Technical Difficulties

A couple days ago I wrote about how the Pitbull Investor system I purchased in the early Nineties led me to the book 'How to Make Money in Stocks,' by William J. O'Neil. I want to cover that some more today and reflect on how I viewed the content the first time I read it.

I think my investing methodology early on was not unlike most folks - I felt I needed to find an 'under-valued' stock, buy it 'cheap' and wait for the fireworks. O'Neil's book, 'How to Make Money in Stocks,' flies in the face of this so-called 'convential wisdom.' It outlines a method called 'CAN SLIM' - I described it in my post two days ago - which is an acronym for some basic investing principles. The method goes beyond what fits neatly in the acronym, nonetheless it works well as a simple name for the system.

The method was developed from a study of winning stocks from the past, and much of it made obvious sense - demanding stocks have outstanding earnings, for instance. All things being equal, earnings (present or future) are what drives a stock's price higher. It stands to reason that bigger earnings growth would drive bigger price appreciation.

Another one of the key tenets of CAN SLIM is technical stock action, particularly buying at the right time. This is usually at or near a new 52 week price high, something that seems counter-intuitive to many investors who feel you need to buy low and sell high. When you think about it logically though, how does a stock that's traded at a high of $50 double? Making new price highs all the way up - that's how. Stocks making new highs tend to go higher, and those making new lows tend to go lower.

The CAN SLIM method teaches an investor to find a stock that is not only fundamentally superior to most others, but also has strong institutional sponsorship. Missing either of these traits (and of course there are more than just these two) would make it very difficult for a stock to perform well.

I was quickly on board with the fundamental philosophy that How to Make Money in Stocks outlined, and was anxious to begin trying to apply this method. The problem was I couldn't understand how to determine market direction or read a stock chart. Direction of the overall market is the single most important factor in trading stocks, and one has to be able to read a stock's chart to know if it's formed a healthy correction and is near a buy point.

I read the chapter on market direction and paged through the section on stock charts over and over and I just couldn't understand the terms or see the patterns in the charts. I didn't understand a 'distribution day,' nor what the first day of a rally attempt meant, nor numerous other terms that were used. It was like a foreign language to me.

As much as I liked the CAN SLIM approach, I eventually decided that I could not learn the technical side and therefore I could not apply it to good use. I think this was around 1997, so for 10 years I resigned myself that mutual funds were the best option for me. Every once in awhile I would get the Pitbull Investor back out and take another crack at paper trading it, but I couldn't produce any positive results, so I'd give up again stick with the mutual funds. This was hard to do because it was a dream of mine to make a living investing, but I just decided I wasn't capable.

I guess I never really surrendered though, because here I am 10 years later, committed to becoming a full time speculator.

-Geoff

New Buy:(SOHU)

It was my intention to spend a couple of weeks (boring you to death) covering my journey from roulette-style penny stock trading to the method I follow today. I had not a single stock on my radar so that seemed like a good possibility. However, things lined up in such a way that I made a new buy today, so I'm going to go into my thought process a bit and talk about my purchase of (SOHU).

I'm torn about how deeply I want to describe the CAN SLIM method here. On the one hand, understanding the system is pivotal to understanding my thought process when considering a stock. On the other hand, there is a book written about it - How to Make Money in Stocks, a website dedicated to it - http://www.investors.com/, and a paper that helps investors with it - Investor's Business Daily. I could hardly cover it fairly in a few blog entries. I think instead I'll cover the basics and let my future posts get into more specific detail as the topics call for it.

CAN SLIM is an acronym. It stands for:
Current Earnings per Share (EPS)
Annual EPS
New - as in New Product, New CEO, New 52 week high in price - some catalyst
Supply and Demand - this honestly is less meaningful now, there is so much money in the market that a stock of almost any size can move well
Leadership - Leading stock in a leading group
Institutional Sponsorship - is the big money supporting the stock?
Market Direction - the most important of all factors

For more on CAN SLIM straight from the fine folks at Investor's Business Daily:

http://www.investors.com/learn/c.asp

I've read some books by folks who paved the way before William J. O'Neil brought us the CAN SLIM system: Jesse Livermore, Gerald Loeb, and Nicolas Darvas so far. William O'Neil took most of the best ideas from these traders and others (Jack Dreyfus, for instance) and put it all together along with probably the most comprehensive market data you can find. IBD includes invaluable proprietary rankings which compare a stock with all other stocks in the market on a variety of factors. O'Neil also did an exhaustive study of past winners and detailed their characteristics to design the fundamental and technical criteria of the CAN SLIM method. It's comprehensive, logical, and based on history rather than opinion.

I plan to cover my growth in trading with this system in the future, so I hope I've covered it enough now and haven't thoroughly confused you. Now, on to today's buy.

