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After you’ve populated your Watch List using the concepts outlined in the Generating Ideas section, your next step is to do an in-depth analysis. Your goal is to buy the very best stocks at the very best times.
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Fundamental Stock Analysis
Understand the Company
Your first task in analyzing a stock is to understand the company behind it. What are its main products or services? Who are its customers? What advantage does the company have over its competitors? The better you understand a company, the better you’ll be able to make sound investment decisions and stick through normal market corrections. Growth investors will want to pay particular attention to what is new about a company’s story. Large stock moves are almost always driven by a compelling new product or service, or by new management that brings new ideas, or by new industry conditions that affect an entire industry group in a positive way. In our study of the greatest stock market winners from 1995 through 2001, we found more than 95% met at least one of those criteria.
A good place to begin your search for this kind of information is the News section of the Related Information panel in MarketSmith. You’ll want to review the latest headlines offered in the panel by MarketWatch. If you subscribe to Investor’s Business Daily, you can access IBD articles on the stock being viewed through this panel as well. Pay particular attention to any IBD New America articles that have been written on that company. These articles offer a useful overview of a company’s operations.
A link to each company’s web site is provided at the top of every MarketSmith Chart. Check out that site to get a better grasp on what the company does. You can go to the company website’s Investor Relations section to get the firms’ latest SEC filings.
After consulting these materials, you should be able to summarize in a few sentences what the company does and why it has a compelling competitive position. There’s always a chance that a particular stock’s story is so complicated or its industry group so far beyond your understanding that you won’t be able to get your mind around what it does. If that proves true, then you may need to move on to another stock (don’t worry there are nearly 8,000 domestically traded stocks in the O’Neil Database).
You’ll next want to take a closer look at the fundamental data offered in the MarketSmith Data Boxes on the daily and week chart views. An overarching concept to keep in mind is that the biggest winners in the stock market tend to be the number one companies in their fields. Your goal is to identify the present-day leaders, the companies that have the best economics in their respective areas.
In our studies of the biggest winning stocks of all time, we identified a number of characteristics that were common to those companies before their stocks went on to tremendous gains for their shareholders. You’ll be able to identify each of these characteristics in the MarketSmith Data Boxes.
One of the first things you’ll want to focus on is the company’s earnings history. Growing earnings are the lifeblood of almost all major stock moves. Without increased earnings, there is little reason for a stock to advance in price. MarketSmith offers eight quarters and nine years of earnings history (including estimates for the next two fiscal years).
We identified three earnings-related parameters to use to analyze stocks:
- Earnings per share in the latest quarter should show a major percentage increase versus the same quarter a year ago. At least 18% or 20% and preferably much more.
- Earnings growth should be accelerating in recent quarters compared with earlier rates of change. This means that the rate of year-over-year earnings growth in recent quarters will exceed that of previous quarters. The acceleration doesn’t have to occur in the latest period. It could have started up to six or eight quarters ago.
- Annual earnings for the last three years should be increasing at a rate of 25% per year or even more. If you are looking at a younger company that recently had its IPO, you might accept the last five or six quarters being up a significant amount.
A time-saving way to evaluate the above earnings growth measures is by looking at the EPS rating available in MarketSmith. This rating averages a company’s most recent two quarters of EPS growth with its three-year to five-year annual growth rate and then compares its growth to all other publicly traded companies in the O’Neil Database. Stocks are rated on a 1 to 99 scale with 99 being the best. Growth investors should spend most of their time focusing on companies with an EPS Rating of 80 or higher.
In addition to earnings growth, you’ll want to see an accompanying increase in sales. A company can cut costs only so much to increase earnings. Big profit gains must eventually be accompanied by sales growth. Use the following sales-related parameter during your analysis:
- Sales should be up 25% or more in one or more recent quarters, or at least accelerating in their percentage change for the last three quarters.
Finally, you should analyze how efficient the company is at generating returns given the amount of capital it employs. Return on equity(ROE) measures how much net income (earnings) a company generates in relation to the amount of shareholder equity it has. The very best companies will generate consistently high ROEs. Keep the following parameter in mind:
- Return on equity should be 17% or higher.
To recap what key fundamentals to focus on in your research, here is what we covered:
- Earnings per share in the latest quarter up at least 18-20% versus the same quarter a year ago
- Earnings growth accelerating in recent quarters compared with earlier rates of change
- Annual earnings for the last three years should be increasing at a rate of at least 25% per year
- Sales up 25% or more in one or more recent quarters, or at least accelerating in their percentage change for the last three quarters
- Return on equity of 17% or higher
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Technical Stock Analysis
Once you’ve indentified the very best stocks on a fundamental basis, you’ll need to determine the optimal time to buy these stocks. This is the point when the stock stands the greatest chance of increasing in price soon and becoming a big winner. In our experience, the best way to identify best buy points is to use stock charts. MarketSmith offers detailed Daily, Weekly, Monthly and Intraday price-volume charts to aid you in this process.
