One of the most enjoyable aspects of trading is the hunt for new stock ideas.
It is extremely satisfying to discover a stock with great fundamentals and then watch as the technical conditions improve as others make the same discovery, which leads to an extended run. That is where outsized profits come from. If you make some good selections and use effective trade management, you can't help but produce exceptional returns.
Unfortunately, great stock picking only works some of the time. Even highly skilled stock pickers will endure periods when their efforts and hard work go unrewarded. Just because you have found a great stock does not mean that the market will also recognize it. How great a stock might be if the market never embraces it doesn't matter.
The first and most important step to being a great stock picker is to recognize when you are in the right environment. There are two basic types of markets. The first are those that are driven by the indexes and macroeconomic conditions, and the second are those that are driven by fundaments, valuations, and stock selection.
Bear markets tend to be index driven as macroeconomic events result in a focus on the big picture rather than the merits of individual stocks. Fundamentals don't matter much when the Nasdaq 100 (QQQ) is being sold, and breadth is running from zero gainers to 100 decliners, as it did earlier this week. There simply is no great advantage to picking stocks in these environments.
If you understand and appreciate how the overall market environment impacts the power of stock picking, then the key steps in developing a methodology that works are as follows.
1. Develop a Shopping/Watch List
I will cover this in far more depth in a future column, but there are a number of ways to develop a good shopping list. One method used in a bear market, as we have now, is focusing on stocks with relative strength. The theory is that the stocks that are holding up best in a bad market are the most likely to excel in a better market.
Another approach is to focus on fundamentals and try to find good values with the potential for strong growth once market conditions shift. The problem here is that you never know how accurate your fundamental research may be or whether the market will even recognize a good value at some point.
2. Watch for Price Action to Confirm Your Fundamentals
Once your watch list is developed, your primary job is tracking the stock as market conditions evolve. I will often take smaller positions in stocks that I favor as it forces me to keep an eye on them, and I become at least a little emotionally invested in the movement. The downside is that there can be lots of small losses that add up when market conditions are as bad as they are now.
The goal is to learn the personality of the stock and try to discern how evolving market conditions will impact the name. Is this a sector that the market will favor? Is there rotational action coming into play? Where is speculative money heading
3. Keep Vigilant and Patient
The most important aspect of stock picking is to stay vigilant and patient while you watch the price action. There is often a strong inclination to keep buying favored stocks as they go lower when we really need them to show strength as a signal that buyers are ready to start buying more.
If you are going to average into a stock, it must be down very slowly and patiently. The most common mistake is that investors pile into a stock too big and too fast, and when market conditions don't improve, they take sizable losses.
Watch what is happening to the stocks you favor, but fight the impulse to do something just to stay busy. Patience is the key to good timing.
4. When You Are Right, Get Paid
When a good stock pick starts to work, that is the time to press and leverage up. When market conditions shift, and you are in the correct stocks, those stocks are going to develop strong trends. That is where you make big money, but it is imperative that you also maintain very stout trade management. As George Soros has said: It isn't whether you are right or wrong about a stock. It is how much you lose when you are wrong and how much you make when you are right.
Stock picking is not working in the current market, but like everything in the market, it is cyclical. It will eventually regain its luster, and the profits will be sizable if you prepare for it.