A few months ago, I needed a DVD player. I didn’t care if it was fancy, I wanted something fast, and didn’t feel like spending much money on it.
So I picked up a little portable player at CVS for about $30. Quick, easy and it served the purpose.
For a short time.
The other day it just randomly stopped working. And I really wasn’t surprised – after all, it was a $30 piece of you-know-what.
This might seem surprising, but the same principle holds true with stocks. You get what you pay for. Some stocks seem like decent purchases, but in many cases, they don’t have what it takes to really deliver results for you.
There’s plenty of garbage available on the stock market. Yes, garbage. Companies with no earnings history. Stocks that sell for less than $10 a share. Stocks that trade very few shares every day.
Let’s look at why each of these factors could have a big effect on a stock’s potential to rise higher.
1) No earnings history:
A lot of people don’t realize this, but the main buyers of stocks are professional investors, not individuals. When you pick up 1,000 shares of a stock, that’s a drop in the bucket, compared to what mutual funds, hedge funds and pension funds are buying.
Those guys accumulate shares in the tens of thousands on up, even in the millions. And they’re drawn to companies that have been profitable, and which have the potential to be even more profitable in the future. And because they are investing huge sums of money, they’re forced to get in and out of shares at a somewhat measured pace.
As a result, they’re on the lookout for companies that already have a stable history of earnings, and which appear likely to grow earnings even more.
Do stocks rise without profits? Of course. You can see it every day. But frequently, those increases last only a short time, while speculators run the stock up, or a rumor drives a buying frenzy.
For example, here’s a chart for ICXT, a cheap stock which had a huge price run-up in late December. The company, which makes sensors that detect chemicals that could be a threat, zoomed higher after the Christmas Day failed terrorist attack, and investors’ speculation that ICXT and other defense companies would profit from increased investment in the airline security sector.
But it just as quickly pulled back, retracing a third of its gains over the next three weeks.
And that’s not unusual, in more speculative company like ICXT.
Stocks like this are not typically those that professional investors continue buying for weeks and even months.
If you’re a day trader, someone who likes to get in and out of stocks and take a quick profit, these speculative names might make sense.
But that’s not a very simple approach is it? It requires constant vigilance about your stocks, and constant updating of a watch list. You have to stay extremely current on which names are zooming higher, and be ready to buy quickly. You also have to sell fast, to escape sudden downdrafts which these stocks are prone to.
It’s very time-consuming, too, another strike against simplicity.
2) Stocks that sell for less than $10 a share:
Some of the same principles that apply to unprofitable companies also apply here.
Professional investors don’t put much money into cheap stocks. These stocks are generally very erratic and illiquid, limiting the exposure that mutual funds, hedge funds and pension funds can have.
That means the price isn’t likely to go on a sustained run-up, because there simply aren’t enough buyers.
So again, if you want to chase the cheaper stocks, be prepared for a lot of ongoing research. You’ll also have to act quickly when it comes time for buying and selling. Again – that’s not really simple and easy.
Bear in mind, there will, of course, be exceptions. Cheap stocks can suddenly zip higher on some piece of news, or even just a rumor.
But the risk of sharp, sudden downside volatility is high. And it’s no simple matter to remain vigilant for those fast shifts in direction.
3) Stocks that trade very few shares a day:
So we’ve already seen how this one applies, since cheap and unprofitable companies are often thinly traded.
In a bull market, the best stock gainers typically trade about a million or more shares a day. That’s the kind of level that professional investors seek.
Why? It’s because they have so much money they need to deploy. For example, if a fund has $100 million under management, its manager needs to find highly liquid, profitable, stable stocks to put the money into. That’s because if the fund is invested in illiquid stocks that don’t trade many shares, the fund can’t quickly reverse its decision and pull out all its money fast, if the investment suddenly turns south.
So they mitigate their risk by buying stocks with the traits we’ve discussed here: Profitability, a high number of shares traded, and relatively high price.
For example, as of this writing, Fidelity’s Software & Computer Services Portfolio has around $101 million under management. Its top 10 holdings range from trading 1.7 million shares a day (BMC Software) up to 49.4 million shares a day (Microsoft).
Most funds will keep the majority of their holdings in these widely traded stocks. The liquidity makes it easer for them to maneuver.
So if you want to simplify your investing, and still make sure you will be getting outstanding performance, look for stocks that show a recent history of profits, are trading above $10 a share, and which trade at least 1 million shares each day. Those are the qualities professional investors are generally seeking.
By the way, this isn’t a new discovery. It’s something that the most successful growth investors have used for the past 50 years, because it’s been proven to work.
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