Now that we know what causes market trends and what causes stocks in these trends to outperform other stocks, how do we hone in on these stocks that will outperform – while or even before they do so?
How to definitively NOT find them
Before we get into this, let’s look at a couple of things not to do. You should NOT speculate in a stock based on whether a company has a great product, service, that has good reviews, etc. – at least NOT ONLY. This can still be the case, but needs to be corroborated by other factors. You should also not buy a stock because you personally like or work at a company, because it has a good work environment, etc.
Another thing you definitely should not do is buy stocks based on valuations. A major mistake of private speculators is that they think they need to act like huge mutual funds, using valuation models and having all their capital tied up in the market almost all the time. I’ve written a lengthy article on my blog on the fallacy of valuations for the small speculator. There, I explain that stocks that have low valuations tend to be in established downtrends, and buying it there will likely cause immediate losses from the likely continuation of said downtrend. The same is true for selling a stock due to overvaluation – a stock in an uptrend will more likely tend to stay in that uptrend, and the market does not care what we think something should be valued at.
It’s very important to grasp that a stock’s price has momentum. Due to various elements of crowd psychology that we will discuss later, stocks that trend up are much more likely to continue trending up further than to reverse, and vice versa. Check out below the up-trend of Moderna (MRNA) in 2020 to 2021, and the down-trend of Affirm (AFRM) in 2022, to see this in action. The black bars in the chart represent price development over time, which we’ll get into much more detail later.
The details are not really that important here, but to sum up, cheap stocks tend to attract even more selling and lose even more value, and expensive stocks on average tend to attract even more buying and thus rising prices. Valuations are useful for someone deciding whether to put 50 Billion dollar into a stock and hold it for ten years, but for those “smaller” operators of us aiming for more active management, they are irrelevant.
How then do we find the best stocks that institutions are shoveling their money in, much like a mad coal worker shovels fuel into the engine car on an old steam locomotive?
Don’t try to “out-research” the big boys
You could try to front-run them and make an educated guess what they will buy by using their own methods. But you will quickly run against a brick wall quickly there.
Institutional investors have access to the best research in the world, paying literally floors or whole buildings of analysts to find the most promising upcoming companies in the market – studying costly datasets, phoning or getting audiences with company CEOs, and much more.
Neither do you have access to this research, nor the resources to replicate it, nor will institutional investors freely hand it to you. There are quarterly SEC ownership filings that funds have to submit, but these are 3 months late and there are many thousands of funds to look through …
A two-pronged approach
But you don’t have to, as there is a much easier way – because you can see where and when they act to buy or to sell given stocks.
There are two factors that corroborate each other here. One, the fact that a stock IS already being bid up heavily by institutional money (which causes a trend as we discussed), to be spotted on a stock chart – and Two, finding a reason why it should continue to be bid up, a reason why we can expect a trend to continue further for a while and thus to profit from, to be found in fundamental review.
The next two guides will briefly outline each from a high-altitude perspective.