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Lessons On Buying Stocks

lessons on buying stocks
How To Select The Right Stocks At The Right Time
The seven lessons in this course explain the characteristics of successful stocks and the forces that push them up. The first seven lessons explain specific traits to look for when buying stocks.

Earnings: The Indispensable Element Of Great Stocks

Earnings: The Indispensable Element Of Great Stocks

Research shows that earnings growth is the single most important indicator of a stock's potential to make a big price move. In this lesson, you'll learn how to find the companies with the best earnings growth and avoid some pitfalls that trick many investors.

Why Earnings Growth Is So Crucial

How many times have you kicked yourself for passing up a great stock like financial technologies or pantaloon retail? There were tell-tale signs that these winners were about to make major moves before they became household names.

A study of the greatest stock market winners dating back since a decade of research looked at all the biggest stock winners - stocks that doubled, tripled, and went up even more. This was a comprehensive study that analyzed every fundamental and technical variable. What emerged were seven common characteristics among the big winners with earnings growth being the most significant factor. (The other winning factors from the study are discussed in subsequent course lessons.)

Three out of four companies had average earnings increases of 70% or more in the quarter right before they started to make huge price moves.

75% of these top stocks showed at least some positive annual growth rate over the five years before their major price move.

What Are Earnings?

Earnings, also called net profits or net income, are what a company makes after paying all its obligations, including taxes. Companies often conclude their quarters at the end of March, June, September and December, though some companies end their quarters in different months.

Earning Per Share (EPS) is calculated by dividing the total earnings by the number of shares outstanding.
Example: XYZ Corp., with 45 million shares, reports net earnings of Rs. 90 million will have an EPS of Rs. 2.
The EPS is most relevant for investors.

Acceleration Is Also Important

Many stocks that make major advances have another trait. Their earnings accelerate over the previous three or four quarters. Acceleration represents an increase in the earnings growth rate quarter over quarter.

Improving bottom-line growth nearly always precedes a burst in stock price. What's important to realize about this is that it's not just rising earnings that make a good stock. The key is to focus on companies whose earnings may be drawing professional investors' attention -- the phase when a stock prepares to spring higher.
(For a detailed description of the importance of volume and institutional sponsorship, see "Sponsorship: Catching The Stocks The Pros Are Buying.")

So, Here's What You Want To Look For When Researching Your Stocks:

  • Quarterly earnings-per-share growth of at least 25% over the same quarter the year before.
  • Preferably, accelerating earnings in the three most recent quarters.
  • Annual earnings-per-share gains of at least 25% over the past three years.

Remember 25% is the least you should look for. Ideally higher the better 100%, 200% or even more. Strong companies with good management teams, innovative products and leadership in their industries boast the best earnings and reflect the best investing potential.

Evaluating Earnings

Unless you have time to sift through endless earnings reports, odds are you'll miss out on those companies announcing superior earnings. And how do you know the difference between a one-hit wonder and a potential stock market winner when you are looking at raw earnings numbers on thousands of companies? compares the earnings performance of all the traded stocks on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) using its proprietary Earnings Per Share Rating. The EPS Rating measures each stock on a scale of 1 to 99 (99 being best) for a quick assessment. An 80 EPS Rating means that stock is outperforming 80% of all other stocks based on earnings growth. Seen another way, a stock with an EPS Rating of 80 is in the top 20% of all stocks in terms of recent quarterly and annual earnings growth.

Our research shows that the stocks that make powerful gains usually have an EPS Rating of 85 or higher.

Stocks don't live on strong earnings alone. We use a proprietary Corporate Ratings System (CRS) which helps us round out for you the stock selection process. This set of tools also compares other meaningful factors, such as sales growth, return on equity, profit margins, industry vitality and a stock's price performance.
(Subsequent chapters will go into detail about each of these factors.)

The top 100 stocks that come up in the CRS are then analyzed and the ' top 5 stock picks ' are presented to you in the market analysis section.

Watching For Pitfalls

Investors can easily be misled by popular myths about earnings.

Myth: You should buy stocks with low price-to-earnings (P-E) ratios.

