We all enjoy a bargain.
It could be a half yearly clearance or a humble garage sale. A big discount can be hard to resist.
The Boxing Day sales are a classic. Long lines snake around street corners. The prospect of nabbing a bargain is irresistible. People want to buy as soon as the price drops.
But should we approach stocks the same way?
A famous stock market maxim is ‘buy low, sell high’. The saying is possibly as old as the market itself.
Now, you may think ‘buy low, sell high’ sounds obvious. That’s how you make a profit, right?
But there’s a bit more to it. How do you define buying low?
Many people believe buying low means to buy when prices are falling. This strategy may work well for consumer goods. But does it stack up in the stock market?
Well, I’ve done some back-testing to find out. I’ll tell you about this in a minute. But first, I want to recap last week’s report.
You’ll remember I was talking about buying stocks after a strong advance. This was in response to a member’s concern that to do so would be ‘extremely risky.’
As you know, I did some back-testing. The aim was to see if buying after a big rise was asking for trouble. The test had two key rules for buying:
- A stock must be at a one-year high; and
- It has to be at least double its value from a year ago.
I also set a minimum entry price of 20 cents. This was to remove the ‘penny dreadfuls’. These stocks can double or halve in value overnight, and often increase a portfolio’s volatility.
Finally, I gave the system Quant Trader’s exit strategy. This lets profitable trades run, while cutting losing trades relatively early.
Here’s the chart you saw last week…
This shows the hypothetical profit from the strategy (excluding costs and dividends). The date range is 1 October 2000 to 6 October 2016. It assumes putting $1,000 on every buy signal.
Remember, these results are not for Quant Trader. The graph plots the performance of a very simple strategy. It’s not one that I’d trade myself. You can read the full report here.
The result is clear. You can do rather well buying shares at a 12-month high.
Many people find this surprising — but it shouldn’t be. You see, buying stocks at their highs is trading with the trend…and the odds favour a trend continuing.
The biggest issue many traders face is fear. They worry that a strong stock is nearing a peak. It can be hard to imagine that a big move can get even bigger. But it often does.
Let me show you what I mean…
Follow the money
I have three examples for you. These stocks are from Quant Trader’s live signals. They show why you shouldn’t avoid a stock simply because it’s had a big run.
The first stock is mobile phone retailer Vita Group [ASX:VTG].
Quant Trader’s first buy signal was at $1.28 on 16 December 2014. The shares were 201% off their 12-month low. VTG was also trading at a record high.
I know many people would back away from this type of stock. But it often pays to follow the money.
Here’s what happened next…
Vita Group has gone from strength to strength. The shares went on to post a 199% gain from Quant Trader’s initial entry signal. The second and third signals are also showing triple-figure gains.
The next example is a salary packaging business, Smartgroup [ASX:SIQ].
This is how things looked at our entry point…
SIQ was trading at an all-time high. The share price was also more than double what it was a year earlier. Many traders would think the time to buy had passed.
But here’s the thing. Strength often leads to more strength.
This is what happened…
SIQ has run a lot further. The share price is up more than 150% since Quant Trader’s first buy signal.
This is still an open trade. You can see the trailing stop tracking below the share price. Quant Trader will stay with this stock until it hits the trailing stop.
Last but not least is Blackmores [ASX:BKL].
Quant Trader’s first buy signal was at $33.93 in December 2014. The shares were at a 52-week high, and 71% off their lows.
The result tells a familiar story. Here’s the final chart in the series.
You can barely see the initial 71% rally. It pales in comparison to what was to come. This trade went on to produce a 353% profit at the time of its exit. There were also big profits from signals 2 and 3.
It’s important to note that this won’t always happen. There’ll be times when a stock at a one-year high turns lower the next day. We have a stop-loss for this very reason.
But many will run further than you might think. These are the ones that can make a huge difference to your returns. That’s why it’s a mistake to overlook them.
You may be curious as to why the signals didn’t occur sooner. These were all established trends. Why didn’t Quant Trader get on these moves earlier?
There’s a simple explanation.
Quant Trader has a buying limit of 100 companies. The portfolio was full when these stocks first met the entry criteria. Remember, you don’t need to buy at the lows to make a lot of money.
Bargain or bust?
OK, let’s return to my opening question: Should you buy a stock that’s falling in value?
Many people like buying at a 12-month low. These traders reason that the worst has passed, and that a bottom is near. They believe this is safer than buying after a big rally.
But does this strategy really stack up?
Let’s put it to the test. I’m going to modify the back-testing you saw earlier. This time, I’m going to set the entry algorithm to buy at a one-year low (or lower).
Like before, the minimum entry price is 20 cents. The system will also use Quant Trader’s exit strategy to run profits and cut losses. Each trade is set at $1,000.
Here’s what happens…
What a mess. Buying at a one-year low has been more of a trap than a bargain. The strategy has mostly gone backwards for the last 15 years.
I found an interesting article while preparing this update. It was published by a popular stock advisory in November 2014. The story was about potential bargains at a one-year low.
The author put forward three stocks: Crown Resorts [ASX:CWN], Woolworths [ASX:WOW], and The Reject Shop [ASX:TRS]. Each of these stocks was trading near their lows after big falls.
It’s interesting to look back on these predictions now. TRS was the pick of them. It hit rock bottom about seven months later, and the shares are now in an uptrend.
But the same can’t be said for CWN and WOW. Both stocks are lower today — despite the All Ordinaries being higher. Trading against the trend is often a costly mistake.
Yes, a beaten up stock could be a great buy. But not everything that goes down rises again. I want to see signs of an uptrend before buying. That’s the Quant Trader way.
Until next week,
For The Daily Reckoning
Editor’s note: Are you prone to buying down-and-out stocks? It’s a popular strategy. But the problem is that many of these stocks can languish for years. Counter to what many people think, buying into strength can be a much more productive method.
Quant Trader specialises in finding stocks that are on the rise. The system’s algorithms are constantly scanning the market for opportunities. It then gives you a buy signal, and calculates a unique exit stop.
And right now, you can get instant access to Quant Trader with a 30-day money back guarantee.
Try it. See if it makes sense to you. It could change the way you trade forever.
PS: Quant Trader sources all images and charts above.