Pasadena IBD Meetup

Investing with Conviction

March 13, 2013Mike Scott

If you don’t have rules to keep you in a stock you will never make big money

William J O’Neil

What are common themes connecting each Wednesday’s IBD article How To Find & Own

America’s Greatest Opportunities?

Themes

1. Impeccable timing2. Knowing the company3. Having a set of trading rules4. Investing with conviction

THE MARKET

KNOWINGYOURSELF

THE “IT” FACTOR

FUNDAMENTALSAND

TECHNICAL ACTION

THE ECONOMY

PYRAMID OF CONVICTION*

* Developed by David Sato Chung

The EconomyMarkets respond to decadal shifts in demographics, technologies and world economies

– Technological innovations create gigantic shifts in allocation of resources

– Resource ConstraintsShortages/Over Supplies

Government induced constraints

– Government policies

– Global consumerism

Steam engine AutomobilesElectrification InternetRadio/TV Biotechnology

Tax cuts / Interest Rates Deficit spending

Growing welfare states Making war

Demographic Trends Effect Markets

Baby boomers will spend less overall but will spend more in areas like health care and wellness, nursing homes and assisted-living facilities, and in conveniences like lawn and gardening care. The up and coming (albeit slightly smaller) echo boom generation will spend more on the basics as they form new families in the next decade, on things like apartments, starter homes, smaller cars, basic furnishings, basic cosmetics, and etc…. Harry S. Dent

10,000 boomers turning65 every day

Where are We in theSecular Market Cycle?

Low cyclically adjusted P/E appears to be necessary to initiate a secular bull market

Cyclically Adjusted P/E PerspectiveP/E = S&P Price/10-Year Avg Earnings

1982

1950

Source: http://www.econ.yale.edu/~shiller/data.htm

You arehere

Need toget here

S&P500 Cyclically Adjusted Price/Earnings

Market Timing• 75% of stocks follow the major trends in the market• Your chances of landing a big winning stock are much greater

at the beginning of a bull market• Typically cyclical bull markets last 3-5 years

– Containing 2+ up legs separated by intermediate corrections– Most leading stocks will breakout at the beginning of the bull market

run. Others will sporadically breakout somewhere in the first two years

– Late stage initial breakouts are suspect• Try to know where you are on three time scales

– Secular, multi-cyclical cycles– Cyclical, multi-year cycles– Intra cycle, early-middle-late

Higher Risk

Lower Risk

12

3

You are here

Two cyclical bull markets in a secular bear market, so far

Secular Time Frame Risk

Cyclical Time Frame Risk

Tools to Navigate Cyclical Trends

• Follow-through days with action of leading stocks signals shift from cyclical down move to a new rally

• Market School exposure model-a refinement of the above

• Other tools– IBD6000 %E (IBD)– Coppock curve (www.freestockcharts.com)– Market internals thrusts (Eureka, Phoenix)

Market Thrusts

• NYSE market internal data (Advancing issues, Declining issues, Advancing Volume, Declining Volume)– Eureka: Positive thrust, three conditions:

• A/D > 2.98• Adv Vol/Dec Vol > 5.4• (A/D)/(Adv Vol/Dec Vol) < 0.63

– Phoenix: Negative thrust, three conditions• A/D < 0.63• Adv Vol/Dec Vol < 0.33• (A/D)/(Adv Vol/Dec Vol) > 2.43

A Eureka within 2 weeks of a FTD increases likelihood of a tradable rally

Monthly Coppock

Helpful for cyclical cycle starts

Buy BuyBuy

Weekly Coppock

Helpful for intra-cycle starts

Buy BuyBuy

Weekly Coppock buy within 4 weeks of a FTD produces higher probability of a tradable rally

IBD6000 Index %E

%E = 100*274/(723+2542+1293+809+274) = 4.9%Low %E (<7.4%) on FTD often leads to rally failure

Follow-through day compilation

  10/10/2012     All Markets   Bull Market   Bear Market    Total Pass Fail   Total Pass Fail   Total Pass Fail  FTD   83 32% 67%   53 42% 58%   30 17% 83%           +Eureka   42 43% 57%   27 48% 52%   15 35% 65%  -Eureka   41 22% 78%   26 35% 65%   15 0% 100%                    Coppock          <4 weeks   31 61% 39%   20 80% 20%   10 40% 60%  > 4 weeks   52 15% 85%   31 19% 81%   20 5% 95%                    %E <7.4%   24 13% 88%   15 20% 80%   9 0% 100%  %E > 16%   28 21% 79%   14 29% 71%   14 14% 86%  In-Between   30 60% 40%   23 65% 35%   7 42% 57%  Unknown   1               

 +Eureka

+Coppock  21 76% 24%   14 86% 14%   7 57% 43%

This is what a new cyclicalBull Market looks like

A new bull market is born…Just when the biggest opportunity is there the news is often just terrible. Without mechanical rules to operate by most investors will not act.

