Craving New Stock Leadership
An ETF that’s Starting to Lift Off
Many people, even investors, are afraid of math … or at least uncomfortable with it. But myself, I’ve always liked math—there’s a certainty to it, and given that everything in the stock market is totally uncertain, it’s nice to be able to rely on a trusty partner.
(In fact, I actually was planning on getting a minor in math in college, and the first handful of classes—calculus one, two and three, etc.—were no problem. But I specifically remember, at the start of a semester, going to exactly two classes of Linear Algebra (whatever that is), listening to my professor teach for an hour, and having absolutely no idea what he was talking about. None. So I dropped the class and my minor the next day, and haven’t regretted it since.)
Luckily, any math needed for the stock market is basic stuff, and we all have calculators or spreadsheets that do the heavy lifting for us. Today, I want to touch on the four factors that affect your portfolio—they’re really the only four things that determine your portfolio’s return.
The first is the one that most people focus on: Your winning percentage, or what is often called your batting average. This is simply the number of winning trades versus the number of losing trades.
The second factor is routinely named your slugging percentage—that is, the average amount of money you make on your winners, divided by the average amount of money you lose with your losers.
The third factor is something that few investors focus on, but actually has an outsized effect on your total return: your average position size (what percent of your portfolio you invest in each stock).
The last factor is simply your turnover—i.e., how many trades you make per year (or per quarter or per month).
Why write about these four factors? Because, if you’re striving to improve your results, these are really the only four things that move your performance. Think of them as levers—changing one up or down usually affects the others, and it has an effect on your performance.
For example, if you’re determined to have a very high batting average, the chances are you’re not going to take huge positions, and you’re also going to be taking a lot of quick, small profits … thus lessening your slugging percentage. Or, if you decide to constantly strive for big winners, you’re going to have to give your winners time to move up … thus decreasing your turnover.
Are any of these four factors more important than the others? Well, interestingly, most investors focus on their batting average; in fact, investors subconsciously work to not necessarily maximize profits, but to maximize the number of times they are right. That’s why so many investors are quick to sell winners and slow to sell losers (the wrong strategy with growth stocks).
Yet it turns out that your batting average is not overly important for your results, or at least, it’s not any more important than the other factors. Yes, if you’re only correct on 10% or 20% of your trades, you’re doing something wrong. But usually, any batting average above 40% should be good enough to produce profits for you.
As a growth stock investor, I would say the most important factors are going to be your slugging percentage and your position size. If you’re able to keep all your losers relatively small, yet hit on a few big winners each year, while at the same time having the courage to manage a concentrated portfolio (say, 8% to 12% of your portfolio in each position), you’ll be in position to make great money.
I really don’t have any specific conclusion on the best balance between these four factors because, well, there isn’t a perfect balance—as usual, it depends on what kind of investor you are and what your true goals are.
But the next time you’re sitting around looking for ways to improve your results, be sure to do some work ahead of time and determine your batting average, slugging percentage, average position size and turnover. Just examining these four metrics will help you spot the strengths and weaknesses in your investing practice, and hence, help you make more money.
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At this point in the overall bull market that began in March 2009, many stocks have made huge moves and have become rather obvious to the crowd. These obvious names can still work, and in fact, it’s usually true that the best part of the major uptrend occurs in the last 20% of the move—so names that have already had big runs and are still strong could have more in store should the market’s nascent rally continue.
An example here is Baidu (BIDU), which remains one of the top institutional-quality growth stocks in the market. Growth at the firm is truly astounding, and estimates call for more of the same for many quarters into the future. However, after a mega-advance during the past 15 months, it’s hard to say BIDU isn’t already known by most investors. That means there are more investors who will be willing to book some profit, which could stunt any advance.
Just to be clear, I like Baidu a lot and think it could easily have another leg higher, but to be fair, nobody can say the stock is in the second or third inning of its overall advance; more likely, it’s in the seventh or eighth, though we’ll let the stock decide.
In addition to monitoring extended leaders, now is the time to look for new leadership, or stocks that have been good performers during the bull move, but haven’t been the much-talked-about names. These stocks tend to have higher potential for the simple reason that most investors don’t already have a position … and thus, if business is truly turning around, lots of institutional investors will be piling in.
One such stock is Citrix Systems (CTXS), which gapped out of a good-looking base last week following a solid earnings report. Before this gap, the stock had been a decent performer during the bull market, more than doubling during the past year, but it certainly wasn’t on the lips of every investor. But now, thanks to its industry-leading desktop virtualization product, CTXS is acting well.
Even so, my beef with CTXS is that its current and projected growth just isn’t there—even after an analyst ratcheted up estimates, the bottom line is only supposed to jump 4% this year and 17% in 2011. Maybe those numbers are just way too low, but my own experience is that these great charts with so-so growth are not easy to handle, at least after they’ve gapped up.
Another idea isn’t a stock at all—it’s an exchange-traded fund (ETF) that tracks the MSCI Emerging Markets index (symbol EEM). Emerging markets, of course, were all the rage for much of last year, and EEM rallied from a bear market low of 19.5 all the way to 41.3 in October.
But then, the ETF effectively entered into a long consolidation phase—shares made a marginal new peak at 43 in January, but bobbed (down to 36 in February) and weaved (back up to 44 in April) and bobbed (down to 35 in May) and are now weaving again (back up to 42.5 this week).
The bottom line is that shares have been consolidating their huge 2009 advance for more than nine months, and I think EEM is ready to enter a new, sustained upleg. Backing this view is the action of commodity-related stocks, which tend to trade alongside emerging markets (China in particular), and are showing renewed strength.
My bet is that if the market rally is for real, EEM could be a leader among ETFs.
Until next time,
For Cabot Wealth Advisory
Editor’s Note: Mike is the editor of Cabot Market Letter, which was recently rated as one of the best long-term market timers by Timer Digest. Our proprietary indicators keep subscribers in the market when it’s going up and quickly get them out when things go down. Don’t get wiped out by another downturn or miss out on incredible gains when the market is shooting higher. Click here to get started today!