Simple Rules for Stock Investing?

Simple Rules for Stock Investing?

The Difficult of Implementation

Game On! In China

Investing in stocks involves a huge number of variables, so many, in fact, that the whole system simply defies complete analysis.

Think about it. Even the most sophisticated organizations (mutual fund houses and hedge funds), with battalions of analysts and rooms full of computers, can’t get the business of making money by investing in stocks down to a science.

That’s why most stock investment strategies are exercises in simplifying, seeking to gain an edge on the market by reducing decisions on buying and selling to a manageable system. And the essence of most systems is that there are only three things (or four, or five, but nowhere near double figures) that you need to pay attention to.

The Cabot growth investing strategy certainly does this. Here are the principles:

1. Invest in stocks whose charts show increasing investor interest.
2. Increase your market exposure when markets are advancing and reduce exposure when markets are declining.
3. Cut losses short, especially in negative market environments.
4. Let winners run.
5. Stick to stocks trading above 14 and that average 400,000 shares traded per day.

That’s about it.

And there again, the implementation isn’t all that simple. You have to learn at least the rudiments of technical analysis of charts. You need a reliable indicator of the direction of the market, especially when indexes are soaring and swooping like a flock of starlings. And you need to develop guidelines on when to sell.

By contrast, value investors can ignore most of these things and just look for undervalued companies with good prospects.

Of course, the implementation is far from simple. You need to learn how to analyze truckloads of data on assets and liabilities. And you must develop techniques for projecting the future of a company’s revenue, earnings, free cash flow, margins and market share, management and competition.

There are stock investment techniques that are simple, dead simple. You can, for instance, buy stocks that your brother-in-law recommends. Or you can only buy stock in the company at which you work. (That’s what my father-in-law did, and his holdings in Amoco–which is now British Petroleum–provided years of dividend income for him.)

You might try to emulate Noel Constant, a character in Kurt Vonnegut’s book The Sirens of Titan. Mr. Constant achieved enormous wealth by buying stocks whose names corresponded to the successive letters of the King James Bible. Although fictional, Mr. Constant’s system is simple and easy to understand. All you need is a massive amount of luck (or divine intervention).

You might also consider the venerable Dogs of the Dow strategy, which involves a once-a-year buy of the 10 top dividend-payers from among the 30 members of the Dow-Jones Industrial average. The strategy beats the performance of the S&P 500 Index in the long run.

But if beating the S&P 500 Index is your benchmark for success, you’re not really aiming very high, are you?

Personally, I find the Cabot growth discipline is just right for my investment personality (that’s my level of aggressiveness, tolerance for risk and need for mental stimulation).

I’ve always enjoyed “Two Out of Three” rules. One favorite says that food can be fast, cheap and nutritious, but you can only have two out of three in any one food. A Twinkie, for example, is fast and cheap, but fails miserably at nutrition. You can fill in the other categories.

In investment, I’m not sure what the three categories would be. How about 1) simple, 2) high potential, and 3) consistent. Simple and high-potential might be penny stock investing, where the upside is huge, but the volatility cuts both ways. Simple and consistent would be an index fund, which lacks big upside chances. And high-potential and consistent could, at least in theory, be hedge fund investing, which is anything but simple.

So where would growth investing fit in this scheme? Well, despite the implementation difficulties I ventured above, the principles are indeed simple. And the potential is genuinely high. But growth investing, at least as the Cabot system practices it, looks to make the bulk of its annual returns from a small number of successful stocks that deliver big gains. You have to cut off a lot of losers in pursuit of a few big winners.

In fact, Cabot’s rules for cutting losses short are the key to success in growth investing.

And if you subscribe to our flagship growth publication Cabot Market Letter, implementing a growth strategy can also be simple; you just follow the advice in the advisory.

Sound interesting? You can get a trial subscription to Cabot Market Letter by clicking here. And with our generous cancellation policy, if you decide it’s not for you, you can cancel within 60 days and get a full refund. That’s about a low-risk as you can get.

My stock pick for today is a Chinese Red Chip stock that has all the hallmarks of a big winner, but whose chart says a little more patience is necessary.

The company is NetEase.com (NTES) a Chinese Web portal that offers a standard menu of Yahoo-like services, including news, blogs, search, matchmaking, social gathering spaces and so on. But what sets NetEase apart from other Chinese Web giants like Sina.com (SINA) and Baidu (BIDU) is that it derives 85% of its revenue from online gaming operations. The hot items among the company’s massively multiplayer online role-playing games are Fantasy Westward Journey, Westward Journey Online II and III, Heroes of Tang Dynasty and Datang, plus World of Warcraft and StarCraft II, which it operates under license from Blizzard Entertainment. Game revenue comes from playing time fees and from the sale of in-game items.

The company’s revenue growth hit 49% in 2010 and averaged 40% for the first three quarters of 2011, while earnings growth for the period averaged nearly 61%. After-tax profit margins have topped 40% for the last six quarters.

The company has no long-term debt, and the stock is liquid (trading over a million shares a day) and sports a laughably low P/E ratio of 13.

So why isn’t this a screaming buy right now? The answer is in the chart, which has shown that NetEase has the power to move big, but is now trading at about the same level it attained in September 2009. The culprits are the usual suspects, general market weakness, fear that the Chinese government might initiate another one of its occasional crackdowns on playing time (just like parents in the U.S.!) and a general distrust in the reliability of Chinese reporting.

So when should you buy NTES? The cue will come from the chart, with special emphasis on rising volume accompanying a move past resistance at 48, 50 or 52, depending on your level of aggressiveness. But take the warning of the chart seriously; NTES looks like a high-quality bargain, but the chart counsels caution, probably in the form of a tight sell stop.

Sincerely,

Paul Goodwin
Editor of Cabot China & Emerging Markets Report

Editor’s Note: To learn more about high-potential stocks from Brazil, Russia, China and India (the BRIC countries), check out Cabot China & Emerging Markets Report. Hulbert Financial Digest has consistently ranked it as one of the top-performing newsletters for the last several years, quite a feat considering the market’s performance during that time. Click here to learn more today!

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