What are the best practices of growth investors?
Here are some keys to becoming a successful growth stock investor:
1. Work to identify truly great growth companies
2. Cut your losses short
3. Let your winners run
4. Hold stocks of good companies long term
5. Avoid buying on margin, avoid short-selling and avoid options
6. Use market timing to reduce risk in bear markets
7. Understand the effect that public sentiment has on the price of stocks
How does Cabot pick growth stocks?
Cabot’s growth stock selection system starts by focusing on stocks that are strong, going up faster than the general market. These stocks are said to have positive momentum. But we need to see more than that. Behind each stock we want to see a great growth company. In most cases we require a company to be demonstrating strong growth of both sales and earnings. And we want to find a story that convinces us this great earnings growth is likely to continue in the years ahead. How does Cabot determine that a stock is strong? We look for stocks with strong relative performance (RP), sometimes called relative strength. These are stocks performing better than the general market over the long-term.
How does Cabot identify a great growth company?
In short, we want to see a company that appears capable of multiplying its earnings rapidly. Characteristics we like to see include a revolutionary product or service, mass markets, high barriers to competition, excellent and innovative management, high profit margins, triple-digit revenue growth, and accelerating earnings growth.
Do all Cabot’s growth stocks go up?
No. No one picks winners all the time. Sometimes your stocks will go down right after you buy them. If they do, you should get out of them, keeping your losses small. On the other hand, you should hold your winners as long as they are doing well, cultivating them with the hope of holding on for the huge profits that can develop over several years time. In general, we feel we’ve done a good job if 60% of our stock picks end up as winners. The key to success is letting the profits in your winners get larger while keeping your losses small.
The most important rule in growth investing, and the hardest to learn is, “Cut your losses short.” That means if your loss exceeds 15% or 20% at the end of any trading day, you sell. Period. On the other hand, you will have many winners, and knowing when to sell them is more difficult. In general, though, we believe it is wise to sell when a stock has underperformed the market for eight weeks or more. The stock’s RP (relative performance) line is a good indicator of this.
All right, it’s not really magic. But when you see the way it can turn a small amount of money into really big money, sometimes it seems like magic. In plain English, you might say that money makes money. And the money that money makes, makes money. Understanding the power of compounding is one of the keys to real success in the market.
For growth investors, no. Remember, a trend, once established, tends to persist longer than expected. So if you’re convinced a stock’s trend is up and you’re convinced the business is capable of great earnings growth in the years ahead, you should buy. Because the most likely trend is up! At the root of this, you will generally find a shifting change in the public’s perception of the company. We call it sponsorship. As more and more people come to develop improved opinions of the company, it’s natural they will buy more of the stock and drive it to higher prices.
Companies are in business to make money. Thus, earnings are the ultimate score card. Companies that can grow their earnings rapidly and do it repeatedly see their stock prices rise to reflect their success. Conversely, companies that stumble on their growth path see the price of their stock fall. Investors are always looking ahead to what they believe the company’s earnings will be in the future. Thus investors’ perceptions of the company’s prospects can be as important as the reality in the short term. But in the long run, earnings and earnings per share are most important.
If you divide a company’s stock price by its earnings per share, you’ll come up with a price/earnings ratio, or PE. This simple number reflects how well-thought-of the stock is by investors. A single-digit PE is considered to be low, while a number over 20 is considered to be high. If stocks were commodities, like bananas, a low price/earnings ratio would represent a bargain, a good value. But stocks are not commodities. A high PE simply confirms that investors believe a company will experience fast earnings growth in the future.
No! While the long-term course of a stock’s price will ultimately reflect earnings, its short-term course is highly dependent on investors’ perceptions. . . and their emotions. Investors, generally, can be motivated by fear or greed. When they are fearful, they can sell a stock so that its price falls to unreasonably low levels. And when investors are greedy, they can bid a stock’s price up to unreasonable heights. The challenge for the individual investor is to avoid getting caught up in the emotions of the crowd.
