Book Summary by Blinkist
You should learn stock chart patterns, and one pattern especially.
If you study the history of the stock market, you’ll notice that many things remain the same. Regardless of the era, there are great winners and great losers: stocks that have climbed over a short period of time, those that have crashed, and those that have just plodded along unprofitably.
This means that you can learn from the behavior of past stocks and apply it to the present. Whether it’s the dramatic movements in the Northern Pacific Railway at the beginning of the twentieth century or Apple in the twenty-first, you can learn from history.
And the best way to do that is to read stock charts.
The key message here is: You should learn stock chart patterns, and one pattern especially.
In almost every field, we assess current conditions to plan our next move. Think of the X-rays, MRIs, and brain scans doctors use to treat illnesses before they progress. Or consider how seismic data is used by geologists to study earthquakes or to help companies find hidden oil reserves.
By learning to see patterns that have replicated themselves time and time again, we can decide how to act in the present. The same is true for investing. We can use all of the stock-market data from the last hundred years to find patterns. That way, we know when to jump in, or out, of a stock. Many investors fail to do this, and unless they’re spectacularly lucky, they lose money.
So, what should you be looking for in stock charts? Quite simply, price patterns.
There are many price patterns, but one of the most important to remember looks like a cup with a handle. In fact, that’s its name: Cup with Handle. So, after rising for a period of time, a stock will often fall. As it falls, it sometimes makes a rounded, downward curve, which then becomes a steady, flat line. This is the base of the “cup.” This base is very important. Because, without a strong base of investors who believe in the stock, it could just collapse. But with this solid foundation, the stock will rise properly when its fortunes change. As it climbs upward, it will form the other side of the cup. Just then, it dips back again, and it will form the “handle.” It’s precisely at that point that you should buy in. More times than not, the stock will shoot upward.
Whether the stock is Apple in the 2000s or Sea Containers in the 1970s, this trusty stock-market pattern has resulted in great rewards for investors over the decades.
An increase in earnings is the most important quality in a good stock.
It’s very simple: profitability is the key to any successful business. And, generally speaking, with a successful business comes a growing stock price. It figures, then, that when choosing stocks, you should look for those with big earnings increases.
The key message here is: An increase in earnings is the most important quality in a good stock.
Firstly, history bears this out. Consider two modern tech giants, Google and Apple. Google started trading at $85 per share in 2004 and climbed to $700 in 2007. Then, in only 45 months, Apple went from $12 per share to $202.
Yes, both companies were revolutionizing their particular space. But they also showed a big increase in earnings just before their stocks shot up. Google showed earnings gains of 112 percent and 123 percent before its stock rocketed. As for Apple, its earnings were up a staggering 350 percent in the quarter before the stock really took off.
However, as with so much in the stock market, there are pitfalls to this approach. One of these is getting dazzled by rumors of big future earnings. For instance, during the big internet boom of the late 1990s, there were many speculative stocks. They didn’t have concrete earnings to show for themselves. Investors were drunk on the optimism of the moment, though, so they bought into them.
Come the dotcom crash, these companies suffered enormous declines. But tech companies which did have serious earnings, like AOL and Yahoo!, suffered much less. So, the lesson here is: only invest in companies with real, growing earnings.
When searching for these profitable companies, you should focus on the earnings-per-share or EPS number. This number is calculated by dividing a company’s total after-tax profits by the number of shares issued. You should search for companies with big, consistent percentage increases in their EPS number.
Of course, you shouldn’t buy a stock on earnings growth alone. There are other important factors to consider, which we’ll look at in the coming blinks. But the percentage increase in EPS is the most important factor to look at when making a decision to buy.
Innovative companies can make for a good return, but you need to know when to invest in them.
For over a century, the US has been an engine of change. It has brought disruptive technology to the rest of the world – from Thomas Edison’s incandescent lightbulb to the digital inventions of Silicon Valley.
This affects stocks, too. Study the stock market from 1880 onward, and you’ll see that companies which introduced revolutionary technologies also enjoyed rocketing stock prices. Great returns on the stock market and innovation go hand in hand.
The key message here is: Innovative companies can make for a good return, but you need to know when to invest in them.
Innovation has led to remarkable stock-price growth over the years. There’s Northern Pacific, the first transcontinental railroad. From 1900 onward, its stock shot up 4,000 percent in only two years!
