earnings report was so good, or why a stock trades at 100 times earnings when there is so much competition, or why the market is going down when corporate earnings are so healthy … you get the idea.
These questions involved dozens of different stocks and many different points in time, but they all have one thing in common; they all relate a stock or the overall market to the “humdrum dimensions of fact and figures”—they are all based on the concept that the market should be highly correlated to real world measurements like production, output, growth and earnings.
“Mike, what are you telling me? That things like production and earnings have nothing to do with stock prices?” Yes … and no. In the long run, the market is an excellent barometer of the health of the economy, and clearly, earnings are important for stocks. But it’s really not the earnings themselves—it’s the anticipation of bullish earnings in the future that gets stocks and the market moving higher. (One investor I know of uses earnings estimates as his sole fundamental criteria when hunting for stocks.)
The point is that, while the fundamentals of the economy or a stock provide vital background, they are not going to tell you exactly where a stock or market is headed, and when it’s leaving the station. If they did, anyone with good math skills would make millions! Unfortunately, that’s not how the world works.
It’s in the third and fourth dimensions of emotions and dreams that stocks really trade, and the more you keep that in mind, the better you’ll be at avoiding common (but incorrect) assumptions of what drives stocks higher or lower. Remember that the market is the market, and the economy is the economy—they’re related, but they’re far from the same thing.
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Staying on the general topic of trading psychology, raise your hand if the following has happened to you some time in the past: You buy a stock that’s strong and you’re optimistic it will keep going, but within a day or two, the stock turns tail and falls a few percent. Some analyst cites difficulties at the company. You panic and sell out to book the small loss … only to see shares move higher in the weeks after your sale as your original bullish thesis proves correct.
When you do your post-op analysis on this trade, the real reason this investment lost money wasn’t because you picked a bad stock, or even that you bought incorrectly. It’s because you were unwilling to stand any sort of loss in the stock. And I’m here to tell you that the investor who isn’t willing to take some heat is going to lose money in the stock market.
I see this all the time (and, in fact, talked to a couple of subscribers this week about this very subject). The fact is, if you are going to freak out every time a stock goes against you by a couple of points, you’re going to lose a ton of money, as every stock—even the market’s best leader—is going to fluctuate a bit. So you’ll be repeatedly stopped out, with your portfolio dying the death of a thousand cuts.
Don’t get me wrong—cutting losses short is definitely rule #1 when it comes to growth stock investing. But you also have to be reasonable with your loss limits; selling every time a stock falls 2% from your buy point is going to create a ton of small losses. Equally important, losing so frequently will seriously mess with your head.
It all boils down to one of my favorite sayings: Don’t invest scared. While a lot of investors end up losing because they invest with guns blazing (buying huge positions, poor stock picking, disregarding the potential downside, etc.), some also fail because they’re unwilling to lose money; it’s almost like going up to the blackjack table but walking away if the first two hands go against you.
The bottom line is that you should be thinking ahead of time how you’ll handle your stock (“plan your trade and trade your plan”), including when and where you’ll pull the plug. That will keep your emotions from getting the best of you, helping you to hold on to fidgety stocks that go on to become big winners. This was one of the toughest lessons for me to learn, but once I did, my results improved immediately.
For my stock idea today, I’m going with one I’ve been recommending for many weeks. It came through the market correction in fine shape and is now testing new-high ground.
It’s Brigham Exploration (BEXP), possibly the leading mid-cap player in the Williston Basin, a huge area located in eastern Montana and North and South Dakota. It’s possibly the hottest new oil discovery in decades, at least in the U.S., and many companies are busy buying up acreage and drilling wells, which have been gushing with oil.
Brigham isn’t the biggest player in the area, but it might be the most successful; compared to other publicly traded companies, it’s getting more than 70% more oil per well than everyone else (on average). That’s thanks to management’s know-how and experience with newer drilling techniques like fracturing and horizontal drilling.
The company has drilled just 7% of its currently identified well inventory, and even that figure is likely high, as the firm is confident of listing hundreds of new wells as it more officially analyzes its acreage in Montana.
Thus, there’s a long runway ahead of Brigham, and when you combine that with extraordinary production growth rates (likely up 80% this year alone) and high oil prices, sales and earnings should continue to boom. As it stands now, analysts see earnings of about $1.20 per share in 2011 and $2.00 per share next year, up from 59 cents per share in 2010!
As for the chart, what catches my eye is that, even before this week, BEXP has advanced eight of the last nine weeks (this week will probably make it nine out of 10). And, impressively, all but one of those weeks came on above-average volume; even the one down week was really a sign of support, as shares dipped during the market correction, but found support at their 10-week moving average and closed the week mid-range.
Obviously, if oil prices slide 20 bucks, BEXP is going to head south; there’s no getting around the fact that this is an oil stock. But buying around here or on any weakness, with a looser stop around 32, makes sense to me.
All the best,
For Cabot Wealth Advisory
Editor’s Note: Mike Cintolo is VP of Investments for Cabot, as well as editor of Cabot Market Letter, a Model Portfolio-based newsletter of the best leading growth stocks in the market. It’s been just over four years since Mike took over the Market Letter, and during that time, he’s beaten the market by 13.3% annually (up a total of 59% since then, compared to a loss of 7.5% for the S&P 500) thanks to top-notch stock picking and market timing. If you want to own the top leaders in every market cycle, be sure to give Cabot Market Letter a try by clicking HERE.