The holy grail of investing is to identify the winning stocks in the market first. These are the stocks that break all of the records: the outliers. Studies have shown that the majority of the gains in the stock market over the past few decades are from only a handful of stocks. If your portfolio didn't have some of these leading stocks, it didn't outperform the market. Knowing that a few winners are all that investors need, these two questions come up: do these prior winners share common traits? If there are shared attributes, can we systematically find them early?
- Studies have shown that the majority of the gains in the stock market over the past decades are from only a handful of stocks; if your portfolio didn't have some of these leading stocks–considered "outliers"–it didn't outperform the market.
- To identify these outliers, there are three main attributes investors should be aware of: great fundamentals, great technicals, and unusual institutional trading activity.
- There are two fundamental attributes that consistently reveal themselves in great stocks: growing sales and growing earnings.
- A winning stock should have is great technicals over the long-term, meaning the stock should be trending higher and achieving new highs.
- A top stock should have continual demand for the shares by big investors.
To use the analogy of basketball, a portfolio only needs one Michael Jordan to make all of the difference. Here is an example of what an athlete who is an outlier looks like:
Michael Jordan is an outlier, but there are outliers in every industry, not only sports. They exist in entertainment, business, and investing (think Warren Buffett). Outliers also exist in the stock market. Take a look at the chart of Align Technology, Inc. (ALGN) shown below:
Align Technology is an outlier stock, up +1,620% since Mapsignals identified it in April 2011. Over my many years of pouring through data, I've found that the best stocks out there have three main attributes investors should be aware of: great fundamentals, great technicals, and unusual institutional trading activity. That's what you see represented by the green bars in the chart above. Each bar is a bullish signal created by combining these three essential qualities. The gray shaded area is the lookback period in our dataset.
The first quality a stock needs to have to be great is a strong grounding in fundamentals. This should be intuitive. If it's a good business, shareholders should get rewarded. There are countless fundamental data points out there, but there are two fundamental attributes that consistently reveal themselves in great stocks: growing sales and growing earnings. There is no magical threshold, but if a company wins new business year after year while managing its costs, it is likely sitting on a strong foundation. My personal preference is to look for double-digit annual sales and earnings growth.
Below is a snapshot of Align Technology's earnings and sales growth from March 18, 2016:
The second quality a great stock should have is great technicals over the long-term. In other words, the stock should be trending higher and achieving new highs. The best companies out there tend to also have the best charts. As the company performs well fundamentally, the chart will reflect those positives in higher stock prices. For this reason, waiting for pullbacks in market-leading stocks can be tricky because the best stocks tend to keep climbing year after year, and pullbacks in the shares may not last long at all.
Below is a snapshot of Align Technology's technical picture from March 18, 2016:
Unusual Institutional Trading Activity
The third–and most important–quality is that a top stock should have continual demand for the shares by big investors. This is what makes the Mapsignals process unique–we specifically look for unusual trading activity in stocks that are likely being accumulated by institutions. We believe that many of the smartest institutional investors in the world can spot the best stocks out there before anyone else, and we want to be along for the ride.
We believe that our method stacks the odds of success in our favor and exploits these footprints over time. We want to spot these signs without having to sit on an institutional trading desk. An easy way to conceptualize how we find these signals is that we try and measure how a stock is trading relative to its price action. We look at many different relationships between volumes and prices that can indicate when a position in a stock is being taken.
Our process combines all three of these crucial characteristics needed for tomorrow's leading stocks into a simple signal. The more times the signal appears, the more confident we become.
Below is a Mapsignals' chart on Align Technology from January 2016 through August 2018:
The Bottom Line
There is an age-old debate about which is a better predictor of future stock price appreciation: fundamentals or technicals. The bottom line here is that the way a stock trades can oftentimes foreshadow the forward fundamental and technical picture more than by looking at financials or a chart alone.
To learn more about Mapsignals' institutional signals and to receive a free copy of Mapsignals' white paper on Outliers that shows how this strategy has done over a nearly 30-year back-test period, please visit our "About Us" page.
Investment Research Disclaimer
Disclosure: The author holds no position in Align Technology shares at the time of publication.