The goal of trading or investing is to compound your capital quickly without taking unnecessary risks. Although there are many financial markets like stocks, futures, bonds, market indices, precious metals, and currencies. we will be learning about achieving super-performance by trading stocks without substantial risk to your financial and mental capital.
Most retail investors follow the "buy low, sell higher" rule and buy a stock when its price falls. Let us carefully examine the first part - "Buy low" doesn't necessarily mean to buy a stock when its price is at a discount. Although this strategy may work in some situations, many investors incur huge losses by buying stocks in a downtrend. For example, a stock drops from $100 to $50, and you bought some shares thinking the price may not go any lower. The stock price may recover and start trending up, but what if it drops to $40? Do you buy more shares and average down? What if the stock price further plummets to $20? No matter how good a company is, its stock price can still go lower. Stock market history provides many instances where stocks of once great companies went to Zero, and averaging down will wipe out your capital.
Imagine you are running a fashion boutique with ten green and ten red dresses in the store. For whatever reason, consumers are eagerly buying red dresses compared to green ones. Now, if you want to re-stock your store, which dresses would you order more - green or red? The red ones, because they are in huge demand and selling out quickly. And what happens to the existing green dresses in the store? - you would offer a discount to sell out the low-demand merchandise to make space for the ones in high demand(red). Similar to the fashion boutique situation, as a stock trader, the goal is to buy stocks having high demand and sell them for a higher price to book profits. But, the price of a product with high demand will never go from $100 to $50. Instead, it will be trending upwards to greater than $100. That's why you don't buy stocks in a price downtrend. A downtrend implies lower demand. Change your mindset to follow the "buy high, sell higher" rule. Buy high means looking for stocks that are in an uptrend.
So what does stock in a downtrend or an uptrend means? All stocks have four stages in their lifecycle.
Stage 1 : Basing or accumulation period where institutional investors slowly begin acquiring positions in a stock. The stock price will be range bound for months, or in some cases, years. Moving averages will be almost flat. The stock may be at a bargain, but it is not wise for an individual investor to initiate position as the price may not increase for a long time, tying up your money which can invested in other names.
Stage 2 : The advancing or uptrend phase is when the stock price breaks out of the accumulation phase price range accompanied by huge volume. The moving averages will be turning up, and this is the ideal time to buy a stock. Most of the trading profits are made in this stage 2 uptrend.
Stage 3 : The topping or distribution phase is when institutional investors start unwinding their positions. The stage 2 uptrend loses momentum, price action begins to move sideways, and volume picks up as the bulls and bears fight for control.
Stage 4 : Declining or downtrend occurs as the remaining investors rush to liquidate their positions. Volatility often increases even more during this phase.
If you avoid buying/averaging down stocks in stage 4 decline and only purchase stocks which are in stage 2 uptrend, your results will improve significantly.
So what causes an increased demand for a stock. In our fashion boutique situation, maybe the consumers prefer the red dresses because of the color red or the fitting or the fabric is softer. So what attributes of the stock drive the demand? Significant increase in recent one or two quarterly Earnings Per Share(EPS) compared to the prior year's same quarter(s) is the single most important element in stock selection. The greater the percentage increase, the better. Look for accelerating quarterly earnings growth, it's not only the eps growth, but the rate of eps growth(earning's surprises) that causes big stock price moves.Investors Business Daily concluded that 75 percent of the best-performing stocks from 1952 to 2001 showed earnings increases averaging more than 70% in the recent quarter before they began price advances. The best companies show earnings up 100% to 500% or more! A mediocre 10% or 12% increase is not enough. When picking winning stocks, it's the bottom line that counts.
Even though the EPS growth of companies is the best metric, not all growth rates are the same. Companies can still inflate earnings for a few quarters by reducing costs or spending less on advertising, research and development, and other constructive activities. Earnings growth accompanied by higher sales validates the quality of earnings. Annual revenue growth with accelerated earnings growth is the best criteria for finding super-performance stocks. Make sure to select stocks with 25% to 50% and higher annual revenue growth rates.
Relative Strength measures the stock performance relative to the stock market as a whole. The average RS Rating of the best performing stocks from the early 1950s through 2008, before their major run-ups was 87(means the stocks are in top 87 percentile). In other words, the best stocks were already doing better than nearly 9 out of 10 others when they were starting out on their most explosive advance yet. So the rule for those who are determined to be big winners in the stock market is: look for the genuine leaders and avoid laggards and sympathy plays. Don't buy stocks with Relative Strength Ratings in the 40s, 50s, or 60s.
Mark Minervini, U.S investing champion(1997 & 2021), have created a trend template to search for up-trending stocks. The screening templates are available at the MarketSmith website.
MarketSmith already provides stock screeners with the above mentioned criteria. Stock Screens used by Mark Minervini are :
To conclude, You should buy stocks when they're on the way up in price, not on the way down. And when you buy more, you do it only after the stock has risen from your purchase price, not after it has fallen below it.