HELPFULFACTS.NET

I must admit, I am not smart enough to have devised these ridiculously simple trading rules. A great trader gave them to me some 15 years ago. However, I will tell you, they work. If you follow these rules, breaking them as infrequently as possible, you will make money year in and year out, some years better than others, some years worse - but you will make money. The rules are simple. Adherence to the rules is difficult.
“Old Rules…but Very Good Rules”

If I’ve learned anything in my 17 years of trading, I’ve learned that the simple methods work best. Those who need to rely upon complex stochastics, linear weighted moving averages, smoothing techniques, Fibonacci numbers etc., usually find that they have so many things rolling around in their heads that they cannot make a rational decision. One technique says buy; another says sell. Another says sit tight while another says add to the trade. It sounds like a cliche, but simple methods work best.

1. The first and most important rule is - in bull markets, one is supposed to be long. This may sound obvious, but how many of us have sold the first rally in every bull market, saying that the market has moved too far, too fast. I have before, and I suspect I’ll do it again at some point in the future. Thus, we’ve not enjoyed the profits that should have accrued to us for our initial bullish outlook, but have actually lost money while being short. In a bull market, one can only be long or on the sidelines. Remember, not having a position is a position.
2. Buy that which is showing strength - sell that which is showing weakness. The public continues to buy when prices have fallen. The professional buys because prices have rallied. This difference may not sound logical, but buying strength works. The rule of survival is not to “buy low, sell high”, but to “buy higher and sell higher”. Furthermore, when comparing various stocks within a group, buy only the strongest and sell the weakest.
3. When putting on a trade, enter it as if it has the potential to be the biggest trade of the year. Don’t enter a trade until it has been well thought out, a campaign has been devised for adding to the trade, and contingency plans set for exiting the trade.
4. On minor corrections against the major trend, add to trades. In bull markets, add to the trade on minor corrections back into support levels. In bear markets, add on corrections into resistance. Use the 33-50% corrections level of the previous movement or the proper moving average as a first point in which to add.
5. Be patient. If a trade is missed, wait for a correction to occur before putting the trade on.
6. Be patient. Once a trade is put on, allow it time to develop and give it time to create the profits you expected.
7. Be patient. The old adage that “you never go broke taking a profit” is maybe the most worthless piece of advice ever given. Taking small profits is the surest way to ultimate loss I can think of, for small profits are never allowed to develop into enormous profits. The real money in trading is made from the one, two or three large trades that develop each year. You must develop the ability to patiently stay with winning trades to allow them to develop into that sort of trade.
8. Be patient. Once a trade is put on, give it time to work; give it time to insulate itself from random noise; give it time for others to see the merit of what you saw earlier than they.
9. Be impatient. As always, small loses and quick losses are the best losses. It is not the loss of money that is important. Rather, it is the mental capital that is used up when you sit with a losing trade that is important.
10. Never, ever under any condition, add to a losing trade, or “average” into a position. If you are buying, then each new buy price must be higher than the previous buy price. If you are selling, then each new selling price must be lower. This rule is to be adhered to without question.
11. Do more of what is working for you, and less of what’s not. Each day, look at the various positions you are holding, and try to add to the trade that has the most profit while subtracting from that trade that is either unprofitable or is showing the smallest profit. This is the basis of the old adage, “let your profits run.”
12. Don’t trade until the technicals and the fundamentals both agree. This rule makes pure technicians cringe. I don’t care! I will not trade until I am sure that the simple technical rules I follow, and my fundamental analysis, are running in tandem. Then I can act with authority, and with certainty, and patiently sit tight.
13. When sharp losses in equity are experienced, take time off. Close all trades and stop trading for several days. The mind can play games with itself following sharp, quick losses. The urge “to get the money back” is extreme, and should not be given in to.
14. When trading well, trade somewhat larger. We all experience those incredible periods of time when all of our trades are profitable. When that happens, trade aggressively and trade larger. We must make our proverbial “hay” when the sun does shine.
15. When adding to a trade, add only 1/4 to 1/2 as much as currently held. That is, if you are holding 400 shares of a stock, at the next point at which to add, add no more than 100 or 200 shares. That moves the average price of your holdings less than half of the distance moved, thus allowing you to sit through 50% corrections without touching your average price.
16. Think like a guerrilla warrior. We wish to fight on the side of the market that is winning, not wasting our time and capital on futile efforts to gain fame by buying the lows or selling the highs of some market movement. Our duty is to earn profits by fighting alongside the winning forces. If neither side is winning, then we don’t need to fight at all.
17. Markets form their tops in violence; markets form their lows in quiet conditions.
18. The final 10% of the time of a bull run will usually encompass 50% or more of the price movement. Thus, the first 50% of the price movement will take 90% of the time and will require the most backing and filling and will be far more difficult to trade than the last 50%.