For some time now my stock screens have been coming up daily with the same cast of characters - lot's of well extended (beyond a valid buy point) Oil and Gas stocks. I missed the run on these, and don't intend to chase (buy once extended) them. I've instead devoted my time to reading, research, and recently this blog. I've checked my screens daily just in case, but nothing new has come along.

However, last week something caught my eye. Investors.com has a screen running all day called 'Stocks on the Move' which shows high quality stocks that are up that day on big volume. Last week I kept seeing Internet content stocks making this list: (JRJC), (BIDU), (PWRD), (SINA), (GA), and (SOHU). (JRJC) made a HUGE run last September from $15 to $47 in a couple of weeks, so I recognized it, and of course I knew (BIDU). I'd also heard of (SINA).

I went to my Daily Graphs Online (a premium chart and data tool offered by http://www.investors.com/) and pulled up one of the stocks in the group and noticed that (SOHU) had the best Relative Strength rating. A quick glance at the other stocks in the group convinced me that (SOHU) was the leader and therefore the one to focus my study on.

(SOHU) had one glaring defect - it's Industry Group was an abysmal 158 out of 197. This is a group, Internet-Content, that 7 months ago was in the top 20. One of the major changes I made going into 2008 was to limit my focus to stocks in the top 20 industry groups - Jesse Livermore called this 'top down investing.' Find the leading stocks in the leading groups during a healthy market uptrend and you can't go too wrong.

So why was I still looking at (SOHU)? It's a fine question, and I guess the answer is because every other characteristic of this stock was damn near perfect. Earnings growth has been accelerating for 2 quarters from -9% to 36% to 105%. Sales growth has been accelerating for 3 quarters from 9% to 14% to 46% to 90%. Additionally, (SOHU) was forecast to continue accelerating when they released this morning.

(SOHU)'s ROE is 23%, cash flow is $1.50 compared to $1.12 eps last year, no debt, and earnings were forecast to grow 62% in 2008 and 22% in 2009.

Still, studies show that a stock's Industry Group accounts for 40% of it's price movement - so how could I consider a stock in such a weak group?

Again, I took a further look at it. I found there are 36 stocks in the group, and about 10 of them are Chinese. Of the top 10 stocks in the group, 6 are Chinese. I concluded that the group rating is not truly representative of the Chinese stocks in the group, especially when considering the recent action of the Chinese Internet-Content stocks.

I knew (SOHU) was releasing earnings before the open this morning, so I decided to let their earnings be my guide. They knocked the cover off the ball, beating estimates by 70% and continuing their earnings and sales growth acceleration with 256% and 156% respectively. They also increased their Q2 guidance. I decided I would make a buy.

Having looked over the chart I found a deep cup pattern from 12/7/2007 to present with a buy point of 64.93, 10 cents above the high on the left side of the cup. The stock gapped open around $69.60, well above the buy point - but with a gap up open you can buy as high as 10% past the buy point (normally you would not buy a stock more than 5% past the buy point).

I did not buy immediately, though. My trading experience has convinced me that more often than not it's better to sit out the first 15 minutes after the market opens. These first 15 minutes tend to be very volatile and I usually get a better fill (or end up avoiding a stock) if I let them pass and wait for the trading to settle down a bit. In the case of (SOHU) I missed the lows for the day in the $66's but got in at $68.12 - a couple percent lower than the price at the open.

Once the stock got up above 70 and was holding there, I moved my stop loss just below my buy point. If it had sold off after holding up so well I just wanted to get out. It did not sell off though, in fact the stock traded almost 12 million shares, over 10 times it's normal volume, and closed at $70.81 - up 14% and near the highs of the day. It was a picture-perfect breakout, and I'm always happy when I'm up a few percent on the day I purchase a stock. I will probably now adjust my stop to 10 cents below the buy point, giving it some room to correct but not drop below the buy point.

Of course I still have a concern over the group's relative strength. Only time will tell if I was right to take a chance on this stock or if I was 'pressing' and have once again burned myself not being patient enough.

-Geoff

A Step in the Right Direction

I've covered my foray into penny stocks and 'story' stocks, and suffice it to say that they resulted in the loss of all my capital - I think around $10,000. I didn't know what to do at this point, but I was adding to the list of what not to do.

I can't remember where, but I stumbled across an ad for an investing system called 'The Pitbull Investor.' Although it sounds pretty silly, several features in the ad caught my eye. First of all, they promised my money back if I wasn't satisfied. Of course they could've been lying, but if not I always appreciate a money back guarantee. Secondly, the system was mechanical. That's what I was looking for. I wanted something that took the guesswork out and told me what to buy. Finally, it was based on sound fundamentals. It would filter through the best stocks in the market and then show me which one to buy. The system cost $50, a sum I was willing to lose if this was a hoax - so I put in an order.