The P-E ratio is a comparison of the stock's price to its annual earnings per share. For example, a stock quoted at Rs.50 a share with annual earnings of Rs.5 per share has a P-E ratio of 10. In other words, the stock is selling at 10 times its annual earnings.

Conventional wisdom says stocks with higher P-E ratios are overpriced and should be avoided. But the truth is that the best stocks often have high — some would say ridiculous — P-E ratios when they start their big climbs. And they continue having high P-Es throughout their advances.

Studies prove the percentage gain in earnings per share over the year-earlier period had a greater impact on a stock's price.

Would you have purchased these "high" P/E stocks?

P/E Ratio before advance
108 (Up 920% in 20 months starting April 2006)
93 (Up 1050% in 23 months starting January 2006)
Financial Technologies
235 (Up 500% in 24 months starting June 2005)
Pantaloon Retail
56 (Up 310% in 12 months starting August 1994)

If you weren't willing to pay the higher P-Es, you eliminated some of the best stocks of all time.

And believe me the list is long. Have a look at the biggest winners in history, more often than not they would seem 'overpriced' before their biggest price moves

Key Points to Remember

  • Insist on the best earnings performance, not just a promise of earnings. This way, you will pick stocks with the best probability of making substantial gains.
  • Look for companies reporting earnings growth of at least 25% in the most recent quarter.
  • Find companies with earnings that have accelerated in the three or four most recent quarters.
  • Identify stocks with annual earnings growth of at least 25% over each of the previous three years
  • Don't overemphasize the price/earnings ratio as a way to compare a company's stock relative to its earnings.

Sales, Margins & ROE

Key Fundamentals: Sales, Margins, Return On Equity

Sales growth, profit margins and return on equity are vitally important in evaluating a company's health. This lesson explains the significance of these financial gauges and how to identify the companies with best numbers.

It All Starts With Sales

Sales figures are a key measure of a company's strength -- or lack of it. Perhaps no other piece of financial information reflects growth better than sales: the money that comes into a company from products sold or services rendered. If a company is run efficiently, sales growth essentially drives earnings growth. Companies basically have two ways to increase earnings. They either increase sales or reduce expenses or ideally do both.

When you search for the best stocks, you want a company to have strong sales growth to support its earnings growth. Think of sales growth as the foundation under your house: if it is loose, it's not as stable as one with all the structural elements in place. When you see a company increasing its sales, it's telling you its business is drawing larger demand and is structurally sound and prepared to expand and generate the earnings capable of boosting its stock price.

Demand is driven by a number of factors, including larger numbers of customers, customers increasing their purchase volume, introduction of new products, expansion into new markets and the improvement of existing products.

The top performing companies show consistent double- or triple-digit sales growth. It's even better when the percentage growth rate increases quarter after quarter. Such acceleration is the hallmark of quality growth companies. They reflect a well-managed organization.

How high should sales growth be?
The three most recent quarters should each have strong sales growth of at least 25% compared to their year earlier quarters. Otherwise, sales growth should be accelerating in the last three consecutive quarters.

Watch For Pitfalls In Sales Figures

Sometimes sales numbers mask problems at companies. Companies may rely on just a handful of customers, and losing any of them may mean big trouble. Other companies are overly reliant on overseas markets, putting them at risk of bad economies or political strife abroad. Also, fluctuations in foreign-exchange rates can seriously dilute sales figures. Some companies, such as pharmaceuticals, get the bulk of their sales from a few flagship products. If sales in these items falter, it could mean more trouble than if the overall sales drop. With retailers, additions of new stores increase the sales figures, even if sales at existing stores slow down. That's why retailers report total sales as well as same-store sales, to provide an apples-to-apples comparison. Another pitfall happens when companies include sales that haven't actually taken place. Orders that won't be shipped or paid until weeks or months later sometimes are added to the sales total to inflate results. Also many a times the sales increase because of the price inflation and not actual demand, typical in commodity companies. Therefore price increase should be sustainable and not just a one time temporary phenomena.

