Independent Investment Advice Since 1970

Frequently Asked Questions

By Michael Cintolo, Cabot Vice President of Investments and Editor of Cabot Market Letter and Cabot Top Ten Report

Here are questions and answers to general investing questions most often asked by our readers. They can help all investors better understand not just how we invest, but also some important principles that will quickly improve your skills. To submit a question, go the Cabot Forum on our home page or send an email to customer service@cabot.net.

Q: You just recommended XYZ stock a couple of weeks ago...and today you're advising to sell it. How can you change your opinion that quickly; I thought it was a great company!

A: As Paul Goodwin (analyst and editor of Cabot China & Emerging Markets Report) has written a few times, you need to have three things for a successful stock—a good story (i.e., good future potential based on a unique product or industry upswing), good numbers (particularly strong sales and earnings growth and big profit margins) and a good chart (telling you deep-pocketed investors are accumulating the shares). Paul calls this the SNaC system—Stories, Numbers and Chart—and it's a useful acronym to remember.

The most fluid of these three pieces is the chart—the story and the numbers don't change overnight, but in rare instances, the chart can (either positively or negatively). Most investors refuse to change their minds that quickly, but our studies show that a rapid change in the price of the stock—especially if it comes on earnings news—usually leads to more movement in the same direction. So if your stock collapses soon after you buy it, your best move is almost always to get out. Yes, it's painful...but stubbornly sticking with the stock usually causes only more pain over time.

Q: I've been looking at Baidu (or Google, or Apple, or any other past leader) and business remains great. Yet the stock is down significantly. Isn't it a good buy?

A: This question is closely related to the one above. The answer is generally no, and the reason is that a stock is not the company. A stock can fall sharply and persistently even if sales and earnings are growing quickly. That's especially true in a bear phase for the overall market.

Like I wrote above, you need not only a good story and good numbers, but a good chart as well. One without the other two is far less reliable. We do think last year's big winners have topped, and while the occasional exciting rally will take place, you'll be better off looking for new leaders.

Q: When will this market stop falling?

A: This is a very popular question these days (March 2008). But the title of our Cabot Market Letter three weeks ago was "Forecasting Sells, Interpreting Pays," meaning that, while predictions of the market will sell newspapers, the best investors simply interpret the market's action day by day, week by week, and stay in gear with the trends.

Thus, we don't have any guesses about when the morass will end, although we have seen some signs that a bottoming process is underway. Our biggest prediction is that this bear phase will NOT be like 2000-2003; that was a once in a lifetime event that followed years of huge returns. This past bull move was relatively tame, and we're already four months into the downturn. So the next bull market could begin at any time.

Q: Recently you've profiled a bunch of strong commodity (gold, oil, gas, coal, etc.) stocks in Cabot Top Ten Report (March 2008). Yet you've also continued to tell subscribers to hold plenty of cash and only buy small positions. Why not just go heavy into those areas that are working?

A: Here's the thing about a downtrend in the overall market: It's going to exert pressure on every stock and every group at some point. Now, that doesn't mean an oil or gold stock won't rise over time—many of the picks in Cabot Top Ten Report have put on solid performances—but it's likely to be a three-steps-forward, two-steps-back kind of advance. And a choppier upmove means the timing of your buys and sells must be precise.

Thus, you certainly could ignore the market and just focus on the leading sectors. But, even though those stocks look great right now, it doesn't mean they won't suffer a sharp sell-off in the days ahead. Said another way, it's hard to have a huge amount of long-term conviction in anything while the overall market is trending lower.

Q: The CEO of XYZ stock, which you just recommended, just sold $2 million of his shares last week. Should I still buy the stock?

A: Simply put, insider actions (either buys or sells) have never proven to be a great indicator of future price performance one way or the other. Sure, sometimes a stock tops out after the insiders dump shares, but just about all of the big-winning stocks in history have experienced plenty of insider selling as they rose to scintillating heights.What really matters is what institutional investors think of the stock--which is why we watch the chart.

Q: You've been talking about a possible bottoming process in the market, but with housing sales declining sharply, manufacturing reports looking awful, and inflation measures beginning to tick higher, how can the market move meaningfully higher? (March 2008)

A: All of the problems listed above are economic fundamentals, which are not good leading indicators of market performance. Remember, the market looks ahead three to nine months, so if anything, the market is a leading indicator of the economy, not the other way around. Think of it this way: If investing were as simple as reading the economic indicators and investing based on what they said, we'd all be rich! But that's not going to happen.