Then, between 1913 and 1914, General Motors’ new automobiles fueled a stock rise of 1,368 percent.
Or take Cisco Systems, which created networking equipment that allowed companies to link up local-area computer networks. Its stock climbed an astonishing 75,000 percent from 1990 to 2000.
The USA continues to draw innovators from all over the world. For that reason, there will be many more opportunities like the ones we’ve mentioned. So, if you missed out on Apple or Microsoft, don’t fret. There’ll be others. You just need to put in the hard work to spot them in time.
But when is “in time”? A really great, innovative company will often continue to grow exponentially, way beyond what’s predicted. So don’t follow the traditional logic, which says buy low, sell high. Instead, don’t be afraid of buying when a stock seems to be at a high point already.
Take Cisco Systems, for instance. It was already at an all-time high in 1990. And that’s before it went on its incredible 75,000 percent surge. In fact, a study by Investor’s Business Daily found that stocks like this, which continue to hit new highs over bull market periods, keep hitting them. And stocks that continue to hit new lows keep hitting them, too!
However, just as we saw in the last blink, there is a right time to buy a stock. That is when it has consolidated its base and is about to break out. The “Cup with Handle” is a surefire sign of this. So, the lesson here is: look for great, pioneering companies. And do your best to invest in them at the right time. Do this, and you’ll be ahead of the game.
Supply and demand is an important factor in stock picking.
The price of nearly everything is determined by supply and demand. So, when you buy things in your daily life, like toothpaste, cheese or stationary, the price depends on how much of each product is available and how many people want to buy it.
The principle of supply and demand applies to the stock market, too.
The key message here is: Supply and demand is an important factor in stock picking.
Imagine that one company has issued 5 billion shares, and another has 50 million. To produce a stock rally in the one with 5 billion shares, an enormous amount of buying is required. But the smaller stock, with only 50 million, could shoot up much more quickly. The “supply” for the small stock is much less, so price movements would be much more dramatic.
But just as it could fly upward very quickly, a so-called small-cap stock could also crash just as dramatically. So while the rewards could be more spectacular, the downside is sometimes much larger. A company with many more issued shares is a less risky proposition. That’s because a great deal of selling is needed before the price moves.
So the law of supply and demand dictates that a small company can yield more explosive results, and a big company might be a more reliable investment. But who owns these shares matters, too.
In big and small companies alike, it’s a good sign if top management owns a significant percentage of company shares themselves. If they don’t, they may not have a strong vested interest in the company’s success, so the stock could be a liability in your portfolio. But if management does own at least 1 to 3 percent of a big business, and more in small companies, then the business will generally be a better investment.
Another factor to keep in mind is companies buying back their own stock. This is a good sign. It suggests that the company believes that improved earnings are on the horizon, and, consequently, that their stock could soon be in high demand.
You should buy industry leaders.
Many of us have favorite companies that make us feel good, and it’s these companies in which we tend to invest. Think of companies like Coca-Cola or Nike, with well-loved products and a great, lasting brand. However, in a bull market, old favorites like these can sometimes be left in the dust by dynamic new leaders.
The key message here is: You should buy industry leaders.
As a rule of thumb, you should buy the leading companies in their group. A “leading company” is not necessarily the largest or the most recognized brand name. They’re the ones with the best quarterly and annual earnings growth, the strongest sales growth, the widest profit margins, and the highest return on equity. These companies will also have a unique and innovative product which is driving these results.
For instance, the author’s own big winners over the years have all been those who dominated their particular spaces. Whether that was Pick ‘N’ Save from 1976 and 1983, Amgen from 1990 to 1991, AOL from 1998 to 1999, eBay from 2002 to 2004, or Apple from 2004 to 2007, they were all number one in their particular area.
It’s always better to buy these dynamic companies over the sentimental old favorites. This was clear during the big bull market of 1979 and 1980. The most dynamic companies of the time, Wang Labs, Tandy, and Datapoint had up to sevenfold increases. At the same time, the grand old computing giants, like IBM and Burroughs, were pretty much static. Just because they’d been reliable over the years didn’t mean that they could bring the dramatic returns of the leading companies.
You should always avoid the second-best or the copycat company. The leader will nearly always outperform these. But oftentimes, people invest in these second-best companies because they hope that some of the luster of the industry leader will rub off on it. Sadly, that’s hardly ever the case.