Profit Margins: Another Way To Assess Earnings Performance

Profit margins are the portion of a company's sales that end up as earnings. As an investor, look for companies that generate an increasing percentage of profit out of every dollar of sales. The larger the margin, the better a company is at managing and leveraging its business.

Studies of the greatest winning stocks revealed that most showed strong and even expanding profit margins before they made huge price moves. The best small and midcap stocks of the 2003-04 period had after-tax profit margins, on average, of 10% in the two quarters right before they made their main price gains. For big-capitalization stocks, the margins were 13%. Profit margins can be a major clue in finding the best stocks to buy, although the numbers vary widely among industries. For example, retailers tend to have smaller profit margins. Whatever the exact numbers, a company's margins should be among the best in its industry.

Let's take profit margins one step further. There are two types of profit margins. One is called the after-tax margin, and it calculates the percentage of earnings that come from sales after taxes have been paid. Let's take one company that earned Rs.10 million from Rs.100 million in sales. This gives it a profit margin of 10%. What if this company had to pay Rs.2 million in taxes? What would that do to the margin? Well, deduct the Rs.2 million tax payment from the Rs.10 million in earnings and you've got Rs.8 million in earnings. Divide that by the Rs.100 million in sales, and the margin is now only 8%. The other type of margin is the pretax profit margin and it ignores the taxes a company pays. Analysts and investors scrutinize both numbers. Some prefer pretax margins because they show realistic profitability without the distortion of varying tax rates.

The rule of thumb for all companies except retailers: seek companies with annual pretax profit margins of at least 15%. After-tax margins should be at all-time highs for the company or within 10% of the high.

Of course, increasing profit margins alone don't make for a good investment. You need to keep an eye on all the key fundamentals, such as earnings growth. Rising profit margins mean little if sales are dropping, unless there's a change in strategy and the company drops inefficient product lines, for example. Also, if margins start trending lower, it could indicate the company is losing ground to competition.

One other note: increasing profit margins aren't the same thing as increasing earnings, as we've shown with the above examples. Suppose a company earns Rs.10 million from Rs.100 million in sales, resulting in a 10% profit margin. The next quarter it earns Rs.10 million from just Rs.80 million in sales, for a 13% margin. You see how a higher margin doesn't automatically mean bigger profits?

Return On Equity: How Efficient A Company Is With Its Money

ROE is one of the most popular ways to evaluate the financial performance of a growth company. ROE, sometimes called earnings power, indicates how well a company is being managed to allow a profit on its shareholder's money. It is also a reliable indicator of what a company can earn in the future. High ROEs, year after year, tend to reflect increasing profitability and superior management. Cyclical stocks, those that roughly move along with the economy, usually show more mediocre ROEs.

You should generally avoid companies with less than 17% return on equity. ROEs vary among industries, but this is the minimum you should find acceptable. And be sure to compare a company's ROE against others in the industry to get a realistic comparison. In most industries, the top-performing companies tend to have ROEs of 20% to 30%. Occasionally, companies will boast ROEs of 40% or even higher. The higher the percentage, the more efficient a company is in utilizing its capital.

The best stocks of the 2005-06 period had, on average, an ROE of 20%. For big-capitalization stocks, the average ROE was 29%.

ROEs have been increasing over the past several decades, largely because high technology has helped cut costs and boost productivity.

A Quick Way To Weigh Fundamentals

The Sales+Profit Margins+ROE (SMR) Rating -- part of the Corporate Ratings System (CRS) -- saves you the arduous task of going over the financial reports of every company and helps you find the best companies in terms of financial performance. The rating looks at a company's sales growth over the last three quarters, its before- and after-tax margins and its return on equity. These four fundamental factors are widely used by analysts.

The SMR Rating ranges from A to E, with "A" being the best and representing the top 20% of all companies. The "B" stocks are in the next 20% and so on. The "E" stocks represent the bottom 20% and the lesser-quality companies. The rating also assigns a greater value to stocks in which any or all of these fundamental factors are accelerating. Look for stocks with ratings of "A" or "B."