It was not a hoax, and in fact it was another step toward the method that I use today. I say another because I believe even my first bonehead failures were a useful part of my trading education. Some folks get everything right the first time, I need to break a few eggs to make an omelet.

The Pitbull Investor arrived - it was a home-made looking, cheaply bound 30 page manuscript. It was however well written and, in my opinion, delivered on it's promise enough to warrant the price. I don't believe that this or any other 100% mechanical system can really work. What makes investing such a fantastic challenge is that it's as much art as science.

To summarize, the Pitbull Investor takes the CAN SLIM method from How To Make Money in Stocks, by William J. O'Neil, and distills it into a mechanical process whereby one scans Investor's Business Daily once a week applying a set of criteria to produce a list of buy candidates. Investor's Business Daily, or IBD, was founded by William J. O'Neil and offers CAN SLIM (and all other) investors an excellent resource. It includes proprietary rating information such as an EPS (Earnings Per Share) and RS (Relative Strength) rating that compare each stock to all other stocks in the market.

So the Pitbull system has the investor look through the paper once a week for a stock making a new 52 week high, having an RS rating of 'x' or better, EPS rating of 'x' or better, average daily volume 'x' or higher, etc... This system really does produce a decent prospecting list, and in fact I use it as one of my screens now and it's produced a potential big winner in SOL for me a couple of weeks ago.

The problem for me at the time was, I still didn't find it to be truly mechanical. For one thing, you still have to know the overall market direction - the system wouldn't tell me that, at least not explicitly. You could gauge the health of the market to some degree by the length of the list of stocks that met all the criteria each week. If the list was short for a number of weeks in a row, chances are the overall market was struggling.

Nonetheless, even if the market was healthy, I couldn't seem to produce consistently positive results. I paper traded the system for some time, but the percentage of stocks that made it through the criteria and stopped out for a loss was still too high. There were some big winners too - but I could find no means to determine which of the stocks selected in the system would succeed, and which would fail.

I communicated with the author and he suggested that the final piece in the puzzle was chart reading - more commonly known as 'technicals.' He recommended that I pick up the source material, 'How To Make Money in Stocks,' and pay particular attention to the section on chart reading. I did, and couldn't make anything of it.

I read and re-read the section on charts, and I'd stair at the charts in my broker's office, and I just couldn't make any sense of them. I couldn't see patterns as they were forming, I couldn't understand what the book was telling me.

At this point, I became frustrated with the whole thing and resigned myself to mutual funds. I became convinced that I could not produce any better returns than the 10% or so that I could expect to get from the funds that mirror the S&P 500 index. So that's where my money went for just about the next 10 years.

-Geoff

More Ancient History:Story Stocks

So now that I knew the difference between the bid and the ask (and in all fairness, I did take some time and read some more about the market) I headed once more into the fray confident that I was well prepared.

I'm afraid I can't remember exactly how I found my way to them, but I started reading stock message boards. I guess I believed them, because somehow I found my way to a Canadian gold mining company. No, I'm not kidding - I actually invested in a Canadian gold mining company. This really may have been the low point.

I don't remember the name of the company, but I remember I was on the phone with the Investor Relations (read:promoter) guy several times a week. I would ask him about 'assay results' - to this day I can't tell you what the hell an 'assay' is - and he would tell me everything was looking great. He'd tell me that they were organizing a 'short squeeze' and I should try to buy some more. I'd tell him I was already fully invested, which was true.

For those of you not familiar with the term 'short squeeze' - it refers to a level of buying that drives a stock's price up forcing those short (sold the stock without owning it) a stock to cover(buy the stock), creating more buying interest which forces more shorts to cover... It is a legitimate phenomenon, but was nothing more than a story to get a rube (me) to invest more money in this company in my case.

I remember watching the price of gold believing if it would move up the price of my stock would go with it. I don't remember if gold went up or not, but the price of my stock went down and eventually I sold for a substantial loss.

I went back to the forums and found a stock called Ecogen - the ticker symbol was ECGN. The company bio-engineered produce to be resistant to insects and disease. This sounded like a no-brainer to me, and I bought it.

I remember that some positive things seemed to happen for the company, parterships with Monsanto and the like, yet the stock price never improved. I don't remember how long I held it, but I believe I sold for a loss.

I don't know why early on I thought that message boards and forums were good prospecting ground for stocks. I don't know why I believed what someone I'd never met had written. Unfortunately, I don't think I'm uncommon in this mistake.

Even more common I believe is the desire to find a stock with a good 'story.' It's easier to understand why investors head down this road - it seems intuitive. Find a good story, check the fundamentals, maybe apply a value to the stock, and then buy if it's undervalued. I think this even works for some folks, but it didn't work for me.

