The normal rules don’t apply!
Follow the insiders?
Looking for pullbacks and tightness
I am not a big fan of video games–nothing against them, just not my thing–but some of my friends are, and occasionally, if the stars align and I actually have some free time (imagine!), we might sit around and play a game to escape reality for a couple of hours.
When this happens, of course, I generally have no idea of how to play; my friend then explains how to equip my character with weapons or magic, the best way to improve his strength or other powers and the workings of the game in general. In other words, in this fantasy realm, there are all sorts of rules and tools, and I have to pick up on them to compete. I don’t argue with any of the tactics because, well, they are proven to work in the game.
In a way, I think that is how new investors should think about the stock market … as a fantasy game where different and unusual rules apply. If you go into the market as a blank slate–just like how I went into this video game, realizing I didn’t know how to play at all–you’ll be better able to learn (or, if you’ve been at it a while, re-learn) what actually works in the market.
However, that is an impossible task for most. Because the market is rooted in the real world (business and earnings news, dividends, buyouts, etc. have an impact on stock prices), investors believe that the market as a whole must follow a certain set of rules that “make sense.” Said another way, they have biases and preconceived notions about how the market should work.
Unfortunately, that is often the exact opposite of how the market actually works! Things that make sense in the real world often cause investors to lose money when it comes to the stock market. It truly is a contrary animal.
The reason why can best be summed up with a passage from an obscure book called Ten Years of Wall Street, by Barnie Winkleman. I think I’ve written about this before, but it’s one of the best paragraphs I’ve ever read on the market:
“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 [and] 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 operators, or who overlook the technical basis of advances and declines, must meet with disaster, because their judgment is based upon 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.”
In other words, the stock market is a totally different game than the business world; the same facts and figures that successful businesspeople rely on can spell ruin … or at least underperformance and frustration.
Today, then, I wanted to review a few of the most common misconceptions about how to make money in stocks. If you’ve been reading my Wealth Advisories (or Cabot Market Letter or Cabot Top Ten Trader), consider this a review. If not, I hope this helps get you on the profitable path.
1. Buy low, sell high: In real life, all of us want a bargain, but in the market, stocks tend to trend–and that means stocks in major downtrends tend to move even lower, while stocks at new highs tend to move higher. Of course, I am generally referring to growth stocks; there are plenty of value-based stock picking systems that buy beaten-up stocks with success.
2. The fundamentals are good, so I’ll hold it: Sure, there is occasionally one super stock that can keep pushing higher for five or six years. But, on average, a stock’s best performance comes in just 18 months, and afterwards, the stock tops out permanently and drops 70%! That is a fact, and we’ve seen a dozens of recent examples, such as OpenTable, Riverbed, Acme Packet, Green Mountain Coffee and Netflix.
3. The insiders are selling, so I should sell: Insider selling sounds like a great tool, but we’ve been at this more than 40 years and have yet to find a great system that involves insider selling. We think the reason is two-fold: First, many insiders sell to book some profits and diversify, not because they think business is about to collapse. But, second, the real drivers of a stock aren’t the insiders, it’s the institutional investors. So if insiders are selling a few million shares, but mutual funds, pension funds and other institutional investors are buying tens of millions of shares, the stock is headed higher.
4. I can’t buy that stock–the P/E is too high!: In a value-based system, sure, evaluating P/Es can help. But the fact is that most big-winning stocks have P/E ratios that are “too high” even when they start their run-up. When I recommended Baidu in July 2009, it was priced at 55 times earnings. First Solar, back in March 2007, was 245 times earnings! But both went up more than five-fold during the next year or two. At the end of the day, P/E ratios aren’t a big factor with growth stocks–things like sales and earnings growth are.
5. I can’t buy that stock because I can’t afford the price!: Ah, yes, the price of the stock; to many, it’s the # 1 indicator of a stock’s quality. But nothing could be further from the truth–again, remember that institutional investors are the ones that drive stocks up and down. And I can tell you one thing for sure–they don’t care if a stock is 20 or 50 or 100 or 500. Instead, they say, “I want 2% of my assets in that stock.” If the price is higher, they buy fewer shares, if lower, they buy more shares … but their total dollars invested is the same. Actually, it’s a fact that the big winners usually come off their launching pads around 20 to 50 per share.
Of course, there are exceptions to every rule; heck, we have our own newsletter (Cabot Small-Cap Confidential) that ferrets out under-the-radar, low-priced stocks with big potential. But realize that editor Tom Garrity is an expert in this subject; most investors, on the other hand, are not, and simply go with low-priced stocks (to continue with this example) just because, well, they’re low priced.
The bottom line is that, in the stock market, what “feels” right is often wrong. It’s important to constantly focus on what actually works in the market, not what you or someone else thinks should work.
As for the current environment, the story remains the same–stocks are in a strong bull trend. You would think such a market would provide ample buying opportunities, but most of the best stocks at this point are well extended from proper entry points, or at least, lower-risk entry points.
As I talked about in my last Cabot Weekly Review video, the key isn’t to obsess about a market pullback. Yes, a retreat is going to happen at some point, though I still think the odds of a full-blown market correction of 10% or more are small … though a sharp 3% to 6% retreat isn’t out of the question.
Still, while buying after a few down days in the market is wise, the real key is to buy the real leaders at the right time. Thus, look for top-performing stocks that have either consolidated for a few weeks, or have recently staged big-volume rallies out of consolidations and are now pulling back a bit.
One name on that front is SXC Health Solutions (SXCI), a fast-growing pharmacy benefit manager that has outstanding growth prospects. Here’s what I wrote about the firm in Cabot Top Ten Trader back on March 19:
“Any company that can offer ways to simplify and control costs in the healthcare arena is going to get a long look from investors, and that’s exactly what SXC Health Solutions does. SXC is a specialist in pharmacy benefit management (PBM), and can take over the pharmacy operations of a health plan, including claims management and review, billing, patient education and formulary analysis and control. The company has done a fantastic job growing both organically (such as its three-year, $1.2 billion deal with Blue Cross Blue Shield of Rhode Island) and through acquisitions (three of them in 2011 alone). The acquisitions make the revenue growth (triple digits each of the past four quarters) seem higher than it is, but the company’s bottom line looks great — in fact, growth has picked up of late and analysts see earnings gaining 48% this year and another 24% in 2013. It’s not changing the world but SXC Health Solutions has plenty of growth ahead of it.”
Indeed, on that last topic, analysts estimate the company’s earnings to leap to $2.41 per share this year, up 48% from a year ago, and then push up to $3 per share in 2013. Historically, the company has generally beaten estimates and guided higher, so my guess is that these figures are actually conservative.
Just as important, the stock itself formed a deep double-bottom base during last year’s market maelstrom, but then rallied back and tightened up in the 60 to 65 area in January and February. Then came a nice breakout, taking SXCI up to 73 or so by early March.
Since then, though, the stock has moved straight sideways on light volume, as its moving averages catch up. I think the stock can be bought either on (a) a drop toward its 50-day moving average, currently around 67.5 and rising, or (b) a big-volume push above 74, which would tell you the current pause has run its course. Either way, it looks like SXCI could offer a relatively low-risk entry sometime during the next couple of weeks.
All the best,
Editor of Cabot Market Letter
Editors Note: When it comes to your investments, you want advice from the best place. Cabot Market Letter has 40 years of market-beating performance behind it, and has been ranked #5 among financial newsletters over the past five years by Hulbert Financial Digest–the arbiter of investing newsletter performance. Click here to learn how Cabot Market Letter can turn your portfolio into a money maker.