Thursday, November 15, 2012
Different Stocks Require Different Trading Styles
When the market is up, trading seems so easy.
When the market is down however (like now), it can seem like every stock is going down along with it.
But believe it or not, there are plenty of stocks going up right now.
Growth stocks, Value stocks, Growth & Income stocks and Momentum stocks.
Some are more conservative, while others are more aggressive.
So Which Style is the Best One?
The best style or strategy is the one that's in alignment with who you are, or want to be, as a trader.
Because if you find yourself trading a strategy that's not in alignment with who you are as a trader, or the kinds of stocks you want to be in, you're going find yourself abandoning that strategy the moment the market hits a rough patch. (And the market indeed has hit a rough patch lately.)
So let's go over what the four main trading styles are and some tips on how to use them most effectively.
Momentum traders look to take advantage of upward trends (or downward trends) in a stock's price or earnings. They believe that these stocks will continue to head in the same direction because of the momentum that is already behind them.
And there's a lot of evidence to support the idea that stocks making new highs have a tendency of making even higher highs.
I know some investors shy away from stocks making new 52-week highs. If you're one of them, that's ok. Don't trade them. Remember, the best strategy is the strategy that's right for you.
The biggest concern a momentum trader will have (and probably one of the reasons why some people shy away from them) is in determining if the stock is ready to keep moving higher, or if it's getting ready for a fall?
Tip 1: I have found that by adding a solid valuation metric to these stocks, you can identify the high flyers that are still bargains from the ones that are overpriced.
My all time favorite valuation metric to use with momentum stocks is the Price to Sales ratio; preferably 1 or less than the median for its respective industry. And my experience has shown the Price to Sales ratio to be absolutely one of the best ones to use.
Aggressive Growth Style
Aggressive Growth traders are primarily focused on stocks with aggressive earnings growth or revenue growth (or at least the potential for aggressive growth).
You'll often find smaller cap stocks in this category because smaller cap stocks are typically newer companies in the early part of their growth cycle.
But a word of caution, it's not as easy as just looking for stocks with the highest growth rates. So don't go out and start looking for stocks with a 500% or 1,000% growth rate. While there will definitely be stocks out there like that and do well -- my studies have shown that those kinds of companies will typically underperform. In fact, often times, you'll see companies with the highest growth rates perform almost as poorly as those with the lowest growth rates.
The reason for this is because many growth stocks are priced for perfection. For example: a stock that earns 1 cent, that is then expected to earn 6 cents, is a 500% growth rate.
Now let's say, for whatever reason, the analysts now believe they'll only earn 5 cents. That's still a 400% growth rate. But that's also -100 points less than the original growth rate and a -16.6% downward earnings estimate revision.
And if you're the person that just got into that stock the day before, and you're wondering why on earth a 400% growth rate stock is going down? That's why!
Tip 2: Instead, look for stocks with growth rates above the median for their industry, but with growth rates less than 50%.
Why 50%? Because in my testing, I have found that once you get above 50%, the returns start to drop. It's usually because those growth rates are just simply unsustainable. And for the ones above 50% that do pan out, many of them will carry with it a higher degree of risk. So use your head when looking for those kinds of companies, so those shooting stars don't fizzle out on you.
Value investors and traders favor good stocks at great prices over great stocks at good prices. However, this does not mean they have to be cheap stocks in price. The key is the belief that they're undervalued. That they are, for some reason, trading under what their true value or potential really is. The value investor hopes to get in before the market 'discovers' this and moves higher.
The value investor will typically need to have a longer time horizon because if that stock has been undervalued, i.e., 'ignored' for a while, it may take a bit of time before that stock gets noticed and makes a move.
You can usually spot these kinds of stocks by looking at their valuations, like their P/E ratio for example.
I know a lot of investors out there look at P/Es. But not all low P/E stocks are good value stocks. Many companies have low P/Es because they don't have any real growth to speak of. They lack earnings power. And people aren't willing to pay up for these stocks because there's nothing to pay up for.
Tip 3: The key to finding true value stocks that are ready to move is to make sure there's a catalyst. Buying a stock and sitting with it for years just because you believe it's undervalued won't make you any money.
So make sure your value stocks have a catalyst. And nothing can wake up an investor more than the catalyst of upward earnings estimate revisions.
My favorite upward earnings estimate revisions are for Q1 and F1 over the last 4 weeks. And if you really want to increase your odds of success, you can also focus in on the Sectors with the best upward earnings estimate revisions as well.
It's been said that value investing is one of the most profitable ways to invest. And it's true.
While value stocks usually require a longer time horizon; by combining value stocks with the right catalysts, you can find yourself getting into the best value stocks for an immediate price response.
Growth & Income
Growth and Income investors and traders are looking for good companies with solid revenue that pay a good dividend.
Oftentimes, these are more mature, larger-cap companies. Companies that may not have the kinds of spectacular growth rates like some of the younger or smaller companies have (or like they had themselves when they were younger and earlier in their growth cycle as well).
But that doesn't mean they're not making money. Far from it. A lot of these companies might be great companies, generating huge amounts of cash. But because of their size, they may not have the same growth opportunities they once had.
For example: let's say there was a small-cap company that does $100 million in sales. And someone comes up with a great idea that will increase sales by an additional $100 million. That's great news. And that company is now looking at a 100% growth rate.
But apply that to a mid-cap company that does $1 billion in sales and that $100 million-dollar idea is now only a 10% increase in sales.
Now apply that same $100 million to a company that does $10 billion in sales and that's only a 1% increase.
Simply put, for some of these companies, the law of big numbers makes it harder to grow at the same pace that a younger and smaller company is capable of. But the consistency of earnings can be pretty impressive in its own right.
And instead of investing all of their earnings back into the company, they reward their shareholders by paying out a portion of their profits in the form of a dividend.
Tip 4: Not all dividend paying companies have to be large-cap companies. There are plenty of mid-cap stocks offering exciting dividends with impressive growth prospects as well.
Just remember, you don't have to focus in on just the largest of the large-caps for solid dividend paying stocks. Focus in on the mid-caps and smaller large-caps with the best dividend yields too, and watch your profits grow.
By focusing more attention on the mid-cap stocks and smaller large-cap stocks, you can increase the growth portion of your growth and income stocks, while still enjoying the income portion you normally would with large-cap stocks.
Putting It All Together
Picking winning stocks has never been easier once you know what to look for.
In fact, you'll find winning stocks all around you.
Think about the last car you bought. Once you decided what kind of car you wanted, you probably saw them everywhere. They didn't just magically appear on the road. They were always there. You just became aware of them.
And the same can be said for picking stocks. Once you've identified what kind of trader you are and the style that suits you the best, it'll become easier to find stocks with those kinds of characteristics.
This can help you take full advantage of the next big move in the market and even outperform when the market isn't as cooperative.
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