The stars in the constellation of the stock market are mature, established companies. Companies that flare up unexpectedly in the market sky are like meteors. Their hot stocks tend to be highly volatile and shake many traders out of positions. But both of these types of securities deserve to have their place in your portfolio. Let’s take a look at how to find them.
In general, there are two ways to place capital on the stock market – investing and working on your own trading account (trading). Their task is the same – to give a good income with the lowest possible risk. But the approach to investing is completely different. To buy, investors are looking for hot stocks of companies with excellent fundamental indicators (profit, growth dynamics, etc.). Traders are of the opinion that a good foundation is not an indicator of long-term success. Profits and growth rates can serve as a good starting point for a trade, but ultimately success can only be judged by price action. Therefore, in trading, the value of a stock is determined precisely by price movement, and not by fundamental factors. After all, what is the use of a company reporting good earnings and growing sales but not increasing its stock value?
Trading and investing has advantages and disadvantages; there is an eternal debate about which of the methods allows more efficient capital management. But is it really possible to say that one of these approaches is better than the other?
Stock Market – “Universe of Possibilities”
Our task is to find in the universe of the stock market those securities that can become market leaders. They are worth paying attention to and worth investing in. As in the days of the gold rush, market participants sift through thousands of charts to find nuggets of opportunity in the mud. Every industry goes through cycles, from weak to strong, and then vice versa. With the next cycle change, such nuggets of opportunity can reveal their potential. But watching the emergence of new strong stock, you need to understand that there are two classes of securities – meteors and stars.
Each decade is marked by the emergence of new companies that capture the attention of Wall Street. Often they are predicted to have a great future, and their fame goes beyond the circle of financial professionals. Such stocks can be described as “meteors”, they outpace the growth of the broader market, but ultimately “burn out”. At first they start slowly and are inconspicuous at first glance. Before dramatic growth begins, they exhibit three common qualities:
- Consistently strong reports
- Explosive price movements
- High relative strength
Potentially, meteors can generate returns of 100% to 300% over a period of 1-3 years, which gives a good chance of catching favorable movement. Therefore, they attract the attention of institutional investors who start buying available shares, which leads to an increase in the share price and trading volumes. These two elements – the increase in price and volume – attract additional investors, and as a result, a trend that is visible to the general public unfolds. But subsequently, such a stock loses its luster, and investor enthusiasm fades. This is a warning signal that the days of this security are numbered. The stock reaches a top, the trend starts to weaken, the price stumbles and reverses.
Sometimes meteors turn into other kinds of stocks that do not want to completely burn out and ultimately demonstrate their real lasting power.
At the initial stage, the stars behave like meteors – a slow start, and then – the yield increases like a snowball. The reports are getting more impressive, and the stars provide market participants with the same prospects as meteors. But there is one important difference: these stocks don’t get overvalued. This gives them the opportunity to shine brightly and steadily for several years or even decades, like real stars in the sky. This is an important point because star stocks can consistently return 40% or more even after their popularity declines. When the attention of market participants shifts to other rising stars, such stocks continue to perform solidly, manifested in the growth of the company’s earnings and the price of its shares, which suggests that they were not overvalued.
If you have opened a position on a star stock, then you do not need to actively trade, but only manage your position. This will increase the overall return on investment and get a good risk / reward ratio.
In recent decades, the emergence of both new stars and meteors has been repeatedly observed in a wide variety of industries – the Internet, oil, real estate, gold and computers. During the internet boom of the late 1990s, Amazon.com emerged as the undisputed leader in internet commerce. The battle of search engines in the late 1990s was dominated by Yahoo, but today it is far behind in popularity among users of the current market leader and new star Google.
How to make money from this?
So how do you recognize which of the meteors will remain in the sky as a star? Honestly – nothing. But you can tilt the odds in your favor if you understand that there are always more meteors than stars. Therefore, one must try to recognize emerging leaders before Wall Street does. To do this, you can use the following filters:
– Stable annual profit growth of 25% or more over 5 years
– For three consecutive years, the annual profit has been growing
– The stock is trading at or near the absolute High price
– Less than 10% of the company’s shares are in the hands of institutions
– Do not open new positions on a stock that is 40% or more owned by institutions.
Early on, meteors and stars share common features, including the first two on this list. When a company’s profits start to rise, the major institutional market participants gain larger positions and the share price rises. The rise in price attracts the attention of even more institutional investors who are also starting to buy this share, which leads to a further rise in the price.
When a stock rallies, watch for the technical strength of the price movement and enter a position when the price breaks the absolute High. The key point is that both types of securities described begin to rise when less than 10% of the available shares are in the hands of institutions, before they become apparent to the main body of Wall Street. When a stock comes to the attention of Wall Street, the accumulation of positions by institutions begins to fuel the rise in the value of the stock. An individual market participant can gain an advantage by picking out low-ownership institutional stocks that show improved accountability and technical strength even before funds and institutions find them.
But if the meteor is to become a star, then over time, the stock will lose a significant proportion of the institutions sitting in it, but will continue to generate annual returns of 40% or higher and will not fall below that level.
Exercise caution when institutional ownership approaches 40% or more, because at this point, large institutions may begin to determine the movement of the stock. As a rule, most institutions look at the same criteria when deciding to sell shares, especially when the profit of the stock falls short of expected. If profit expectations are not met, a chain reaction can occur, leading to a sharp decline in price.
Enter a position when there is technical strength and the stock is at the absolute price high. But do not increase the position after the institutional share reaches 40%. At this point, it is better to sell part of the position, taking profit, and manage the rest with a trailing stop. You can also place a trailing stop on the entire position. Options represent a good risk management tool for such stocks. When the meteors stop generating high interest, shorting a Put option can protect against a fall in price and provide an opportunity for profit.
The described approach to stock selection requires deep analysis and subsequent adaptation. It helps to understand what fuels the price movement and why some stocks stay in the sky after they take off, while others fall to the ground. To take advantage of the power of this method, investors must recognize that not only the fundamentals are important, but also the technical ones. Likewise, traders should not only look at the price, but find among the fundamental information that which can lead to a strong movement and trend.
Cisco is a good example of a meteor company – steadily increasing profits and technical strength with new Highs. The problem was that in the late 90s, the Internet boom, which served as fuel for the rise in the share price, led to its significant overvaluation. After the market crash, the institutions withdrew from positions and the stock failed
Amazon is another example of a meteor. In the late 90s, the stock was greatly overvalued, then fell and gained technical strength for several years. After gaining profit, the stock broke the previous $ 115 High. After the institutionalists entered the game, the price increased by almost 600%.
Autozone is a chain of mechanical accessories stores. During the internet boom of the 90s, she was inactive and did not attract the attention of Wall Street. In June 2001, it showed its technical strength after the breakdown of $ 38. Since other popular stocks were already experiencing difficulties at this time, she was noticed and institutions began to recruit. The beginning of the movement of AZO is like a meteor, but thanks to a strong fundamental, it has passed into the category of stars. Today, the company is controlled by institutions, which hold almost 98% of the shares.
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