<<Preparing for the Coming Market Advance
We know it's been a tough year for aggressive growth
investors. You could say it wasn't entirely unexpected
after a 40% rise in the Nasdaq in 1998, an amazing 83% rise
from the Nasdaq last year and an initial 20% burst through
March of 2000. Still, no one predicted such a rough year.
As it turned out, the prior run-ups were unsustainable. So
the market has deteriorated now for seven months.
But don't get pessimistic! As we've said many times, the
market should do well going forward. We believe the market
has been forming a prolonged base this year, which is a
volatile consolidation period that shakes out shareholders,
damages portfolios, creates doubt…and lays the groundwork
for a new advance. We've written of the reasons why in a
number of previous Letters and updates: Lots of pessimism,
great fundamentals, expanding liquidity and the general
aging of our population, which leads to more funds for
stocks.
While a rising market solves many problems, the real task
for investors now is to prepare for the inevitable market
advance. Preparation is the key to success! This is true
for numerous things, including investing.
So how should you prepare? We thought we'd take this
opportunity to share with you our advice for preparing for
a future buy signal. It's not a scientific process, but we
believe it can help you become a better investor. And it
could help you significantly in the present!
Note that the methods explained below are what we actually
do when looking for future winners. It's what we're doing
right now! So expect us to bring you the best of the
litter during the new market advance.
Without further ado, let's get started.
A Tip for You
While this may be hard to do in today's environment of
instant access to news, we strongly suggest you stop
watching the market minute-by-minute. When a downtrend is
in effect, the market is unlikely to turn on a dime and get
away from you on the upside. Remember, there's never been
a solid intermediate-term advance that hasn't lasted at
least a couple of months. Many bull moves have lasted much
longer. So don't get anxious every time the market moves
ahead for a day or two.
Besides, even if the market does turn quickly, what good is
it if you don't have some great potential buying candidates
lined up? So focus on research, while checking the
market's health once or twice a day.
Start Digging
Now that you have some time freed up, dig into your
research. After all, though many investors forget this,
you own stocks, not the market. And while it's true that
most stocks move along with the market, stock selection is
definitely the key to your investing success. So this is
where your effort should be placed.
No Bargains, Please
How exactly should you find those stocks that will lead the
next advance? One step is to stop looking for bargains.
The stocks that have been crushed in a selloff are unlikely
to experience a sustainable advance any time soon. (When
we say crushed, we're talking about a significant
decline…40%, 50% or more.) The reason is simple: All of
those shareholders who bought the stock at higher levels
are probably going to sell once the stock rallies up to
their purchase price. In technical analysis, this is
called resistance. But more plainly, it's human nature,
and it serves to restrict further advance of the stock
price after a short rally takes place.
Now, that's not to say stocks that fall 50% are doomed
forever. Not at all! But the odds of a powerful advance
are relatively low. Ask yourself: Why did the stock fall
so much during the correction? Is something wrong with the
company? Does the big money know something that I don't?
You can never be sure of the answers to these questions.
But during times of market slides, big money managers get
together and figure out what stocks they want to own and
which ones they don't. Most of the time, the stocks that
have been hit hard were dumped heavily by institutions…most
likely for good reason. So avoid them!
Subtle Strength = Clever Accumulation
Now that you've eliminated beaten-down stocks, you can
search for the market's true leaders…those that have held
up like champs during a market decline. Unlike the stocks
above, big institutions did not sell these stocks. Or if
they did, they quickly changed their minds and bought back
in after a one or two day drop. Again, there was probably
a good reason for this…their research departments led them
to these stocks because of their future growth potential.
In case you hadn't noticed, all of the steps above have to
do with the stock's actual performance. It's the best
"initial screen" we know of! So when searching for the
market's future leaders, always, always, always look for
strong stocks. Don't get us wrong…stocks that have pulled
back a bit, for a couple of weeks, are okay to buy. But
avoid the stocks that have been chopped in half or worse.
The best place to find the strongest stocks is the new
highs list. Sounds simple, right? It is! The first
stocks hitting new highs in a fresh market advance are
usually the ones that give you the biggest gains. So
regularly perusing the new highs list is a great way to
screen for big winners.
On to the Fundamentals
More than likely, by looking for strength, you've
accumulated a couple dozen names of potential purchases.
Now what? Look at each stock's fundamentals. Ask yourself
the following questions:
? What's the big idea with this company? Yes, this
is a subjective measure. But it's vitally
important for your stock selection. In fact,
it's the single most important criteria in your
fundamental analysis! You want to invest in firms
that have no foreseeable limit to their growth
potential. Usually these firms are involved in
something new and exciting, something that the
masses don't fully grasp yet. The bigger the
idea, the bigger the upside potential.
? What have been the sales and earnings growth
trends over the past few quarters? As an
Internet investor, focus on companies with annual
growth above 50%. There's no one right number,
of course. And some great stocks will have no
earnings at all. But, in general, you want
lightning-fast growth. An even better situation
is when the growth has been accelerating
recently. (Such as year-over-year growth
increasing from 30% to 40% to 50% in the three
recent quarters.) Contrarily, you want to avoid
firms with little or no current growth. Many
times, the promises of future growth never
materialize.
? What is the firm's position in its industry? Are
there significant barriers to entry? If a
company has a sustainable competitive advantage,
which can range from patents to licensing
agreements to simply having a huge market share,
then its chances of success are good. And that
means your chances for big profits are good, too.
So look for the leaders…and avoid the also-rans
in the industry.
? How large are the company's profit margins? Of
course, this only applies to profitable firms.
You want to favor those companies that have huge
margins. Why? Firms with lower margins have
less room for error if something goes wrong. And
as it turns out, businesses with big profit
margins generally have better business models and
are more dependable year in and year out. That
dependability tends to lead to higher multiples,
which is the key to great stock advances.
While we could list some other measurements to go through,
these are good enough. By now you've weeded out many
strong stocks that just don't have the fundamental growth
potential you demand. (For instance, in today's market,
there are some strong oil stocks. But will they multiply
your investment many-fold from here? Probably not.) And
you've narrowed down your list to possibly five or ten
super-strong, super growth stocks.
Now which ones should you choose? Unfortunately, there's
no easy answer. Some of it may have to do with the current
status of your portfolio. If you already have a lot of
money in, say, chip stocks, maybe you want to avoid buying
any new chip names. And you want to make sure each stock
you're thinking about buying has acted well throughout the
market correction…and begins to blast ahead once the
selling pressures come off the market.
Following these guidelines (and they are guidelines, not
rules) should vastly improve your stock selection. At the
very least, they should get you looking in the right places
when searching out the leaders of a coming Internet stock
romp. As always, no set of rules or guidelines will pick
out only winning stocks. But ours has always given us our
fair share of winners. And as long as you keep your losses
small and let your winners run, your portfolio should do
quite well over time.
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