There is no “genius” in these rules. They are common sense and nothing else, but as Voltaire said, “Common sense is uncommon.” Trading is a common-sense business. When we trade contrary to common sense, we will lose. Perhaps not always, but enormously and eventually. Trade simply. Avoid complex methodologies concerning obscure technical systems and trade according to the major trends only.

How to Identify Short Candidates
Friday February 8, 2:11 pm ET
By David Brown

Gather a group of portfolio managers and active traders together and you’ll hear about a broad assortment of diverse strategies, but one point on which you’ll likely find agreement is that the most difficult task is selecting stocks for shorting. This might seem easier when the market is falling, but in fact consistently finding stocks that will underperform the market indexes is difficult under any conditions. After all, companies are in business to do well and management is focused on bolstering shareholder wealth — using any and all available tactics.
Many traders will just play the charts. That is, they will use their favorite technical indicators to find good short-term or swing trades, such as shorting stocks, buying puts, or opening options spreads. For them, technicals seem to be more reliable than fundamentals when playing the short side. And for very short-term trades, this may be true. However, for longer-term position trading, long/short strategies, pairs trades, or portfolio hedging, pure technical trading often loses its effectiveness, and fundamentals gain much more importance.

For the past 30 years, after applying quantitative models to develop the lunar landing module for NASA, I have been applying my expertise to the equity markets to seek small systematic edges in the challenging pursuit of alpha. Throughout that time, I have been an active investor, trader, analyst, newsletter author, and the CEO of two publicly traded companies serving the investment community, and I currently lead an equity research firm that serves institutional investors, portfolio managers, and self-directed investors.

In my view, these are the five fundamental factors (or “red flags”) that are most useful in identifying stocks poised to underperform the market:

1. Company Growth Ratio. Stock valuation versus anticipated future earnings performance is a cornerstone of any short strategy, often through a trailing or forward PEG ratio. I prefer a slightly different version that I call Company Growth Ratio (CGR). It is the projected 5-year EPS growth rate divided by the projected next fiscal year P/E. So, high is good, low is bad (which is the opposite of PEG). This factor has tested well as an indicator of 3-12 month performance both on the long and short sides.

Investors rarely confine their interest in a stock to only the current year’s data since that data is already discounted. So in essence we are asking, “How much must we pay for the growth that we expect over the next 5 years?” Rather than use current P/E, we use the Projected P/E, i.e., the P/E that will exist if at its current price the company earns what is expected during the next fiscal year. In other words, we assume that most investors are pricing in the next year’s growth. , as shown in the following chart.

2. Net revisors. This factor is the percentage of Wall Street analysts who follow the stock who have lowered their current year earnings estimates during the past 30 days. If a large percentage of analysts have done so, then lowered expectations for the company’s earnings is relatively new news. Again, this indicator tests well in its ability to forecast lower prices ahead. Thus, by combining these first two indicators, we are saying that we want companies that are relatively overvalued in light of their future growth prospects (factor #1) and have had the current year earnings forecast lowered by a significant number of analysts in the past 30 days.

3. Projected next year’s earnings growth. We want to focus on companies that are expected to show decreased earnings next year versus the current fiscal year. The greater the percentage decrease identified by analysts, the more we like them as a short candidate. So not only do we want the company to be overvalued against next year’s projected earnings (factor #1) but we want that earnings figure to be lower than what is expected this year.