- Cup with Handle
- Double Bottom
- Flat Base
- Ascending Base
Cup with Handle
This is the pattern our studies found the most often. This base resembles the silhouette of a cup when viewed from the side.
As with all price patterns, a cup with handle should be preceded by a strong prior uptrend of at least 30% price appreciation. A cup with handle should be at least seven weeks in length, starting with the first week closing down off the stock’s high. That’s the minimum. Many cup with handles take six months to a year to form, though three to six months is the most common. The correction from the top of the formation to the bottom varies from the 12% to 15% range to upwards of 33%. The pattern shouldn’t correct more than 2½ times the correction in the overall market averages.
The typical cup with handle pattern starts with the stock moving down five to seven weeks to form the left side of the cup. In most cases, the bottom part of the cup should be rounded, more in the fashion of a “U” than a “V.” This area of the pattern is important because it wears out the weak investors and establishes a foundation of strong holders who are less likely to sell during the coming advance. The pattern then moves up the right side, traveling more than halfway up the pattern, usually within 15 percent of the pattern’s old high price on the left side.
Next, the pattern starts drifting sideways in the handle portion. Volume in the lower part of the handle frequently declines to a low level. This means there’s not much more selling into the stock, a constructive sign.
The pivot or buy point of a cup with handle pattern occurs after the handle, which should have been drifting down along its price lows, has completed its decline and the stock starts to move back up, surpassing its earlier peak price in the handle area. We call this a breakout. On the day of a breakout, volume should spike at least 40-50% above normal. You can visually track this in MarketSmith by comparing the day’s volume to the 50-day moving average volume line.
It’s important to wait until the pivot point is reached to execute your purchase. Buy too early, and in many cases your stock will never get to its breakout point, leaving you with a stock that has stalled or may actually decrease. You want a stock to prove its strength to you. At the same time, if you buy more than 5% to 10% past the pivot, you are buying late, and you will likely get shaken out in a normal price correction or could suffer a sharp loss if the breakout fails.
This pattern is similar to the cup with handle, but is shallower and tends to stretch out over a longer period of time. A typical saucer pattern corrects 12% to 20% from peak to trough. While some saucers may last only seven weeks, often this pattern can take several months or even a year to form.
In most cases, you will see a handle with this pattern as well. If a handle forms, the pivot point for a saucer is the top of the handle. If a handle does not materialize, the pivot point is the top of the left side of the base.
This pattern looks like the letter W, but in almost all cases, the second leg down should undercut the low price of the first. This is constructive because it shakes out the weak holders that held on during the first leg down. Double bottoms may also have handles, although this is not essential.
As with a cup with handle, a double bottom needs at least seven weeks to form. The middle peak of the W should be lower than the high at beginning of the base, but above the midpoint of the base. Pay attention to the volume within this and all patterns. Constructive signs would include tight price ranges in light volume, weeks of high-volume support at the 50- and 200-day moving average lines, and price declines in the second part of the base on low volume.
A double bottom’s pivot is usually the same price at the middle peak in the W. This peak should definitely be below the old high peak price of the overall double-bottom pattern. Look for a volume surge of 50% or more above average on the day of the breakout. In some cases, a double bottom will form a handle before reaching the middle peak in the W. In those situations, the pivot point is when the stock clears the highest price point in the handle.
This pattern basically goes sideways, not correcting more than 10 to 15 percent. This base doesn’t take as long to form, with five or six weeks as a minimum. Flat bases usually form as second-stage base after a stock has advanced and retained most of the 20 to 25 percent or more move from its initial base. If you missed the initial breakout, a flat base can give you another entry point into a stock.
The pivot point for a flat base is the same as that for other bases and usually occurs when the stock reaches the high point of the consolidation. You can sometimes find an earlier pivot point for a flat base and for the handles on other bases by drawing a down trendline across peak points in the stock’s flat base or handle. The buy point is then when the stock crosses above the trendline.
This is another pattern that usually occurs after a stock has broken out of an initial base and runs up partway through its overall advance. It’s generally 9 to 16 weeks in duration, with three 10 to 20 percent pullbacks in price. Each pullback has a higher low and each rally has a higher high. Short-term general market sell-offs are usually the cause of these three price pullbacks.
After the stock completes its third pullback , the stock will begin to rebound. The pivot point for the ascending base is where the stock clears the high point of the third rally.
You can learn more about these concepts along with a few other less common base patterns in William J. O’Neil’s books How to Make Money in Stocks and The Successful Investor. You may also want to take a look at the investment education resources of Investors.com.
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You’ve found a stock with a great looking chart. It has a fantastic record of earnings and sales growth. It has an innovative new product. The market is in an uptrend. Ready to buy? Wait! Do you know who owns your stock?
It’s estimated that institutions (mutual funds, pension funds, banks, etc) represent 70% of trading activity in the market. If a stock is going to make a big move, it’s going to need institutional sponsors.
