What Makes a Company Good?
Stockscores.com Perspectives for the week ending July 29, 2011
In this week's issue:
I received the following question today,
"What's the best Market Scan to use (or criteria if I build my own) to find good quality stocks that are getting really beaten up over the past few weeks (due to US debt "crisis")?"
Crisis situations create some of the best trading opportunities because fear causes people to accept too low of a price when selling their stock. When the fear goes away, the stock will bounce back significantly and provide a nice return for the trader willing to step in front of fear.
The market's gains since March of 2009 are a good example of how buying at the right time in the midst of a crisis can lead to nice returns. The S&P 500 index has more than doubled since the 2009 lows, but not all stocks have gone up the same.
This leads to the somewhat loaded nature of the question that was asked. What is a good quality company? Does this mean a company with a low price to earnings ratio relative to its peers? A company that has a solid balance sheet with a low ratio of debt to equity? How about a company that has a high earnings growth rate or one that has experienced and respected management? Is the company with a strong consumer brand better than one that people do not know?
It would be difficult, if not impossible, to get agreement on what makes a good quality company. However, the answer is very simple if you look at it from the investors' point of view.
A good quality company is one that goes up after we buy it.
Isn't that all we really care about? You could get a positive answer to many of the questions about what makes a company good if you asked them of Walmart (WMT). Good brand, leader in the industry, solid balance sheet, respected management etc. However, if you bought WMT five years ago, you paid about $50 a share. Today, the stock is at about $53. Not a great return, leaving anyone who has suffered as a long term holder of the stock feeling that they did not own a very good quality company.
There is a huge misperception among investors that the companies that have good fundamentals are the ones that perform well in the stock market. There are so many examples of stocks that go up week after week, month after month because they are liked rather than because they are good.
This is really the core of what makes a stock good. It is the company that people want to own, that has a story that makes investors want to buy it that goes up. Certainly, the business fundamentals have a lot to do with motivating buyers, but so too do some purely psychological reasons.
For example, there is a tendency for people to want to buy stocks because they are going up. A stock that is rising over time gives investors confirmation that what they are doing is good. A rising stock shapes perceptions of the fundamentals in an optimistic way.
There are fads in the stock market; times when investors pile in to sectors because they receive a good deal of publicity. If Oil prices go up dramatically, investors tend to take notice of stocks that are in the alternative energy sector. Investors are willing to pay more for these stocks because the marketing angle for the alternative energy stocks is more compelling when Oil prices go up.
Michael Eisner, former head of Disney, once said that it is not the company with the best product that wins, it is the one with the best commercial. The same can be said of the stock market. Often, the best stocks are the ones that are able to capture the market's attention the best.
A good example recently has been Netflix. Good company, yes. Is it one that deserves to trade at $260 a share when it was less than $60 only a year and a half ago? Questionable. I have heard countless analysts state that the fundamentals for NFLX do not justify the price. Nearly 20% of their outstanding shares have been shorted, so many are betting against the long term upward trend of the stock.
Would I want to short the stock? Not today! The simple reason is that this stock remains in a strong upward trend. It has price momentum because investors like it and, whether they are right or wrong, I don't want to get on the wrong side of a crowd with this kind of conviction. That may change tomorrow, but until that trend is broken, I will trade with the trend and not fight it.
Returning to the question, what good quality stocks can we buy that will bounce back well if and when the US Debt crisis is resolved.
That is a tricky question to answer as I explain below in the Strategy of the Week.Back To Top
We have a difficult situation going in to next week. Many stocks that have been pulling back over the past couple of weeks managed to close above their opens on Friday. This demonstrates that investors are speculating that the US government will do something by Tuesday's deadline to fix the debt ceiling issue. If this happens, we should expect stocks to gap up Monday or Tuesday.
This is not of much use to us this weekend since we cannot make a trade before Monday to take advantage of a jump. The Pull Back Play Market Scan would show us some stocks that have a good potential to continue their upward trends next week as they bounce off of upward trend lines. However, the entries should probably have been made Friday before the close.
It is not really that necessary to be a stock picker in this scenario. If the debt issue is resolved, most stocks will go up. If there is no resolution, most stocks will go down. You can flip a coin to determine what will happen since it is a difficult thing to predict.
Will stocks that have been weak go up more than stocks that have held up well if a deal is announced? That depends on what kind of stocks we are considering. Stocks that have done well this past week may be hedges against the uncertainty. For example, Gold stocks have outperformed the overall market because people are putting money in to Gold as a way to protect against risk. If a deal is done, you have to assume that there will be at least a pullback in Gold and Gold stocks. If no deal is done, these stocks will continue to move higher.
The stocks that have not performed well will mostly all go up together, making it relatively unimportant to pick individual stocks. It will be a market move, not a move focused on individual stocks.
Once the initial reaction to a deal has passed, the market will go back to buying the individual names that investors like. These are the stocks with good chart patterns, which generally have Sentiment Stockscores above 60.
For now, I am doing nothing but sitting on cash. Trading before a clear signal from the market is shown is too much like gambling.
What I will be doing is watching the intraday 5 and 15 minute charts of the SPY. If there is a break of the downward trend on that chart, I will be a buyer of the index, but moving in to it in stages as the directional move is confirmed. That trade may last a few days.
As time passes, the trade will be less focused on the market and more on individual stocks. A few days after a positive resolution of the debt ceiling issue, I will go back to picking stocks using the Abnormal Breaks and Stockscores Simple Market Scans.Back To Top
1. SPY
Watch the intraday chart of the SPY for a break of the short downward trend line that was building over this past week. Until then, I think it is best to sit in cash and be very selective.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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