The Launch Pad

OK, let's say you've found a company with great sales growth, profit margins and return on equity. What's next? As good as these indicators may be, don't ignore other critical factors, such as a stock's earnings growth (the earnings lesson discusses how to evaluate earnings.), institutional sponsorship (The amount of buying by mutual funds and other institutional investors is important and is discussed in the sponsorship lesson) and relative price strength. (Relative Price Strength Rating takes a stock's price performance over the past 12 months and compares it to all other stocks. The rating is expressed on a scale of 1 to 99, with 99 being best. This is covered in the leaders lesson.) Also, studying a stock chart completes the stock selection picture. (Charts are explained in detail in the charts lessons.)

Key Points To Remember

  • Strong sales growth is one key indicator of a company's success. Quarterly sales growth should be up at least 25% in the most recent quarter. Otherwise, they should be accelerating.
  • Profit margins tell you how much of a company's sales end up as earnings after expenses. Generally, the higher profit margins, the better.
  • Return on equity measures how well a growth company can produce earnings with shareholders' capital. Look for ROEs of at least 17%.


Catching The Stocks The Pros Are Buying

FIIs, Mutual funds and other professional investors represent the vast majority of trading activity in the market. As such, they wield tremendous influence on stocks, capable of sending their favorite stocks up significantly. Here, you'll learn how to spot the stocks benefiting from "institutional sponsorship."

What Is Institutional Sponsorship?

There's a term on Wall Street everyone soon learns to appreciate: institutional investors. These are the mutual funds, pension funds, banks and other financial institutions that do the bulk of stock trading on any given day. It is estimated institutions account for massive chunk of all trading activity. So when institutions target a stock for purchase, it's more likely to go up in price thanks to the increased demand they create. This professional stock buying is called institutional sponsorship.

Institutions make a living buying and selling stocks. They employ analysts, researchers and other specialists to gather comprehensive information about companies. They meet with executives, evaluate industry conditions and study the outlook for every company they plan to invest in.

Tracking What The Institutions Are Trading

Now, wouldn't it be great if you knew exactly which stocks the institutions are buying and when? Actually, you can.

Although mutual funds and other institutions don't disclose their buys and sells frequently, you can track their moves by watching for clues in trading activity.

One of the most useful ways to spot current institutional trading is to study volume percent change figures, in other words, how much trading rose — or declined — in a day compared to normal. (By normal, we mean the average daily trading volume over the past 50 trading days.) Because this information is continually updated, it is the quickest way to detect institutional trading in a stock. When volume spikes up 50% or more at the same time the stock goes up in price, that's generally a clear sign that major investors are moving into the stock with both feet. This usually precedes a significant rise in the stock price. But if a stock's price drops on heavy volume, it's a sign large investors may be moving out of a stock. If a stock's trading volume advances but the price goes nowhere, it could mean the stock is reaching a peak. Information about volume changes can be studied on daily charts.

You can also log on to to see the portfolios and performances of all the mutual funds.

Fundamentals, Not Just Funds

A stock with strong buying by top-performing institutions has a greater probability of making you money. But you shouldn't pick a stock on volume, accumulation or sponsorship numbers alone. First, be sure the company's earnings, sales and other fundamentals are strong. Other factors, such as the stock's Relative Price Strength, the industry group's performance and the health of the overall market must be considered, too.

Key Points To Remember

  • Institutional investors represent the bulk of trading activity in the market. As such, their buying and selling power can move a stock's price up or down dramatically.
  • You can learn to spot which stocks institutions are buying and selling by watching for surges in trading volume.
  • Look for stocks with an increasing total number of institutional owners in recent quarters. Look for those stocks that are owned by more funds each quarter.

Industry Groups

The Strongest Industries Often Produce The Best Stocks

The Strongest Industries Often Produce The Best Stocks

Research shows that up to half of a stock's move is traced to the strength of its industry. That's why it's important to track the performance of industry groups. In this lesson, you'll learn how to do that, plus identify the stocks in the most attractive industry groups.

The majority of leading stocks are in leading industries. Being in the right industry group is almost as important as investing in the right company. We lists down for you a list of top performing industry group in the 'market analysis' section.