Make a Sponsorship Check Part of Your Process
When you’re examining a potential stock to buy, get in the habit of always checking the institutional sponsorship. Look for a trend in the number of funds owning a stock, available in both the MarketSmith weekly chart’s Data Box and in the Ownership Menu of the Related Information panel. Favor stocks with increasing sponsorship over the last several quarters.
You’ll also want to see a minimum number of institutional sponsors. Ten might be a reasonable minimum.
Don’t stop your sponsorship research there. Beyond a minimum number of sponsors with the level of ownership increasing, know who those sponsors are. The best mutual fund managers have a consistent record of beating the market. Many have large research staffs that get to know a company and its management inside and out. If you see that one of these top funds has taken a position in a stock you’re researching, it could be a sign that you’re on to a good potential investment. Please see the Sponsorship Rating section below for a discussion on how to develop a list of top quality mutual funds.
Institutional sponsorship is also important because it can take a portfolio manger several quarters to build a position in a stock due to the large positions funds need to take. Thus, a new position by a fund can represent future demand for the stock’s shares by that same fund. Funds that hold their positions for longer periods may also be less likely to sell positions they are just starting to build. Pay close attention to times when you spot a fund taking a new position in a stock.
It can also be useful to know what type of managers own your stock. Are there a lot of aggressive growth managers that buy on strength and may push a breakout stock to new heights? In addition, do the same managers tend to sell on technical weakness? If so, you should be conscious that this could cause more volatility in the name. On the other hand, if a stock has a lot of value style managers, they may be inclined to start unloading their positions as a stock reaches new high territory. This kind of knowledge helps you keep future price moves in context.
To determine the style of a mutual fund, you’ll want to first check out the Objective and Investment Policy Statement available in the Profile tab of the Related Information Panel for mutual fund charts. Another helpful way to determine the style of a mutual fund management team is to simply look at their holdings. Do they own a lot of stocks with fast growing earnings at or near new price highs? Then they probably lean toward aggressive growth. Do they own beaten down stocks with low P/E ratios? Then they probably lean toward deep value.
Another tool for analyzing the institutional sponsorship of the stock you’re researching is the Sponsorship Rating, which appears in the Data Box on a MarketSmith Weekly Chart. This rating averages the three-year performance of all the mutual funds owning a stock. The rating scale ranges from “A” to “E.” A high sponsorship rating indicates that a number of better performing mutual funds own the stock, a positive sign.
It’s important, however, to keep recent market activity in mind when analyzing a stock’s Sponsorship Rating. For example, if you are researching stocks to buy in the early stages of a bull market, the preceding period may have been one when a lot of more aggressive growth mutual funds struggled. As a result, those funds will have poor three-year performance ratings, and growth stocks will then likely have poor Sponsorship Ratings. Or perhaps the preceding period had been one during which strong relative strength stocks dominated and a lot of value funds struggled. Again, those funds will likely have poor three-year performance ratings, and value stocks will then likely have poor Sponsorship Ratings. Keep the market context in mind when using Sponsorship Rating as the measure of the quality of a stock’s institutional backers.
While some sponsorship is a good thing for a potential investment, it is possible for a stock to have too much sponsorship. We call stocks like this “overowned.” The problem with these stocks is that if something goes wrong at the company or a bear market begins, several large institutional sellers may run for the exit at once, crushing the stock. For example, Janus Funds alone owned more than 250 million shares of Nokia and 100 million shares of American Online in 2000 and 2001, which contributed to heavy selling pressure when these positions were unwound. By the time a stock becomes obvious to everyone, it’s probably too late to own. In the Data Box located on the weekly chart, you can see what percent of a stock’s shares are held by institutions. You can also see the raw number of funds in a name. Be cautious of stocks that seem to be owned by everyone.
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Common Stock Analysis Mistakes
Investing in Companies You Don’t Understand
Evaluating charts and fundamental data is an important part of your analysis process, but if you take the time to get to know the companies you are considering for investment you’ll be better equipped to interpret the information. If you know the ins and outs of a company, you’ll be better able to ride through a normal correction in a stock without getting shaken out. At the same time, you’ll be more likely to spot when a company’s period of rapid growth may be nearing an end.
Forgetting About Sales
Earnings growth is the lifeblood of almost all major stock advances. Without increasing profits, there is little reason for most stocks to go higher. As a result, it’s important to look for sales growth to accompany that earnings growth. Companies can only grow earnings by cost-cutting so much. Eventually, to keep expanding earnings, the company must also expand sales.
Looking for Bases without a Prior Uptrend
All bases should be preceded by a strong prior uptrend of 30% or more. This uptrend should be accompanied by improving relative strength and a very substantial increase in volume at some points. This action confirms that the stock has a lot of demand behind it. The subsequent base is usually caused by a general market action, which causes the stock to correct before moving higher.
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