Don’t invest with your sympathies, William J. O’Neil wrote in chapter seven of “How to Make Money in Stocks: A Winning System in Good Times and Bad.”
He wanted investors to buy the best stocks in an industry group: “You should buy the really great companies—those that lead their industries and are number one in their particular fields.” By number one, he is not referring to the biggest company or the biggest brand name.
In O’Neil’s eyes, number one is fundamentally the strongest, the one with the best quarterly and annual earnings growth as well as the highest return on equity, broadest profit margins, strongest sales growth and “most dynamic stock-price action. Such companies will sell unique and superior products—and be taking market share from older, less-innovative peers.”
What is the difference between a leader and laggard? Leaders are those that have the characteristics in the paragraph above, with exceptionally strong fundamentals. Laggards, or sympathy stocks, are weaker companies in the same industry group; investors buy them in the expectation they will be pulled up by excitement about the leader. The problem is their profits are usually lackluster, at least in comparison to the leaders. There might be a sympathy boost, but they never do as well as the leader.
How do you separate the leaders from the laggards? In addition to checking the fundamentals, especially earnings growth, investors can also use a proprietary measure from Investor’s Business Daily. The metric is called the relative price strength rating. Not to be confused with the relative strength index or relative strength as used by other technical analysts, it measures the price performance of a specific stock against the rest of the market for the past 52 weeks.
The ratings from O’Neil’s company are behind a subscription paywall, but there is a legitimate workaround. Check the holdings of the Innovator IBD 50 ETF (FFTY, Financial), an exchange-traded fund based on the top 50 IDB stocks. Any stock on that list should be a leader, based on O’Neil’s criteria. Here’s a look at the top 10 stocks on that list, by proportion of portfolio:
O’Neil next discussed finding new leaders during market dips. If the overall market is moving down, then he expects “better growth stocks” to move down 1.5 to 2.5 times more than the market decline. For example, if the market dips 10%, then expect the best stocks to drop by 15% to 25%.
In bullish markets, the stocks that go down the least are the best investment bets. By extension, the stocks that drop the most during a bull market correction are often the weakest stocks available. In addition, once a bear market is “definitely over,” the stocks of authentic leaders will be the first to show new price highs. This should happen in the first three or four weeks.
The author added that professionals make mistakes, too, when buying stocks that have just plunged, observing: “Our studies indicate that this is a surefire way to get yourself in trouble.” Professional investors, including institutional fund managers, have made many infamous trades while trying to catch falling stocks (knives). Often, they were the stocks of notable companies, including Levitz Furniture, Lucent Technologies and Cisco (CSCO, Financial).
Thus, he said do not buy a supposedly good stock on its way down; and if you find yourself in a losing position, cut your losses at 7% or 8%. He said, “Any stock can do anything. You must have rules to protect your hard-earned money. We all make mistakes. You must learn to correct yours without vacillating.”
On a positive note, O’Neil recommended buying stocks that show abnormal strength during a weak day in the market. He recalled a day on which the Dow Jones Industrial Average was down 12 points (and the market was at 800). He noticed Control Data was trading up three and a half points on heavy volume and bought its stock right away.
He winds up the chapter with these words: “It seldom pays to invest in laggard stocks, even if they look tantalizingly cheap. Look for, and confine your purchases to, market leaders. Get out of your laggard losers if you’re down 8% below the price you paid so that you won’t risk getting badly hurt.”
Some notes
Although O’Neil’s ideas may not look familiar to value investors, there are deep parallels. He, too, is trying to buy good stocks at reasonable prices, but because he is a growth investor, he does not demand discounts (or margins of safety) that are as deep. He is also looking at price action, as might be seen on a chart, to guide him, rather than the fundamentals. However, he too is trying to flush out value for price, as a value investor would.
Second, while his system might be unfamiliar to value investors, the fact he has a system indicates he follows the same discipline and patience as exhibited by value investors.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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