Short selling is the practice of borrowing shares of a stock so you can sell it (short), planning to buy it back later at a lower price …returning the shares and keeping the difference in price as your profit. In brief, you’re betting that the price will fall. At Cabot, we do not recommend the practice, for a couple of good reasons. First is the long-term trend of the market, which has been generally upward over the decades, even centuries. When you invest (long) in a stock, you’re investing in synch with the long-term trend. But when you go short, you’re betting that the stock you’re shorting will move contrary to that long-term, upward market trend. And you’re betting that you’re clever enough to time both your entry and exit points to catch this move. It’s tricky. Equally important is the fact that the potential profits of a short-seller are limited. If the stock’s price falls to zero, the best you can do is double your money. Contrast that with the potential of a fast-growing company that could triple your money, or more, in a year or two. Conversely, on the long side the worst you can do is lose all the money you invested in that stock, while if you’re short, your potential losses are unlimited!
Someday your broker may ask if you’d like to invest on margin. In effect the broker is offering to lend you money so that you can invest it and profit from it. The broker is a guaranteed winner, because you pay him interest on the money you borrow and he gets the commissions when you trade with that money. But your profits will be harder to come by. You’ve got to pay that interest and those commissions . . . and your risk is increased. If you’re doubled up on margin, for example, a simple stock drop of 10% will hand you a loss of 20%! And a 20% drop will give you a 40% loss plus a headache. In general, we don’t recommend investing on margin.
We are strong believers in long-term market timing, mainly so we can sell stocks and preserve cash when the broad market enters into a major decline. This is not an exact science, but it can be tremendously rewarding to avoid losing money. And we’ve had great success with market timing over the years, so we feel confident in recommending that all investors practice it. On average, Cabot Growth Investor gives two major market timing signals per year. If it’s a sell signal, we work to reduce risk by selling our poorest performing stocks and putting close limits on the others. The object is to reduce the risk of loss and to raise cash for the next buy signal, when bargains abound. When that buy signal comes, we invest aggressively in the best-performing stocks we can find. Interestingly, that’s the time most investors are scared to death.
To the contrary, that’s the best time of all! The public, in general, tends to react to what has already happened and assumes that the past will continue. Investors have no way of seeing the end of a trend until it’s well behind them. But we know that all trends end when the last holdout joins the crowd …when the last buyer buys or the last seller sells. The trend ends when sentiment reaches an extreme level. Then, because all the fuel for that trend is exhausted, the trend reverses. In general, the better you are at gauging the mood of the crowd, the more confident you will feel about buying when all about you have sold in panic …and moving to the sidelines when all about you are buying feverishly.
I noticed you sold XYZ stock, yet the shares are acting fine. Why did you sell out?
In recent years, especially in tricky environments like now, we’ve been doing more offensive selling—i.e., selling some shares on the way up. And sometimes, we’ll just sell the whole thing. My experience tells me that investors don’t like to sell. They don’t like to sell winners because they’re performing well. And they don’t like to sell losers because they don’t want to “realize” the loss. (Like that means anything.) But the proper thing to do is to cut ALL losses short when buying growth stocks, and to also sell a few of your less vibrant stocks when you’re up 10% or 20%. That’s not your ultimate goal when you buy a stock, but sometimes, when a stock isn’t living up to expectations, it’s best to get out while the getting is good. Successful investing is not about being right on every stock, or riding a stock as long as possible. It’s about making money, and to do that, you have to sell some stocks on the way up.
What do you mean by a stock’s normal pullback?
There are several ways to identify a “normal pullback,” and they all involve interpreting charts. A classic uptrending chart has oscillations that show a stock hitting “higher highs” and “higher lows,” so that a line joining the major high points slants regularly upward, while a line joining the major low points does the same. The ideal buy in such a case comes when the stock has pulled back to what might be the low point of the current move … but which is still higher than previous lows.