The market will definitely bottom when the news is bad, and the outlook seems poor. We don't know many people predicting great things back in March 2003, when our indicators gave us buy signals just as the bull market kicked off (the Cabot Market Letter's Model Portfolio was up 50% that year). So it's important to filter out the bad news and pay attention to the market itself.

Q: I've been using charts more, but am curious about your opinion about the various stock-based indicators like MACD, RSI, Stochastics, and so on.

A: Very good question. To be honest, I like to keep it simple--my charts just look at a stock's price history, volume history, a couple of moving averages (especially the 50-day moving average) and the stock's relative performance (compared to the market). All those "indicators" you mentioned are basically short-term overbought-oversold measures, which don't carry much weight with me.

That's not to say they're totally useless, but if you're looking for intermediate- to longer-term profits, you want to know whether a stock is under accumulation or not. And MACD, RSI and the like don't help you determine that.

Q: List your top rules (or tools) for investing.

A: They are:

Cut losses short (definitely rule #1 for growth stock investing)
Search for strong sales and earnings growth (especially triple-digit sales growth)
Search for revolutionary products with major benefits (First Solar and Crocs filled the bill in '07 and were our two biggest winners)
Heed the message of the overall market
Never average down, and
Be prepared for all contingencies (always have an exit plan ahead of time, just in case).

Closely following those would be:

Never try to buy at the bottom or sell at the top (if you try to do it, you'll just lose more money)
Stick with stocks that are liquid to avoid gut-wrenching volatility (usually at
least 600,000 shares traded per day or more)
Only put more money to work after your past purchase or two is showing you a profit, and
Be humble—making money in stocks is tough, so don't kill yourself over one
or two bad trades, and be thankful when you hit a big winner.

Q: Should I use trailing stops?

A trailing stop is simply an order you place with your broker to sell your stock if it falls a certain percent off its high, or if it falls through a given price level. In general, I do believe stops are a good tool for the average investor. They will, first and foremost, allow the investor to cut losses short if his stock heads south after purchase. And they do help lock in profits should your stock, after a good advance, begin to break its uptrend.

But as with all tools, the success of using trailing stops is based on the smarts of the user--in this case, the investor. Randomly placing trailing stops on a winning stock isn't a good idea; you can too easily get stopped out on normal fluctuations.

I think the key to successful selling isn't having a blanket "sell anytime my stock drops 20% from its peak" strategy; the key is studying and
understanding charts. If you're going to use a stop, put it somewhere that's technically relevant--having it just below the 50-day moving average, for instance, is a sound strategy. Or, if you're shorter-term, you might place it below the stock's lowest price of the past few weeks.

Thus, I think stops are a good idea, especially if you can't watch the market and your stocks all day. But it's like anything else--if you put effort into learning the best methods to trail your stops, your results will improve.

Q: What books do you recommend on investing, especially charts?

We're always perusing the bookstore, looking for new and interesting investing books. Here is a handful of my favorites.

How to Trade in Stocks, by Jesse L. Livermore. It's a great account from Livermore himself on some of his key principles of trading. One of the big lessons I learned: Being patient not just with winning stocks, but also practicing patience when waiting for the next big move. (I might need to relearn this, given my words in the first section!)

How I Made $2,000,000 in the Stock Market, by Nicholas Darvas. This will take you through a progression from total novice to super-successful investor. It's a great read to reinforce some of the market's basic principles.

Technical Analysis and Stock Market Profits, by Richard Schabacker. If you're just beginning in the world of chart reading, this is a good guide. We don't subscribe to all of the patterns he talks about, but it's still a great place to start.

The Intelligent Investor, by Benjamin Graham. It's not my cup of tea, as I'm a growth stock guy. But most value-oriented investors believe this is one of the best books ever written.

Market Wizards, The New Market Wizards and Stock Market Wizards, all by Jack Schwager. They contain great interviews with a few dozen of the best investors in the world. You are guaranteed to learn some things, about the market and yourself.

For more books recommended by our editors, go to the Cabot Web site, http://www.cabot.net, and click on Books on Investing under the Education section.

To submit a general investing question to Cabot editors, send an email to customerservice@cabot.net.

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