Each new market cycle is led by certain industries. In the late 1990s, for example, telecommunications and Internet-related industries were the leaders. Economic conditions and trends, in large part, determine which industries and sectors rise to lead the market. Through much of 1993, generic-drug makers led the market by offering less expensive medications to a cost-weary pharmaceutical market. In the more recent market cycle of 2004 construction and realty related industries led the market. Companies in the top-performing industries usually enjoy strong demand for their products and services that can drive up their stock's price.

Some Of The Leading Industries In History

Here are a few examples of historically successful industries and the factors that propelled them to the top. As you can see, economic conditions and trends can play a huge role in determining which industries lead the market.

Fundamental Factors
Breakthroughs in gene research.
Growth of "anytime, anywhere" communication technology, such as
Internet Infrastructure
Demand for high-speed connections.

Watch For A "Follow-On" Effect

Sometimes, a major development happens in one industry and related industries later reap follow-on benefits. For example, in the late 1960s in America the airline industry underwent a renaissance with the introduction of jet airplanes. The increase in air travel a few years later spilled over to the hotel industry, which was more than happy to expand to meet the rising number of travelers.

But some industries and individual stocks don't ride the leaders' coattails. Don't assume that just because it's the rainy season umbrella manufacturers will suddenly surge. You must still look for quality companies capable of producing healthy earnings, sales, resulting from exceptional products and services.

Check Industry Performance

You don't have to scan every single stock to find out which industries are leading the market. Each day,'s top industry groups, found in the Market Analysis section, lists the top 5 industry group out of over 250 different industry groups by analyzing the price performance of all stocks in each group over the latest six months. This is a realistic period in which to observe market trends.

Why over 250 industry groups? Because the Indian economy is fragmented, and industries tend to spawn related businesses that become industries in their own right. Take the computer sector, for instance. It's not just PC makers. There's also Computer-Graphics, Computer-Education, Computer-Hardware, Computer-Peripheral Equipment, Computer-Services, and Computer-Software, which itself is divided into large, medium and small enterprises. More specific industry classifications make it easier to pinpoint specific areas leading or falling behind.

Industry Sectors: Another Great Way To Analyze Markets

Reading sector movements helps judge the overall market because different sectors perk up at different stages of the business cycle. For example, the defensive sector (This sector includes supermarket chains, utilities, etc., which are sometimes viewed as havens during market slumps. People don't change their spending much in such industries even when times are tough.) rises during times of economic weakness or when investors think the economy is headed down. The high-technology sector has been strong during expansion phases.

Companies Making New Price Highs

Another excellent way to spot market leadership is look at stocks making new 52-week price highs located. Look for sectors showing the most stocks making new price highs. These are usually the leading market sectors.

Key Points To Remember

  • Much of a stock's move is due to the strength of its industry. You want to own stocks in industries that are displaying strength and market leadership.
  • Different industries move to market leadership as economic conditions and consumer trends change. You can identify the new leaders by watching the top five industry sectors with stocks making the most new price highs.


Leading Stocks Are Leaders For A Reason

The stocks outperforming the market tend to continue performing well, while lagging stocks are likely to remain underperformers. Here, you'll see why this is an important lesson for investors and how to identify the leading stocks.

The Best-Performing Stocks Continue Performing Well

How many times have you concluded a stock's best days are behind it, only to watch it soar as you stand on the sidelines? This assumption has often come back to haunt investors. In reality, the stocks that are doing best tend to keep doing well, while those slumping likely will continue to do poorly. Why? The great companies manifest their strength through superior performance in terms of earnings, sales, profit margins and, yes, even the performance of their stock.

A study of the greatest stock market winners found that all-star stocks had, on average, outperformed 87% of the market before they began their most dramatic price advances. In other words, they were already in leadership positions. This concept is contrary to the popular bargain-hunting mentality, but is based on historical facts.