Another chart might include periods of base-building, with pullbacks thrown in for variety (and also to scare some investors into selling). As long as the pullback is above a previous pullback, their selling is your buying opportunity. Moving averages are very useful, with the 50-day moving average being most appropriate for our growth investing style. A pullback that kisses the uptrending 50-day moving average often marks a great buying opportunity. Also useful are pullbacks that follow “superficial bad news” or brief periods of general market weakness, as long as the major technical picture remains positive.
What is NOT a normal pullback, however, is one that comes on heavy volume (say, two or three times average); it might be the start of something bigger. Also dangerous is a substantial pullback that comes on no news. It may signal that people in the know are selling because of knowledge (or fear) of future bad news.
Every chart is different, of course, and no rules work all of the time. That’s what makes this business so challenging … and interesting. But the more charts you look at, the more you’ll be able to understand what we mean by “normal pullbacks.”
Can the market bottom if the worst sectors of the bear market (financials) continue to head south?
Likely not. My studies show that the worst sectors of the bear market need to hit a low point before a new bull market begins. Note, however, that these sectors—financials in this case—don’t lead the next bull market. Back in 2003, for instance, it wasn’t bubble boys Cisco, Juniper, JDS Uniphase and Nortel that led the way higher. It was newer stocks with newer stories that hadn’t gone through the wringer.
What does it mean when a stock is trading “thinly” and why is it a bad thing?
Thinness refers to how many shares, or how much dollar volume, a stock trades each day. For our purposes, we consider any stock that trades less than 500,000 shares per day to be relatively thin. Being thin isn’t bad, per se, but it usually means that big institutions can’t take big positions in the stock. And if institutions aren’t involved, the stock is going to be very choppy as small hedge funds and other small investors buy and sell. With more heavily traded, institutional-quality stocks, big investors will support shares during most normal pullbacks. If you run a widely diversified portfolio, buying thinner stocks can be fine, and even fruitful. There’s nothing wrong with them. But if you concentrate all your eggs in just a few baskets, and you don’t have the biggest risk tolerance, you might want to stick with stocks that trade at least 500,000 shares to a million shares or more each day.
Why don’t you short stocks in your newsletters? Seems like it would be a good way to make some money during bear markets.
We have nothing against shorting, but most investors don’t realize that making money on the short side is MUCH more difficult than making money on the long side. Why? Because fear is a more intense emotion than greed; when a stock declines, it happens quicker than when it rises. And that means your timing must be much more precise when shorting—if you’re off by a day or two, the stock can rally quickly and force you to take a loss. It’s also mentally hard for most investors to play the short side, since all the work and research we do is geared toward finding big winners during bull markets. In a way, playing both the long and short side is like using two different systems, which can easily play with your mind.
What would you say your most successful fundamental stock-picking criteria is?
If I had to pick just one, it would be triple-digit revenue growth. Companies that are growing that fast, especially if it’s because of a new product or service, often turn into big market winners. It’s important to make sure the 100%+ revenue growth is happening because of internal growth, not because of acquisitions.
If I had to pick one other, it would be a new revolutionary product, like Apple’s iPod, Crocs’ croslite shoes, Google’s paid search, XM Satellite Radio’s, um, satellite radios, and First Solar’s silicon-free solar panels—all of which were Cabot winners in recent years.
I know that August, September and October are three of the worst months in the stock market. Does that mean we’re likely to stay in the dumps until the end of the year?
We’re not huge fans of seasonality. It’s true that, over time, the market has done most of its good work between November and April. But that’s just an average. Some years it does, some years it doesn’t. Last October, for instance, wasn’t a bottom, it was a top! And September was one of the best months of the year. Similarly, in 2006, the market bottomed in mid-July and had a good August, September and October. It’s good to have seasonality on your side, but it’s not nearly the be-all and end-all of your investment plan.