Fundamental Analysis and Position Trading

Evolution of a Trader

Thomas N. Bulkowski

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9781118464205
• eBook ISBN: 9781118508756
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Comprehensive coverage of the four major trading styles

Evolution of a Trader explores the four trading styles that people use when learning to trade or invest in the stock market. Often, beginners enter the stock market by:

• Buying and holding onto a stock (value investing). That works well until the trend ends or a bear market begins. Then they try
• Position trading. This is the same as buy-and-hold, except the technique sells positions before a significant trend change occurs.
• Swing trading follows when traders increase their frequency of trading, trying to catch the short-term up and down swings. Finally, people try
• Day trading by completing their trades in a single day.

This series provides comprehensive coverage of the four trading styles by offering numerous tips, sharing discoveries, and discussing specific trading setups to help you become a successful trader or investor as you journey through each style.

Trading Basics takes an in-depth look at money management, stops, support and resistance, and offers dozens of tips every trader should know.

Fundamental Analysis and Position Trading discusses when to sell a buy-and-hold position, uncovers which fundamentals work best, and uses them to find stocks that become 10-baggers—stocks that climb by 10 times their original value.

Swing and Day Trading reveals methods to time the market swings, including specific trading setups, but it covers the basics as well, such as setting up a home trading office and how much money you can make day trading.

CHAPTER 1

Introduction to Buy-and-Hold

I started dabbling in the markets by researching companies using their annual reports. I pored over the numbers and checked the ratios to make sure the company would not fold anytime soon.

In those days, I learned to love cash dividends and stock dividends as well. They added to the bulge in my wallet and slowly increased my net worth one share at a time. During the bull market of the 1980s, I had a win/loss ratio of 63 percent and made an average of 39 percent per trade. I achieved that without knowing what I was doing.

For example, I bought a stock called Sparton Corp. This was a wonderful stock that never heard of going up while I owned it, but it paid a huge dividend. That is, until they stopped paying it! I bought it three times and lost 23 percent, 39 percent, and 53 percent of my money.

I grew to mistrust the method of holding a stock forever (well, 3.6 years was my average hold time for stocks bought in the 1980s). I was tired of seeing a stock like ASA Holdings (acquired by Delta), which I bought four times in the late 1990s at an average price of 23.36, more than double to 51 and then drop to 34 before I sold it.

Nevertheless, I still like investing, which is a synonym for buy-and-hold. You can make a lot of money with little work. The hardest part is ignoring the daily rollercoaster movements of the market.

As I mentioned in Trading Basics, Chapter 2, under “Hold Time: My Trades,” my best hold time is between three and four years. Research a company, buy the stock, and then hold it until it realizes its full potential. Then sell it.

WHAT IS BUY-AND-HOLD?

You probably know what buy-and-hold means, but let me tell you how I define it. If I buy a stock with the intention of holding it for years, then that is a buy-and-hold position. I expect bumps along the way, such as a quarter or two of weak earnings, but I am focusing on their long-term potential for growth.

Despite the name, I do not interpret it as buy-and-hold forever. Buy-and-wait is a better description. My guess is that I will never hold a stock as long as I did Michaels Stores. Some of those shares I bought in 1990 and sold in 2006 when the company went private. Now, my inner voice—call it the voice of experience—sees that I have doubled my money and will want to capture profits before a dead-cat bounce pattern takes away 70 percent of it in one session.

Often that voice speaks only after the stock has given back too much from a peak, such as in the case of Interface (IFSIA), where I sold 25 percent below the high, or Steelcase, down 26 percent. In fact, I thought we were sliding into a bear market in July 2010 and sold over half of my portfolio in a flight to cash.

I was wrong.

The market bottomed and then went on to new highs. I am more sensitive to price fluctuations because of the recent 2007 to 2009 bear market, especially when I have good gains.

I began concentrating on buy-and-hold positions because I found it more difficult to make money by short-term trading. That was in 2007, just months before the bear market started. Big mistake. Fortunately, it took only nine months after the bear market ended to recover my losses.

That brings up an important question: Who should buy and hold?

WHO SHOULD BUY AND HOLD?

Trading Basics, Chapter 2, “A Better Way? Portfolio Composition,” discusses my thinking about diversification. Build a core portfolio of stocks from the buy-and-hold category and pepper it with other trading styles that fit your needs, such as swing trades or position trades. Diversify your holdings not only by industry, but trading style as well. That way, when the market favors swing trading over other styles, you will have positions ready to take the lead to greater wealth.

This guidance applies to day traders, too. I have heard that day traders tend to burn out after several years of trading (four years comes to mind, but I do not know if that is true). The constant pressure to perform each day coupled with lack of exercise and inability to relieve stress tends to fry the adrenal system. Having buy-and-hold positions available in which to place excess cash will create a cushion if the pressures of day trading become too much to bear. Swing and position trading can give the day trader a more relaxed ride in which to recover while still having the emotional feel of being in the game.

Regardless of your trading style, consider adding to your portfolio positions held for the long term. These are not buy-and-forget positions, but they need not require constant attention, either. Think long-term growth.

MY NUMBERS: BACKGROUND AND TERMS

In the pages that follow, I use almost a thousand stocks covering the period from 1992 to 2007. Not all stocks covered the entire period and dividends were not included unless noted otherwise. The test period includes the 2000 to 2002 bear market.