Another pitfall many investors fall into is the 'mechanical trading system.' A little cold logic would lead one to realize that if any such system worked, everyone would use it, and then it would stop working. However, I did find such a system and though I never made use of it explicitly it did lead me to the methodology that I use today. I'll talk more about that in my next post.

-Geoff

A Little Ancient History:Penny Stocks

I guess the only way to have a true picture of the present is to understand the past. Man, that sounds self-indulgent. Still, before I get to where I am, I want to talk about where I've been.

In 1992, I was attending college in North Carolina and had every intention of becoming a film-maker. My major was 'Film Production' or something like that - I have no idea why my parents were footing the bill for such nonsense. Problem was, I showed up to my French class - a foreign language was required for any liberal arts degree - and my Professor was speaking only French. I don't know what these other kids learned in High School, but if I already knew French I wouldn't need the damn course. After a week I realized there was no way I could graduate if I had to pass a foreign language course.

I was dating a girl who was after a BS in Finance and she told me the business school didn't require a foreign language. The next day my major was switched to Finance, Insurance, and Real Estate. So, for all the wrong reasons, I stumbled upon the only vocation I've ever loved - investing.

My parents are successful but pretty conservative with their money and I don't think I ever heard much about the stock market. If I did, it never really sunk in. That year in college was the first time I really became aware of the market and the potential it offered (I was aware of the potential gains, not so much the potential losses). For me the whole idea of it was just miraculous - it seemed like money for nothing. And that's true and it's not.

Of course one's success in trading stocks, like any other endeavor, will over time stay pretty parallel with the time and effort committed to it. However, work isn't really work if you love it. That's how I feel about investing - but more on that in a future installment.

So I got into the business school like a duck in water and cruised through the economics and finance courses. Sometime around 1994 I told my parents I wanted to pay my own way through school and applied for some student loans to help me do that. I was working full time, making decent money waiting tables, and the student loan money ended up being more than I needed with my income. That's when I got the idea that if I put that money in the market, I could make a return on it, pay off my loans and have the rest left over for me. I'm pretty darn sure that's against the rules, but I figured there is no way to tell which money I used for investing - the loans or the money I earned. Regardless the right or wrong of it - that's what I did.

So in 1994 the overall market is going nuts and basically a monkey can double his or her money each year. I open an account at LaSalle St. Securities (man, did I feel like a big shot), have CNBC on the tv every waking moment, and start digging through the paper for my big gainer.

I came across a company called Great American Recreation in New Jersey - the symbol was GRAR. I noticed in the paper that it regularly traded with a low of 5/32 and a high of 7/32 (yes kids, we used to use fractions). This was just as simple as could be - I'd buy at 5/32 and sell at 7/32 and each time I did that I made a 6% return. The worst thing was it worked once or twice. I'd buy at 5/32 and put in my limit at 7/32 and then sit and watch the ticker on CNBC to see if my trade came through.

Then came the day when it traded at a high of 7/32 and my order didn't execute. I called the broker and furiously demanded to know what the hell they were doing up there. I can't even imagine the laugh they must've had as the broker is explaining to the rube on the phone (me) the concept of the bid and the ask spread. I was trading stocks and didn't even understand the basic premise of it.

I think I ended up getting out of that position at 3/32 with less money and a bruised ego. However, now I knew how things worked, and I was ready to head back in and make my fortune...

-Geoff

Welcome, and I hope you find some value here

Ok, why in the hell would I want to create a blog about my experiences investing? Because everybody has a blog and I want one too? Well, sure, but it's more than that.

For one thing, my first year of investing has taught me that a year ago I didn't know squat. I'm getting old enough to know that a year from now I'll also realize I didn't know squat today. The great traders that I've read about had in common the discipline to frequently evaluate their mistakes, and that was invaluable to their success and constant improvement.

I think it's too easy to 'forget' about a bad trade - to mentally write it off for one reason or another. It's too easy for me to let myself off on my bad decisions. That's why I want to document my trading activity AND state of mind AND rationale here so there is no way for me to revise history. Three weeks after a purchase if a trade blows up I want to come back here and see why I purchased that stock and what I can learn from the experience.

I think it also will add to my discipline in advance of a trade if I know I have to come here and post about it. I won't be as likely to take some bonehead risk knowing that I have to post about it here and face derisive heckling.

Finally, I'm now communicating with about a half dozen folks about my trading activity, and honestly it's easier to post what I'm doing here and let you folks subscribe (if you're interested) to receive updates via email than to send it out to each of you.

So, if you're interested in my current portfolio, my watchlist, my thoughts on the market, what I've read (and what I've enjoyed that I read) on investing, or other investing related topics please bookmark this page or use the subscription box to the right to receive updates via email.

Thanks and may we all get wealthy!

-Geoff