4. Value and growth ratios. Frequently, companies that have exhibited poor growth have a relatively low P/E and hence a high perceived value. But here we want stocks that are forecasted to have poor growth and yet still have poor value (i.e., a rich price). Surprisingly, this is not hard to find. Poor value is represented by relatively high price to book, price to cash flow, and price to sales, as well as low dividend yield. Poor growth is represented by declining forward year-over-year projected growth rates in earnings, revenues, and cash flow.

5. Earnings quality. Here we look for factors like poor ratios of cash flow to reported earnings, slowing receivables and inventory turnover, and aggressive accounting practices (as identified by a forensic accounting score.) Overall earnings quality is a factor which has significantly increased in importance over the past 5-7 years. I suppose we have Enron to thank for that.

As an example, the following chart illustrates the historical performance of my composite long-term value rank. It shows the cumulative bottom decile return of the S&P 400 mid-cap universe vs. the overall index return, rebalanced monthly for a 10-year period.

When making a final selection of short candidates, it’s also good to stick with the weaker overall sectors with respect to recent price performance.

One important caution is to stay away from individual stocks carrying high short interest levels. That might seem counterintuitive, but excessive short interest can easily fuel a powerful short-covering rally — leaving you holding the bag.

So how has this model performed? Well, let me give you a real world illustration of how I have used these factors in an integrated manner. In October 2007, Forbes Magazine invited me to participate in the annual “Love Only One” stock-picking contest in which a dozen institutional analysts were invited to submit a long pick and five were asked for a single short pick — all to be held for a full 12-month period starting with the closing price on October 31, 2007. Each of us would be judged on how the selected stock performed over that time period. I was asked to select a short.

With the help of my team at Sabrient, we initially identified five short candidates for entry positions out of a large database of stocks having analyst consensus estimates to work with. The following table shows how much each had fallen as of January 22, 2008.

Our top pick was FreightCar America Inc. (NasdaqGS:RAIL - News), and it was submitted to Forbes as my single short selection. The CGR was in the lowest 7% of our stock database. Net revisors was in the 50th percentile — not too bad. Projected earnings growth next year was in the 30th percentile. Its value rank was in the 35th percentile and the growth rank was quite low, appearing in the 17th percentile. Finally, the earnings quality metric produced a terrible score, all the way down in the 2nd percentile. All of these combined to create a composite score in the bottom five of all eligible stocks.

I should emphasize that this does not mean RAIL is the worst company in America — far from it. It just means that its prospects when combined with its current earnings outlook made a price decline highly likely. The other four companies in our bottom five were Palm (NasdaqGS:PALM - News), USG Corp. (NYSE:USG - News), Idearc Inc. (NYSE:IAR - News), and First Community Bancorp (NasdaqGS:FCBP - News).

As shown, all five have fallen substantially. In fact, as of 1/22/07 (less than 3 months), the average drop was an astounding -35.9% while the S&P 500 was down only -15.4%.

Of course, it’s easier to find these stocks when you have access to a robust computer model and database like a quant research firm. Also, keep in mind that a fundamental outlook can change suddenly due to significant events like mergers, takeovers, strategic partnerships, breakthrough products, etc.

Nevertheless, when you are looking for short plays and have identified a list of possible candidates through other means (e.g., charts), focusing on stocks with the weakest fundamentals should help enhance your returns. I have found that the fundamental red flags include:

1. Low Company Growth Ratio (projected 5-year EPS growth rate divided by the projected next fiscal year P/E)

2. Reduced current year earnings projections by Wall Street during the past 30 days

3. High percentage decrease in earnings expectations for next year

4. Poor value (high price ratios) coupled with poor growth prospects (declining projections for earnings, revenues, cash flow)

5. Poor earnings quality, including declining ratio of cash flow to earnings, slowing receivables, and aggressive accounting practices.

This should encourage you to look beyond the charts and technical factors when seeking longer-term position trades on the short side, such as for long/short strategies, pairs trades, or portfolio hedging.