Thanks for the Stock Tip, Doc

Thanks for the Stock Tip, Doc!

How Many Shares?

Drink More Milk

A few years ago, (January 2006, actually) during my annual physical exam, my doctor gave me a stock tip.  I knew that he was aware of what I do for a living, but we hadn’t ever talked about stocks or investing or anything other than how to get my cholesterol down.  I was so surprised that I think my blood pressure actually spiked!

But there my very own Primary Care Physician was, telling me about how a drug rep for a big company had dropped a name on him during a sales call. 

Here’s what he told me.

The drug rep’s big company (Eli Lilly) had partnered with a tiny company called Amylin Pharmaceuticals to help develop a new treatment for diabetes called Byetta.  The trials, according to the drug rep, showed that Byetta not only controlled diabetes just as well as insulin glargine (the standard treatment at the time), but that people who used it actually lost weight.  Talk about a one-two punch!

I told my doctor that I’d check it out.  What I found was that Amylin stock (AMLN) had gapped up on August 22, 2005, when news of the successful Phase II trials was released, leaping from 22 to 26 in one day.  Partly because of the strength, the stock had appeared twice in Cabot Top Ten Report in October 2005, closing at 34 on October 10 and 37 on October 17. 

Investors who bought the stock after either of those recommendations could have ridden it to as high as 50 in July 2006, although they would have had to hold on through three substantial corrections to get there.  When my doctor told me about it, the stock was trading at around 45, and would top out at 50 within a couple of months. 

In the long run, AMLN was like a lot of pharmaceutical stocks that get a boost from good news and take off like rockets.  By the time I heard about it from my doc, its fastest growth was already behind it.  Only the most disciplined investors would have walked away with a small profit in late 2006 when the stock lost momentum.

(Since then, AMLN began to slump in October 2007, and was treated very roughly by the big bear phase that began in August, dropping to about 7, which is where it’s trading now.  I don’t know if my doctor ever actually bought any for himself.  I hope not.)

But speaking of my doctor …

Anyone who follows the market with more than a passing interest knows that it takes a while for big market moves to register in the minds of the rest of the world.  And I knew when my physician weighed in with his stock tip, that AMLN’s run was probably doomed.

When someone (for Timothy Lutts, our publisher, it’s his barber) who doesn’t normally pay attention to the stock market begins to get interested, it’s time to make sure you know where the emergency exits are located.

The reason I’m bringing this up now is that what was true of AMLN on the way up is true of markets on the way down: when everyone agrees on a trend, that trend is probably close to reversing itself.  In the case of today’s market, just when everyone and his dog has fled the market in panic and despair, the real pros are freshening up their watch lists and getting ready for some buying.  That’s the case right now with the S&P 500 and the other broad-market indexes.

As I’ve said before, there’s nothing mysterious about this, and not even anything cheaply ironic.  Bear markets punish people until they sell their stocks.  And when there are no more people left to sell their stocks, the market has reached its bottom.  And when markets have reached their bottom, they turn up.

It’s a good time to be cautious, as a market that’s very close to turning up is very different from one that has actually made the turn.  Smart money never calls a bottom in advance. 

If you understand this fundamental fact of contrarian investing, the present cloudy skies and universal gloom should be whetting your anticipation for the sunshine to come.

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There are two questions that I’m often asked about equity investing that I really don’t like.  The first is, “What’s the one stock I should buy right now?”

It’s not an unreasonable question, but it assumes that I (or any of the Cabot analysts) always have one sure thing up my sleeve, one stock that has a “Can’t Miss” label pinned to its collar.  I wish it were true.

If there were ever a stock in which I had absolute confidence, one that I knew would go up in a big way, I’d be as tempted as anyone to put way too much money into it.

The sad fact is that every stock anyone ever buys is a bet, and the best you can do is get the odds in your favor as much as possible.  Just as “There Ain’t No Such Thing As A Free Lunch” (the famous TANSTAAFL Principle), there also isn’t such a thing as a sure thing.

The second question is even trickier.  It’s “How many shares of this stock should I buy?”

It’s not a fair question because the answer depends on how much investible income you control, your risk tolerance, the diversification of your portfolio, your age, marital status, employment and a host of other factors.  That’s why I don’t give personal financial advice.  I’m strictly a stock market guy.  People study for years to learn how to answer that question, and then they’re called financial planners.  If you hire one (and it’s an excellent idea), expect to end up with them knowing everything about you down to your shoe size.

As a simple stock picker, I have only one piece of advice when someone asks how many shares to buy.  I tell them to stop thinking in terms of number of shares.

It used to be that making a buy of an even lot (usually 100 shares) would get you a significant break on your brokerage commission.  These days, however, most discount or online brokers charge only by the transaction, so buying in round numbers doesn’t do you any good.

In fact, buying even-numbered lots of stocks with different prices just skews your risk profile.  You may not be twice as confident about stock YYY as you are about ZZZ, but if YYY trades at $20 a share and ZZZ trades at $10 a share, buying the same number of each will give you twice as much risk exposure to the higher-priced stock.  You need to stop thinking shares and start thinking capital.

The more prudent approach is to divide up the amount you want to invest in growth stocks (or value stocks or income stocks) into equal-dollar positions and then put that amount into each stock.  So if you have $50,000 to invest in growth, and you want an aggressive portfolio, you should aim at having 10 positions of $5,000 each.  This will give you enough diversification so a meltdown in one of your holdings won’t kill your results, while being concentrated enough that a big winner can give you a significant boost.

One mildly positive thing about a bear market is that it allows you to consider a wider range of stocks for your watch list.  During a bull market, with buying decisions to make, there’s not much time to browse through the odd stories on the edge of things.  When buying isn’t a possibility, you can broaden your horizons.

My stock idea for today is American Dairy (ADY), which, despite its name, is actually a Chinese company that produces milk powder, soybean milk powder and walnut products (?!) in northeast China. 

While many Chinese milk companies were hit by a scandal involving the addition of melamine to milk to raise its (apparent) protein level, American Dairy’s reputation is intact.  The company has two dairy farms with a capacity of 10,000 cows each that meet international standards for organic farms.

The purity of American’s products has created a big demand outside its usual Northeast China sales area, pulling the company into the Beijing market.

The stock was pulled down by the melamine scandal, but has rebounded strongly, soaring from 6 to 17 in just a few months.

One big problem with the stock is that the company hasn’t reported earnings since Q3 2007.  This has been the subject of several filings with the SEC, and presumably the results will come out eventually.  Under these circumstances, the fact that a new analyst has picked up coverage on the company is reassuring news.

I wouldn’t recommend buying ADY at this point, but its performance under adverse circumstances shows some real underlying strength.  If the emerging markets can get organized to give us a buy signal and the company can get its reporting in order, American Dairy will be a strong growth story.

Sincerely,

Paul Goodwin
For Cabot Wealth Advisory

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