How To Find The Leaders

If you want to find next year's winning stocks, look at the better-performing stocks today. Remember, the biggest winning stocks historically have been, on average, in the top 13% of stocks at the time they began their major advances. To help you identify today's leaders, we have developed the Relative Price Strength Rating, or RS Rating. This rating compares the price performance of each stock over the last 12 months, with extra emphasis on the three most recent months. Stocks are rated on a scale of 1 to 99, with 99 representing the top 1% in terms of price movement. So an RS Rating of 85 means that stock is outperforming 85% of all stocks in terms of price performance. An RS Rating of 25 means the stock is being outperformed by 75% of the market and should be avoided.

A good starting point for stock selection is identifying the top two or three stocks with the highest RS Rating in an industry group that's leading the overall market.

Evaluating Potential Leaders

Any stock worth considering should have an RS Rating of 80 or higher. This way, you're concentrating on the top 20% of price performers. In fact, the most successful stock selections generally have RS Ratings of 90 or higher just before breaking out of their first or second base structure.

Any stock below an RS Rating of 70 is not in leadership territory. If you consider any stock with an RS Rating of less than 70, keep in mind that you're automatically ruling out the top 30% of the market. It's conceivable these stocks will still go up, but it's more likely they'll have only lackluster performance. Bottom fishers, those investors looking for a bargain among down-and-out stocks, are tempted to buy stocks with low RS Ratings. But history proves the most powerful stocks have shown prior strength and aren't rebounding from last place.

Many fund managers rely on the Relative Price Strength Rating to help make investment decisions.

Another Useful Tool: The Relative Strength Line

It's best when the relative strength line moves up at a sharp angle, showing the stock is outperforming the market. A line moving down indicates the opposite: a weakening stock. The relative strength line offers other clues:

  • It's a positive sign when the line begins moving higher before the stock price itself does. A rising line indicates underlying strength in a stock; frequently, it's just a matter of time until the price itself begins moving higher.
  • If a stock's line stays on an uptrend, that's positive. It shows the stock is keeping ahead of the overall market, acting as a confirmation of the stock's uptrend.
  • If a stock's relative strength line fails to follow along with a new high in price, that's a warning signal. This shows the overall market is moving up faster than the stock. This may signal the stock is weakening, though the price may not reflect it immediately.
  • RS lines that start drifting lower over a period of time, even if prices remain steady, indicate the stock is weakening. This also shows the stock is slipping in comparison with the rest of the market.s

"Sympathy Plays" Don't Play Well

Another common temptation among investors is to seek out stocks that resemble leading stocks in terms of having similar products or services, but are trading at lower prices than the leaders. Usually, though, you're better off sticking with the leader of the industry, even if its share price is higher. Take the IT industry. Wipro after 2000 crash fell about 90% from the peak of Rs. 1700, the price of the stock was only about Rs.350 in early 2008 after 8 years of the crash. On the other hand infosys made a new high and rallied higher sending its stock up during the same span of time. This is not a rare example, for any industry. The moral: stick with the leading stocks in a leading industry group.

Rounding Out Stock Selections

No investor should pick stocks based on a single factor. You must weigh the full picture, including a company's earnings, industry group performance, institutional sponsorship and chart patterns. (Institutional sponsorship, chart patterns and other important elements will be explained in detail in subsequent lessons.)

Key Points To Remember

  • Relative Price Strength Rating measures a stock's price move over the last 12 months compared to all other stocks.
  • Look for stocks with high Relative Strength. The better-performing stocks tend to go higher, while the lagging stocks tend to lag even more.
  • The Relative Strength line helps confirm a stock's upward price movement. You want to see the RS line moving in a strong uptrend.

New Highs

New Price Highs Mean New Opportunities

Many investors have passed up great stocks because they had reached new price highs. Yet, that's when many of the best stocks begin their major climbs, not when they've bottomed out. That's why buying bargain-priced stocks is often a frustrating experience.

Buy High, Sell Higher

How many times have you heard the phrase, "buy low, sell high"? This is the conventional wisdom in the investment world, but research shows you shouldn't be concerned with that part about buying low. Let's walk through this one step at a time. Research shows that the best-performing stocks make new highs before they make their major leaps in price. Moreover, stocks at new highs tend to continue moving higher, while stocks making new lows tend to continue to move even lower.