I refer to year 0 through year 5. Year 0 refers to the first year in which fundamental data and prices for a particular stock were available. It serves as the base year in which other years are compared. Year 5 is the last year. Year 0 through year 5 use the closing price at year's end.

Since I use 16 years worth of data but present only a five-year-wide window, the analysis uses data like a moving average. I use the fundamental number from the new year and drop off the old year. Year 1 becomes year 0, year 2 becomes year 1, and so on in a series of overlapping years as the five-year window slides from 1992 to 2007.

In this manner, each year 0 has the opportunity to see how price behaves during the next five years.

I am sure that none of this makes much sense and you may be asking, “Who cares?” but that is fine. When I start discussing tests, it will become clear and you will understand my thinking.

NOW WHAT?

If technical analysis tells you what will happen in the short term, fundamental analysis tells you what to expect in the long term. Both are useful tools for making money, but a brief review of important fundamentals will help when selecting companies to buy and hold. Those chapters follow.

Even if you are a day trader, some of the discoveries discussed in the coming chapters are worth learning. They may help you select stocks to trade. They may spark a new avenue of investigation that may well send you on a path to greater riches.

CHAPTER 2

Stock Selection

This chapter is about selecting stocks for investors using methods that have proved helpful. Other tips follow in the coming chapters, so you can create selections that are ideal for your situation.

When I created my website (http://thepatternsite.com) in late 2006, I started receiving emails from people asking how I selected stocks in which to trade or invest. I thought back to the 1980s in the public library when I hunted for stocks in Value Line to populate my watch list. I took my picks home and then typed the quote information into my computer each day from the Wall Street Journal. That was easy enough to do until the list grew to 500 stocks, but it usually took less than an hour to update my database manually.

Some old timers will claim that you get a better feel for the stock if you manually type in the quote information. My reply to that is hogwash. With 500 stocks, there is no way I can keep them separate in my mind. I am not that smart.

Anyway, here are the Value Line criteria I used, and they still apply today.

• The stock needs a heartbeat. That means in two of the past five years, the yearly high must be at least twice the yearly low.
• If the stock was too expensive, I threw it out. The preferred price range is $10 to $20. In fact, a study I conducted (see http://thepatternsite.com/prices.html) shows that chart patterns in stocks priced from $0 to $10 outperformed the other ranges, but I did not know it back then.
• The stock must have a price-to-earnings ratio, meaning I tossed any stock with NMF (not meaningful) showing in the P/E box.
• I selected stocks with high three- to five-year price appreciation potential. Triple-digit percentages are tasty, but unrealistic. I relied on it anyway.
• I selected at least five stocks per industry, so I had to relax my requirements to admit some of them. Having many stocks from one industry gives me a better feel for how they are doing as a group.
• I checked the list of insider buying and selling. I wanted to see many insiders buying and few selling. I will discuss this later in the chapter.
• Fundamental factors included a low P/E ratio, climbing sales, positive earnings for the past several years, low debt, and so on. The chapters in this volume will tell you what works best.

WHAT COMES AFTER LARGE PRICE MOVES?

In the first bullet item in the list—the yearly high price must be twice the year low—I interpreted that as price doubling, but it could have been cut in half, too.

I decided to do some research to see if price doubling or cut in half led to better performance the following year. I used 567 stocks from 1990 to 2008 in the test. Not all stocks covered the entire range. For each stock and each year during the test period, I found the yearly low, the yearly high, and the close-to-close move the following year. I sorted the results into two buckets (stocks more than doubling versus not doubling) by years, giving 19 annual performance contests.

The median rise a year after a stock doubled beat the median rise of those not doubling 53 percent of the time. Yawn. Summing the median gains or losses of those 19 contests gives gains of 385 percent versus 165 percent for year-ahead performance of stocks doubling (or better) versus not doubling, respectively. Substituting the average gain instead of the median gives 916 percent versus 273 percent, respectively. In other words, stocks that do well continue doing well.

• Stocks that double substantially outperform the following year 53 percent of the time.

Here is the exciting news. Stocks that drop by 50 percent or more tend to zip higher the following year. They win 13 of 19 performance contests, or 68 percent of the time. The cumulative median rise of those 19 annual contests is 253 percent for those stocks dropping in half (or more) compared to next year gains of 152 percent for those n...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Preface
• Acknowledgments
• Chapter 1: Introduction to Buy-and-Hold
• Chapter 2: Stock Selection
• Chapter 3: Book Value
• Chapter 4: Capital Spending
• Chapter 5: Cash Flow
• Chapter 6: Dividends
• Chapter 7: Long-Term Debt
• Chapter 8: Price-to-Earnings Ratio
• Chapter 9: Price-to-Sales Ratio
• Chapter 10: Return on Shareholders' Equity
• Chapter 11: Shares Outstanding
• Chapter 12: Fundamental Analysis Summary
• Chapter 13: How to Double Your Money
• Chapter 14: Finding 10-Baggers
• Chapter 15: Trading 10-Baggers
• Chapter 16: Selling Buy and Hold
• Chapter 17: Fundamentals: What I Use
• Chapter 18: Introduction to Position Trading
• Chapter 19: Getting Started in Position Trading
• Chapter 20: Ten Factors Make Chart Patterns Work
• Chapter 21: Three Winning Trades and a Funeral
• Chapter 22: What Not to Do: Three Botched Trades
• Chapter 23: What We Learned
• Visual Appendix of Chart Patterns
• Bibliography
• About the Author
• Index