Big stock market winners look a lot alike -- they have strong earnings and sales growth, a dynamic new product or service, leading price performance and rising mutual fund ownership. Interestingly, successful investors share similar traits.
Top investors always keep their losses small; they never average down in price; they don't immediately shun a stock because it has a high price-earnings ratio (P/E Ratio); and finally, they pay attention to the general health of the market when they buy and sell stocks.
Yet, at the same time, many investors still operate using unsound principles. Successful investors learn to avoid the common pitfalls, and follow these insights that can put you well on your way to becoming a better investor.
Buying Low-Priced Stocks
What sounds better? Buying 1,000 shares of a $1 stock or buying 20 shares of a $50 stock? Most people would probably say the former because it seems like a bargain, with more opportunity for big increases from owning more shares. But the money you make in a stock isn't based on how many shares you own. It's based on the amount of money invested.
Many investors have a love affair with cheap stocks, but low-priced stocks are generally missing a key ingredient of past stock market winners: institutional sponsorship.
A stock can't make big gains without the buying power of mutual funds, banks, insurance companies and other deep-pocketed investors fueling their price moves. It's not retail trades of 100, 200 or 300 shares that cause a stock to surge higher in price, it's big institutional block share trades of 10,000, 20,000 or more that cause these great jumps in price when they buy -- as well as great price drops when they sell.
Institutional investors account for about 70% of the trading volume each day on the exchanges, so it's a good idea to fish in the same pond as they do. Stocks priced at $1, $2 or $3 a share are not on the radar screens of institutional investors. Many of these stocks are thinly traded so it's hard for mutual funds to buy and sell big volume shares.
Remember: Cheap stocks are cheap for a reason. Stocks sell for what they're worth. In many cases, investors that try to grab stocks on the cheap don't realize that they're buying a company mired in problems with no institutional sponsorship, slowing earnings and sales growth and shrinking market share. These are bad traits for a stock to have. Institutions have research teams that seek out great opportunities, and because they buy in huge quantities over time, consider piggybacking their choices if you find these fund managers have better-than-average performance.
The reality is that your prospect of doubling your money in a $1 stock sure sounds good, but your chances are better of winning the lottery. Focus on institutional quality stocks.
Avoiding Stocks With High P/E Ratios
"Focus on stocks with low P/E ratios. They're attractively valued and there's a lot of upside." How many times have you heard this statement from investment pros?
While it's true that stocks with low P/E ratios can go higher, investors often misuse this valuation metric. Leaders in an industry group often trade at a higher premium than their peers for a simple reason: They're expanding their market share faster because of outstanding earnings and sales growth prospects.
Stocks on your watch list should have the traits of past big stock market winners we mentioned earlier: leading price performance in their industry group, top-notch earnings and sales growth and rising fund ownership, to name a few. A dynamic new product or service doesn't hurt either.
Stocks with "high" P/E ratios share a common trait: their performance shows there's plenty of bullishness about the company's future prospects. For example: In Aug 2003, stun-gun maker Taser International had a P/E of 44 before a 900% increase. At the time, the market was bullish about the firm's earnings and sales growth prospects. The market turned out to be right. For five straight quarters, Taser has posted triple-digit earnings and sales gains.
More great examples come from the medical, retail, and oil and gas sector, which were all strong performers in the 2003-2004 period. The table below shows leading stocks in the sectors that staged big price runs from seemingly high P/E ratios. In every case, it was explosive fundamentals that drove their stock price.
At end-Oct 2004, the average P/E Ratio of stocks in the S&P 500 Index was around 17.
Letting Small Losses Turn Into Big Ones
Insurance policies help us minimize risk when it comes to our health, home or car. In the stock market, most people don't even think about buying insurance policies with individual stocks but it's a good practice.
Cut your losses in any stock at 7% or 8% and you'll never get hit with a big loss. This is your insurance policy. If you buy stocks at the right time, they should never fall 7-8% below your purchase price.
A small loss in a stock can easily be overcome. It's the big ones that can do serious damage to a portfolio. Take a 50% loss on a stock, and it would need to rise 100% to get back to break-even. But if you cut your losses at 7% or 8%, a single 25% gain can wipe out three 7%-8% losses.
Here's a set of hypothetical trades to illustrate the point. Even if you had made these seven trades over a period of time - and taken losses on five of them - you would still come out ahead by more than $3,700. That's because the two stocks that worked out resulted in a combined profit of $5,500. And the five losses - all capped at 7% or 8% - added up to $1,569.
The rationale for that 7% Sell Rule was never clearer than in the bear market that began in Mar 2000. It caused unnecessary, severe damage to many investors' portfolios. Small losses in tech stocks snowballed into huge ones. Some stocks lost 70%-80% or more of their value. Some will never reclaim their old highs. Others may, but it'll be a long road back. All successful investors share one trait: they firmly recognize the importance of protecting hard-earned capital by selling fast when a stock declines 7% or 8% from where they bought it.
If a stock you own starts to fall on expanding trading volume, it's usually better to sell first and ask questions later, rather than the other way around. Keep losses small to avoid severe damage. You can always re-enter the game if you've only lost 7%. Don't ever look back after a smart sell, even if the stock rebounds. You have no way of knowing its future, so you are best off reacting to what your stock is telling you right now. Learning this trait is hard -- but it will save you a great deal in the long run.
Averaging down means you're buying stock as the price falls in the hopes of getting a bargain. It's also known as throwing good money after bad or trying to catch a falling knife. Either way, trying to lower your average cost in a stock is another risky proposition.
For example, take Amazon.com between June and Oct of 2004. Its chart revealed much institutional selling by mutual funds and other big investors.
In June, it was a $54 stock. In July, it was a $45 stock. Investors who bought in at $45 may have thought they were getting a bargain, but they weren't paying attention to multiple heavy-volume declines in the stock. What's the sense of buying a stock when mutual funds and other big investors are selling big blocks of shares? That's a tough tide to swim against.
When Amazon released its earnings on Oct 21, it fell another 10% to around $37. In general, stock charts tell bullish or bearish stories long before headlines do. In Amazon's case, heavy volume declines between July 8 to 23 told a bearish story.
Buying Stocks In A Down Market
Some investors don't pay any attention to the current state of the market when they buy stocks. And that's a mistake.
The goal is to buy stocks when the major indexes are showing signs of accumulation (buying: heavy volume price increases) and to sell when they're showing signs of distribution (selling: heavy volume price declines). Three-fourths of all stocks follow the market's trend, so watch it each day, and don't go against the trend. It's not hard to tell when the indexes start to show signs of duress.
Distribution days will start to crop up in the market where the indexes close lower on heavier volume than the day before. In this case, a strong market opening will fizzle into weak closes. And leading stocks in the market's leading industry groups will start to sell off on heavy volume. This is exactly what happened at the start of the bear market in Mar 2000.
When you're buying stocks, make sure you're swimming with the market tide, not against it.
CAN SLIM™ and the IBD Way
If you are a reader of Investor's Business Daily (IBD) or any other of William O'Neil's writings, you may have noticed that these five pitfalls compliment the CAN SLIM methodology of stock selection. By avoiding low-priced stocks, looking beyond the P/E, implementing a stop-loss plan, not averaging down and monitoring the overall market, you'll be well on your way to a sound investing strategy based on years of studies and research from IBD.
For more on CAN SLIM, see Finding The Magic Mix Of Fundamentals And Technicals or Guide To Stock-Picking Strategies.