This is a concept many investors find difficult to accept. They assume it's too late to buy a stock that's reached an all-time high. But the great paradox of the stock market is "What seems too high and risky to most investors is likely to continue rising. And what seems low and cheap usually goes down."

Just by applying the laws of supply and demand you can see why new highs are important. When stocks advance, they're demonstrating growing demand as investors raise their expectations about the company. On the other hand, stocks making new lows are usually afflicted by just the opposite: sagging expectations. Yes, there's plenty of stocks in the bargain basement, but they're there because the merchandise, so to speak, isn't hot.

Some stocks may have very strong fundamentals or great stories, yet they don't go up because there's little investor interest. So while you wait for a stock to be discovered -- if it ever does -- other stocks are moving into the spotlight.

Stocks reaching new highs tell you professional investors are moving in and pushing prices higher.

Often, The Best Is Yet To Come

Would you shy away from stocks that more than doubled in the past year or less? Consider taking a look at what happened with the greatest stocks of every bull market. They looked overpriced or had already moved or looked risky to buy just before its biggest move up.

In a good market, opportunities such as these, which start with new price highs, will surface every two or three weeks. In fact, if you ignore this simple rule, you would miss out on just about every major winning stock.

However, there can be such a thing as an "overextended" stock: one that truly has gone up too much, too fast and is likely headed down. As a rule, don't buy any stock that has risen more than 5% past its buy point. In a nutshell, the buy point is the price after a stock clears the highest point in its basing formation. Basing formations are periods of price consolidation when a stock moves more or less sideways for a number of weeks after earlier advances. The buy point and basing formations are explained in lesson on charts.

Overhead Obstacles

One reason new highs represent better opportunities is because of something market pros call overhead supply. Suppose a stock that once traded at Rs.50 falls to Rs25. If it starts making its way back up, investors who bought near Rs.50 start hoping the stock gets back to the old high so they can sell and break even. This presents selling pressure near the Rs.50 mark. But once it clears that Rs.50 hurdle, the stock is no longer burdened by disappointed investors looking to wipe out their losses.

Avoid Cheap Stocks

Perhaps you're one of those investors who think they'll hit the jackpot buying a low-priced stock that goes on to make huge gains. Some investors equate cheap stocks with better value or low risk. If a stock costs cheaply priced, then you can't lose a whole lot, right? Wrong. The truth is that trying to consistently make money with cheap stocks is difficult, at best. Stocks are cheap for a reason. Think of a stock's price as a measure of its quality and, consequently, its potential. Stocks selling cheap have a much smaller chance of making major advances, because they're usually companies lacking good performance records. Also, professional investors shun low-priced stocks because they tend to be lightly traded, making it harder to move in and out of such stocks.

So, you can see what research bears out: it's best to look for new highs in quality stocks. It's especially good when the stock is coming out of a base. But don't wait too long: As soon as you spot a buy point -- and if all other factors are in place, such as good earnings growth -- it's time to have confidence and conviction and make your move. Otherwise, you may miss your opportunity.

Avoiding Pitfalls

Like you've seen in earlier chapters, you don't want to buy a stock on any single factor. Where a stock is in relation to its 52-week high and low price is just one part of your stock-selection checklist. Other important ingredients are the Earnings Per Share (EPS) Rating, the Relative Price Strength (RS) Rating, the Industry Group Relative Strength (Group RS), and so on. These concepts are explained in the lessons on earnings, leaders and industry groups.

Also, be careful with stocks that make new highs on less and less trading volume. This could be a sign of a stock topping (reaching its peak), especially in cases when a stock has gone up at least 50% in a few weeks after an extended advance. When a stock goes up on low volume, it's a gain produced by relatively small purchases. It's much safer to go with a stock that makes a new price high on higher volume, which indicates broader support for the stock.

Key Points To Remember

  • Quality stocks making new price highs just as they emerge from sound bases on higher volume are often likely to continue climbing, while stocks making new lows are probably headed even lower. Therefore, focus on the new price highs list for the best potential opportunities.
  • The great paradox of the stock market is that what seems too high and risky to most investors is likely to continue rising. And what seems low and cheap usually goes down.
  • You can think of a stock's price as a measure of its quality and, consequently, its potential. Typically, stocks higher in price reflect higher quality.