The “IT” Factor

• The Fundamentals• The Story• The Behavior– The path chosen– Price Targets

IT Factor Fundamentals Screen

Screen developed by David Sato Chung around Cisco and Microsoft fundamentals before they

made their big run

Price Club “IT”Story

“I saw my first Price Club in the summer of 1981…they only had two stores then…every gondola was packed with $100-$200 or more of merchandise. So Price Club had just invented a new type of cash-and-carry wholesale warehouse store.” WJ O’Neil

Leading-Stock BehaviorIf you know how leading stocks have behaved in the past you are prepared to handle them in the future

1997-2000 Model Book% Move of Length of % Pullback Length of Length of Weeks in PercentBreakout Run after Pullback Consolidation Move MoveRun Days Breakout Days Days

Average 34 15 -17 7 16 56 1532Median 22 9 -16 4 12 61 1031

Best 142 99 -11 1 4 16 872910th Percentile 72 35 -12 1 6 20 309120th Percentile 46 22 -13 2 7 25 205650th Percentile 22 9 -16 4 12 61 103180th Percentile 14 4 -20 8 21 73 56690th Percentile 10 3 -25 14 33 94 448Worst 4 2 -34 60 83 139 228

% Move of breakout run represents increase from close on breakout day to the intraday high that precedes the first 12% or greater pullback

Length of consolidation represents total number of days from the intraday high of the breakout run to the date the stock closes in new high ground

Leading Stock Behavior

Bull market 2nd year Model Book

Beware of quick to bottom stocks and short bases P/E expansion is a key methodto develop conviction

F 5 Networks P/E Expansion Target

145.76, close enough

P/E Expansion Target 136.40

BIDU 130% P/E Expansion

165.96, Close enough

Expansion Target 171.12

ALXN P/E Expansion

130% P/E Target = 120.61

Use 98% P/E Expansion on Large-caps and Cyclical Stocks

Price Target = $718

$705.07, close enough

Know your chartsFlawed chart patterns should usually be avoided

– Buy point not within 15% of 52-week high– Base too short: 7 weeks for cups and double bottoms– Lagging RS line– Vee-shaped cup patterns, should be rounded– Too quick to the bottom (<=2 weeks)– More down weeks (days) with above average volume closing in lower

40% of range than up weeks (days) with above average volume– Correction too deep (>30-35%)– Handle in lower half of base– Lack of tight closing weeks in base– Volume not drying up at bottom of base and handle– Unrecognizable base pattern– Late stage base– Already reached price target

-1+1-1

+1-1

-1 +1S+1

-1

+1-1+1

Upper60% of Range

Support Bar

Accumulation/Distribution Bar Counting

Lower40% of Range

DistributionBar

Any Positive Close

AccumulationBar

S

+1+1

Breakout

Net Count: -1 -1 -1 +1 -1 +1 -1 +1 +1 +1 +1 +1 = +2Daily (not shown): +7

First Week of Base

Net Accumulation-Distribution Weeks and Days Study

• The Accumulation bar minus distribution bar count should be performed on both the weekly and daily charts and the results netted to a single number

• A study was conducted that included 433 stocks that were on the IBD 50 (100) which broke out from 2003 through 2007

• There is a clear performance bias to selecting only stocks with non-negative net counts

Percent of stocks that achieve profit level

Net A-D Stop Loss_Profit Plan

Bar Count 5%_15% 7.5%_22.5% 7.5%_30%

All (433) 38% 36% 30%

<0 (114) 13% 12% 9%

0 (44) 39% 34% 25%

>=0 (319) 39% 37% 32%

>= 5 (98) 38% 40% 37%

2010 100-Best Stock Study

• Pick liquid stocks with great fundamentals showing strong supply/demand

0 50 100 150 200 250 300 3500

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% Gain vs. Liquidity ($M)

0.0 1.0 2.0 3.0 4.0 5.0 6.00

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% Gain vs. Demand/Supply (%)

0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.00.0

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% Gain vs. PTM+ROE

84.0 86.0 88.0 90.0 92.0 94.0 96.0 98.00.0

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% Gain vs. Comp Rating

Preferred Stocks to Buy• US Stocks, ADR’s are okay but none from countries where rule of law or transparency is in

doubt (USSR, Venezuela, etc.)• IPO’s may be purchased. Prefer IPOs and ADRs who are underwritten by one of the

following underwriters: – Goldman, JP Morgan, Morgan Stanley, Merrill – Credit Suisse okay for the Chinese stocks

• Liquidity (price times average volume) greater than $20M/day, greater than $40M/day is ideal

• Minimum price $15 (NYSE) $20 (NASDQ). Consider the market, towards the end of a cycle where stock prices have been bid up. Lower cost stocks (even $50 stocks) could be suspect at the end of the cycle.

• Demand/Supply (50dma volume percent of float) 1% or greater, 3% or greater is ideal• Prefer higher quality CANSLIM fundamentals. Prefer stocks with:

– Triple-digit EPS gains– 3 quarters of EPS acceleration– 3 Quarters of Sales acceleration– 3 Quarters of increased Intuitional Sponsorship– Pre-Tax Margin + ROE > 50%

• Stock is owned by one of the high quality mutual funds• Satisfactory responses to Three Questions:

– Is this the very best stock I could own?– Where is the stock in the cycle? Where is the market in its cycle?– What do I think the stock pattern could be? This is important for an early entry

Knowing Yourself

• Investing is like Baseball– Each team plays 162 games in a season– LA Dodgers 2012 standing was 53% games won– This means they lost 47% of their games– How do the players maintain high morale in the

face of many lost games?– Same problem with investing

• Investors need a method to keep moral up

• Baseball Players are taught to focus on batting, running, throwing and catching

• If they are better at these basics than the teams they play, the win-loss record will take care of itself

• Same with investing

Where we go wrong

• Violate a rule—This undermines your confidence – Single best reason why to follow the rules

• Not cutting losses• Selling winners too soon, fear at work

– If you don’t have a rule to keep you in a stock you will never achieve 100% gains

• Averaging down on losers, ego at work• Trading against the trend, greed at work• Buying a stock before it proves itself, act on what you see,

not what you want to see• Holding out for the last fraction of a point, greed at work• Bottom Fishing• Keeping a pet stock, draws attention away from leaders

Investing with Conviction

Wow!

3 Year EPS +110%Annual Sales +53%ROE 55.4%

P/E Expansion Target >$100