A Stock with a Good Risk-Reward Set-Up

 

How to Speak to Both Old and New

The TtL Methodology

A Stock with a Good Risk-Reward Set-Up

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Advisory publishing is an interesting business because it combines two elements that aren’t found in other enterprises.

First, it’s subscription based, which means that at any given time we have a mix of very long-term subscribers (some have been with us 40 years!), new subscribers (say, between one week and six months “old”), and everything in-between.

Of course, you’ll find that in any subscription business; I’m sure Sports Illustrated has the same mix.

But what’s unique is the second element—that we offer a never-ending stream of advice that builds on itself. We might, for instance, write about or recommend something today because of something we observed in an update a month or two ago. So we constantly have to think of both the people who have been with us for a while and those who may have just jumped on the bus.

Just last weekend, while on a mini-vacation with a group of buddies, I was thinking about the core of our growth stock methodology and how best to explain it to our new subscribers. (To be honest, I was mostly thinking about the NFL Draft, Kentucky Derby, the prize fight of the century and bourbon, but I was also thinking of our core growth stock methodology!)

In terms of explaining our general view of stock selection, I like the SNaC acronym that Paul Goodwin—Chief Analyst of Cabot China & Emerging Markets Report—came up with a couple of years ago. SNaC stands for Story, Numbers and Chart; all three must look good for us to consider buying.

But what about the equally-important rules for stock holding and stock selling? Well, I’m not as good at acronyms as Paul, but I think TtL makes sense—it stands for Tight to Loose, and it applies to both how to handle a position and also how a growth stock generally acts as it works its way higher.

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I’ll start with the “Tight” part of the acronym. The best time to buy a stock is usually when it’s trading tightly—i.e., not making much movement, on quiet volume, which (assuming you’re talking about a stock in an overall uptrend) is a sign no selling is coming to market. I’ll often wait for a tight pattern to resolve itself to the upside before buying, but the point is that a few weeks of quiet, under-the-radar trading is usually a healthy sign.

Tight also applies to how I like to handle a stock right after buying it, i.e., relatively tight loss limits. I did a study for Cabot Growth Investor (formerly Cabot Market Letter) last year that looked at a few years’ worth of losses, basically adding up every single losing trade we had. The results showed that our average loss was just under 12%, and even that figure included a couple of bombs that got away from me during a bad earnings report.

With Cabot Top Ten Trader, we’re usually even tighter with our suggested loss limits, which we give for every stock we recommend. Generally speaking, loss limits in Top Ten are almost always 10% or less, with an average of 8% to 9% or so.

The goal, then, is not just to buy a great company and a stock that’s in a general uptrend, but to find a lower-risk entry point … and then cut any loss quickly if things go awry. It’s not about throwing a dart or being “a long-term investor”—it’s about picking the best stocks at lower-risk entry points and using risk controls to make sure any losses are minor. Makes sense, right?

But what if the stock does what you expect it to, and goes up? That’s when we get into the Loose part of the acronym—for a stock, its action will get a lot looser on the way up. That’s not a bad thing—action on the upside is where our profits come from! Eventually, though, a stock’s action will get very wide-and-loose, which indicates that buyers and sellers are fighting it out … something you often see near intermediate- and longer-term peaks.

Loose also characterizes how we handle our winners. As a stock’s volatility increases, and as my profit cushion grows, I tend to give a stock more and more rope, gradually stretching my mental stop from the current stock price. That doesn’t happen by lowering my stop—I don’t have a stop at 50 one day and then 46 the next. But I will give my winners more room to correct and consolidate in order to hopefully ride out a longer-term uptrend.

Often, I’ll also book partial profits (usually selling one-third of my shares) after a good run, which allows me to give my remaining shares even more rope (while also taking some risk off the table).

So for stock selection, you want to buy stocks that have great stories, excellent growth numbers and a good, uptrending chart. When handling a stock, you want tight charts and use tight stops initially, and then loosen stops (and possibly take partial profits) as the advance progresses, especially with your biggest winners.

Obviously, there’s more to the system, but if you understand that, you understand 80% of what Cabot’s growth stock philosophy is about. Best of all … it works!

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I remember back in the spring 2004, all of our key market timing indicators were positive, but the market and most of our stocks were just chopping sideways after big runs in 2003. “I’m optimistic, but apprehensive,” our founder Carlton Lutts said at the time, “because we’re not going anywhere.” Carlton’s comment came to mind a week ago, and I used the title “Apprehensively Optimistic,” in last week’s Cabot Growth Investor.

And it turns out there was good reason for that—this week, the selling has continued enough to turn one of my key market timing indicators (called the Cabot Tides, which measures the market’s intermediate-term trend) bearish.

I had already been paring back ahead of the sell signal based on the poor action among growth stocks—last week saw a ton of gaps lower on earnings reports, which is rarely a good sign, and even the best growth stocks were basically chopping around, not pushing higher.

Now, I’m not getting too negative here—it’s certainly possible for growth stocks to kick into gear at any moment, especially with earnings season still underway. However, I’m playing things cautiously for the moment. That means holding my stocks that are above support, but jettisoning any stocks acting abnormally and being very selective in any new buying.

On the buy side, I’m looking for stocks that are (a) acting calmly despite the choppy action and (b) are near support, so I can use tight loss limits to limit risk if things go awry.

One name that fills the bill right now is Valeant Pharmaceuticals (VRX), a drug firm that has made its mark by acquiring competitors, cutting costs and executing brilliantly on its expansion plans. Here’s what I wrote about the firm in this week’s Cabot Top Ten Trader:

“While many biotech stocks have hit the skids lately, medical stocks that are executing well and have upcoming positive catalysts are still finding buyers. Valeant Pharmaceuticals is one of the winners, with the stock quickly snapping back from a brief selloff last week after another excellent quarterly report. The big idea here is that Valeant is something of a roll-up story in the drug field—it has bought a ton of firms over the years, and has a pristine record of buying great assets and then cutting costs and growing the acquired business. Its latest acquisition earlier this year of Salix Pharmaceuticals (an emerging leader in gastroenterology) brought some hit products and a strong development pipeline, and Valeant believes significant accretion is likely from that deal in 2016. Meanwhile, last quarter was another great one for Valeant, with sales and earnings topping expectations (despite some currency headwinds), and management boosting guidance going forward. Analysts now see the company’s bottom line up 34% this year and another 39% next year, and while another huge acquisition is unlikely at this time, a small purchase or two would boost growth expectations further. In this choppy environment, the firm’s top-notch execution, big growth expectations and reasonable valuation make it a compelling investment.”

Chart-wise, the stock had a nice run for a few months into February, but then consolidated tightly for about eight weeks. And then, following earnings last week, VRX surged to new highs on good volume before pulling back a bit this week.

I think VRX is a lower-risk buy around here, and you can use a stop in the 202-203 range, which, percentage-wise, isn’t far from the current price. Or, of course, you could just wait patiently for the market to find its footing and re-enter an uptrend. Either way, VRX looks like a stock to at least be high on your watch list.

For further updates on VRX and additional momentum stocks, take a trial subscription to Cabot Top Ten Trader. The advisory features a wide array of stocks and sectors you can benefit from in as little as 30 days. Our most recent issue features a diverse mix of strong stocks, including a huge data center operator whose recent transition to a REIT structure has added tax advantages and generous dividends to the major growth story. 

Sincerely,

Michael Cintolo
Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader


Michael Cintolo can be found on Google Plus.

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