New Products

New Products Or Management

New Products Or Management

Explosive stock growth doesn't happen in a vacuum. Usually, new products, new services or new management propels stocks to astounding heights. That's why it's important to keep up with developments that could launch the next great stock.

The Best Stocks Reflect Success Stories

Stocks don't double, triple or move even higher in a vacuum. There's usually a new story behind a stock's major price advance. Where would Microsoft be today without its Windows operating system? If you look through the list of greatest stocks in U.S., there are plenty of breakthrough products that fueled stock advances:

  • Syntex rocketed 450% in six months during 1963, when it began selling the first oral contraceptive pill.
  • McDonald's surged 1,100% from 1967 to 1971 as its low-cost, fast-food franchising business model swept the nation.
  • From 1978 to 1980, Wang Labs' shares grew 1,350% with the development of word-processing office equipment.
    International Game Technology surged 1,600% in 1991-1993 thanks to the development of game technology based on microprocessors.
  • Accustaff rose 1,486% from January 1995 to May 1996 as outsourcing grabbed hold of Corporate America, sending this temporary-staffing firm to big profits.
  • America Online surged 593% from September 1994 to June 1996 as the company rose to become the leading Internet service provider to a nation eager to log on to the Web.
  • Qualcomm rose 376% from February 1999 to December 1999 on the rising popularity of the company's Code Division Multiple Access technology for wireless telephones.

A study evaluating the greatest stocks dating back to 1953 found 95% of these winners had breakthrough products, new management or new way of doing business that boosted these stocks to staggering heights.

It's worth emphasizing that these and other success stories didn't achieve greatness without proven products.

Often, gullible investors buy stocks because the company promises the cure for cancer or some other breakthrough technology. It's wiser to wait for products to prove themselves in the marketplace before investing in something untested. If a product really hits it big, there will be strong demand for a long time.

For the best companies, success isn't something that happens by accident. They never stop innovating and evaluating the future of the marketplace. As soon as one product is out the door, they're working on the next generation and new ways to sustain their leadership. Microsoft, Google and Apple are one of the greatest examples.

Companies' annual reports occasionally overhype achievements and developments, creating unrealistic expectations. Whatever annual reports promise should be carefully scrutinized.

Many Internet chat rooms and bulletin boards are notorious for stock hype, too. Anything you read in these sites needs to be taken with a big grain of salt. You never know who's posting the information, what their motives are or if details are even true. Rumors and "tips" are plentiful, though few have any truth to them.

Management Makes Success Happen

"Management is what used to be required to run a company. Today it's leadership. A manager basically controls, establishes plans, makes a budget, allocates work and tracks results. A leader is much more focused on vision and beliefs. He or she inspires people and breaks roadblocks so that people can accomplish more."

-- Robert Eaton, ex co-chairman, DaimlerChrysler.

You've probably heard about super-executives who rescue companies from the brink of bankruptcy or take them to astonishing heights. Visionaries such as these can be responsible for a powerful stock move. Apple Computer was faltering in 1997, when co-founder Steve Jobs returned to lead the company back into profitability. Under his leadership, Apple shares more than quadrupled over the next couple of years.

What makes management outstanding? There's more to successful management than inventing the next personal computer or coming up with the next big trend in fast food. Executives must also be adept at guiding companies through difficult times, adjusting to changing market conditions, taking advantage of new opportunities. Good managers are visionaries, able to redefine business models. Often, other companies emulate their successful strategies. These leaders demonstrate the ability to deliver on promises, meet growth projections and deadlines, building a reputation for credibility and integrity. Communication skills in today's corporate world are vital if managers are to reach workers at each layer of their organizations.

Key Points To Remember

  • A stock that makes big gains often result from new products or services. But be wary of unproven products, especially if the company management doesn't have a solid track record.
  • Superior management is essential to a company's success. That's why sometimes a change at the top pushes a stock's price higher.
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