As the industrialist Andrew Carnegie said: “The first man gets the oyster; the second, the shell.” It’s always the real innovators and entrepreneurs that drive the market. These are the companies in which you should look to invest.
You should look for stocks with institutional sponsorship.
Rather than purchase individual shares, some investors put their money into funds. A fund is a whole assortment of different stocks bundled into one investment.
In the United States, they’re called mutual funds. These funds are provided by big institutions. They are run by financial experts who hand-pick which stocks to include. As an individual stock investor, though, it’s worth checking which stocks these experts have picked.
The key message here is: You should look for stocks with institutional sponsorship.
These big institutions make up the bulk of stock-buying in the world. And because of this, they drive the market, pushing stock prices higher or lower. With this in mind, it’s worth paying particular attention to what they do. If you own shares that the big institutions are buying, then you will see the stocks rise in your own portfolio.
Specifically, you should pay attention to what the best performing funds are doing. These are the funds that generate the biggest annual returns and are run by the most insightful investors. To find out about the best performing funds, you can use resources like Investor’s Business Daily and Morningstar.com. Morningstar.com also lists these mutual funds’ top holdings.
Institutional investing also matters in general, whether or not it’s from top-performing funds. If many funds are buying into a stock, it will rise in value.
Along with analyzing the activity of these institutions, it’s worth knowing about their stock-picking philosophy. You can learn from the best by looking at their prospectus, which you can either download or request directly from the firm. The prospectus will tell you which technique each fund employs, along with the kinds of stocks they’ve purchased.
However, it’s worth noting that some stocks can become “over-owned” by big institutions. Some stocks are just bought automatically, even when they might not be in great health. Take Xerox. It was a favorite of institutions in the 1970s, with an amazing track record. But some astute analysts noticed that all was not well at the company. Very soon, the stock headed down.
The lesson here: learn from the best, but also do your homework. Nothing beats your own due diligence.
You should keep a close eye on the general market direction.
Individual stocks only matter up to a point. If the market goes down, you’ll lose money.
Just think back to the crash of 2008 – for the most part, it didn’t matter how good your stock-picking was. If you didn’t sell in time, you lost money. The truth is, three out of four stocks will lose value if the general market is heading downward.
The key message here is: You should keep a close eye on the general market direction.
What exactly is the general market? Broadly speaking, it’s an overview of all of the big stock indices, like the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite. You can monitor these online.
To judge the general mood of the market, then, you should check if there has been significant buying or selling going on. In a resource like Investor’s Business Daily, you’ll be able to see something called an Accumulation/Distribution Rating for a given index, like the Nasdaq. It tells you if investors are buying or selling in a particular index. That will tell you if they have confidence in the market or if they fear a dip.
It’s important to keep a close eye on these indices, as a change can happen over just a few weeks. If you fail to pay attention, you could be left standing open-mouthed as a big crash wipes out your returns.
For instance, if you notice that stocks keep opening high and closing low, the market could be entering a bear market, where prices fall. Conversely, if you notice that stocks open weak and close strongly, it could be the first sign of a bull market. Without daily scrutiny of the general market, though, you’d never know this was happening.
What you shouldn’t do is listen to too many financial analysts or investors’ newsletters on the state of the market. For the most part, these are expensive distractions. “Experts” whose opinions contradict one another can just confuse, rather than clarify, things for you. The best strategy is to observe the market itself.
Think of it as a little like observing wildlife. If you were studying tigers, the best resource would be the tigers themselves. You could read all of the literature on tigers in the world, but nothing would be more instructive than watching the animals in their natural habitat. The same is true of that other wild beast, the stock market!
Before you invest in the stock market, you should learn how to read stock-price patterns; one particularly useful pattern to look out for is called “Cup with Handle.” As well as stock-price patterns, you should make sure that your chosen stock is sound in other ways. For instance, it should be an industry leader, ideally with an innovative product or service, while, most importantly, showing an increase in earnings. Finally, watch what top fund managers are doing but do your own homework, too.
Cut your losses!
You should know not just when to get into a stock, but also when to get out. That is, if you don’t want to lose lots of money. As a rule, it’s a good idea to sell a stock when it plunges to 8 percent below your buy-in price. That way, you can keep your losses small as you chase big wins.
What to read next: Common Stocks and Uncommon Profits and Other Writings by Philip Fisher