Growth Stocks Investment

When you start looking for good stocks, you often come across these terms like large cap, mid cap, small cap, growth and value. Let’s discuss these terms for a moment. Capitalization or cap refers to the combined value of all the share of a company’s stocks. The division between large cap, mid cap and small cap are often blurry and not sharp.

Statistical studies of large cap, mid cap and the small cap stocks has shown that over the years small cap stocks have outperformed. Mid caps are companies with $1 to $5 Billion in capitalization and small caps are companies with $250 million to $1 Billion in capitalization. Anything below $250 million can be considered as micro cap. However the following divisions are generally accepted: Large caps are companies with over $5 Billion in capitalization.

Perhaps the most important ratio is the Price to Earnings Ratio (P/E). Now the most important term that you come across is growth stocks and value stocks. How do you determine this is a growth stock or a value stock? Suppose, company ABC stock is presently selling for $50. Now suppose that last year company ABC earned $5 for every share of the stock outstanding. This means stock ABC P/E ratio is 50/5=10. So the higher the P/E ratio, the more investors are willing to pay for the stock. What is the P/E ratio? The P/E ratio divides the price of the stock by the earnings per share.

Let’s make this clear with an example. Do you know how to read the balance sheet of a company? One of the most important things in doing research on a stock is the balance sheet of the company. Suppose, company ABC stock is presently selling for $50. Now suppose that last year company ABC earned $5 for every share of the stock outstanding. This means stock ABC P/E ratio is 50/5=10. So the higher the P/E ratio, the more investors are willing to pay for the stock. So what is the P/E ratio? The P/E ratio divides the price of the stock by the earnings per share. Over the years, studies have shown that the P/E ratio is somehow related with the growth of a company. Now the higher the P/E ratio, the more growth the company is supposed to have. So it can be either the company is growing real fast of the investor have high hopes of its growth. Now these hopes can be realistic or foolish, you never know!

Eugene Fama did seminal research on stocks and stock market s in’70s. Most of his results were startling and broke many myths. According to Fama and French, two famous researchers who did ground breaking research on stocks, over the last 77 years, large growth stocks have only seen 9.9% annualized rate of return as compared to 11.5% for the large value stocks.

The most probable cause seems to be their immense popularity. Since most of the headlines are captures by high growth companies, investors seem to think that they are the best investments. Now intuitively you might have thought that growth stocks are better. What can be the reason for their lower performance over the years?

Let’s go back to the IPO of Google. Think about Google, how its stock price shot up within a matter of weeks after it hit the market. Weeks after that it began to cool off. In 2007, Google stock was selling something around $500. So large growth stocks tend to get overpriced before you are able to buy them!

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Trading And Seasonality In The Markets

The next best holiday bets are the Labor Day and the Memorial Day because they fall before the first day of trading in September and June respectively. The day before the Presidents day is the worst day and the day after the Easter is the worst day after. However, you should keep in mind that a lot of other factors also come into play and you have a lot of room for error.

The best time of the year to own stocks is the Santa Claus rally which for all practical purposes is the 17 day stretch from December 21 to January 7. This is the best time of the year. Most of the folks usually feel fairly good about themselves around this time of the year.

FED always wants the consumer confidence high during this part of the year. The more shopping the consumers are going to do, the more companies are going to sell and earn. The more companies earn, the more their stock prices go up.FED tends to lower interest rates during holidays in order to go into the New Year with less of a worry if the economy is slowing down. There is a low trading volume which tends to exaggerate the trend if the economy is not doing well and is slowing down. However, when you are dealing with seasonality, you should keep these facts in your mind:

1) The market is not longer static. Money has no borders now. With one mouse click money is transferred from one locality to another. The seasonal effect may get interrupted by other events. More and more people have real time access to information and larger amounts of capital than at any time in the past.

2) At the end of the year, institutional investors want to make their results look as good as possible to their shareholders and tend to buy the stocks and so on. Institutional investors like mutual funds, hedge funds and insurance companies have become important players in the markets. So in case of an event free environment, seasonal tendencies may hold up fairly well.

3) The days of long term investing or what you call buy and hold are dead! Frequent market crashes have taught the investing public that investing for the long term is fairly risky. So there is more short term trading going on. These are the times for day traders and swing traders. With fewer people willing to hold stocks for longer periods, it is very difficult to predict seasonality.

4) The recent market crash was the result of CMO and Default Swaps bringing down the banks and Insurance companies in ways that had not been anticipated or foreseen by the analysts. Many had assumed that derivate securities are safe. Infact they have highly unpredictable tendencies. Derivates and outside the market trading activities can result in highly unpredictable patterns.

Then there is a change in demographics also taking place. With the aging of the population, the overall trend will be towards more income producing investments. So with everyone talking about the seasonal tendencies in the market, it reliability becomes less diminished.

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Never Trade Without A Stop Loss

The market goes in one direction. It has a correction. Then it continues back in its trend direction. It has another correction and so on. Even in sideways or choppy market, there are ups and down in the price action.

It is like the continuous ebb and flow of the tides. You must learn to ebb and flow with the tides in the market. Setting stops on the key levels of price support are crucial. These key support levels represent significant market realities occurring with enough trade volume to warrant a stop loss level.

The market will continuously fluctuate. How do you reduce the possibility of getting stopped out of a perfectly good trend by the normal ebb and flow of the market? The answer lies in the current price, volume and volatility of the market.

You will need to ensure that your trading system and approach take these factors into consideration so as to allow your stops to ebb and flow with the markets. The stops need to protect you from risk but they also need to allow the market freedom to fluctuate.

The market will tell you where to set your stop loss if you know how to listen to the market. To choose a random exit that does not include the crucial information the market is giving you at any time is ignoring what the market is telling you.

First learn to understand the market dynamics. Then you need to learn how to identify the correct stop loss based on the market dynamics. Then learn to adjust your trade size to manage your dollar loss. Never ever use an arbitrary dollar amount like, I will get out of the trade when it goes against me $200.

A stop loss protects you from different types of risks. The value of having the stop loss in place prior to entering the market is that you can unemotionally determine the best exits possible for the different types of risk like the trade risk, the market risk, the liquidity risk, the margin risk, overnight risk and the volatility risk.

As a rule dont try to risk more than 2% of your trading account in a trade. The position of your initial stop should be based on the rule of 2% risk on your trading account. Your stop loss position is determined by how much risk you are willing to take. For some advanced traders it is sometimes beneficial to risk more than 2% of their trading account on a single trade. However, the amount these traders risk must be carefully calculated depending on their proven historical performance statistics.

Remember the saying that there should be some method to your madness. Learn the yin and yang of trading. Placing stop loss correctly is an important part of the money and risk management program. One of the greatest challenges for any trader is to finally come to the point where he/she firmly believes that a sound money and risk management program is vital.

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