Category: Best Of

Imagine if there was a way to know the best performing stocks of each year ahead of time? According to Patrick O”Shaughnessy from Millennial Invest, if you had invested in the 25 best performing large caps of each year, you would have compounded your capital at 80% for each of the past 80 years. Sounds impressive, right? The only problem is that no one has a crystal ball that tells the future.

Mr. O”Shaughnessy looked into the common characteristics of the winners. His conclusion is that they did not have anything in common and it was impossible to identify them ahead of time with any degree of consistency. The 25 best performing large cap stocks of each year were equally likely to be super cheap or super expensive in terms of Price to Earnings Ratio. Earnings growth and price momentum were also not a big help for revealing the best future performers.

For the purposes of his research, O”Shaughnessy considers a large cap stock one with market capitalization above the average in the market. Market capitalization is the product of a stock price and total shares outstanding.

“Last year’s “perfect portfolio” would have included Facebook, Tesla, Delta Airlines, Netflix and Alcoa among others. These companies came from all different corners of the market, and many would have doubled your money in just one year”, says O”Shaughnessy.

It is true that the best performers of last year come from different industries and on a first look have very little in common, but if you dig deeper you will something quite intriguing. All of these stocks reported much better than expected earnings and as a result they gaped to new 52-week highs. More precisely, all of those companies reported several consecutive quarters of better than expected earnings.

On our site, SocialLeverage50.com we keep a list of 50 high-growth stocks, which we update every week. If you take a deeper look at the SL50 list, you will notice that many of the stocks there have crushed earnings estimates and received positive market reaction. One of the most enduring market edges is the so called Post Earnings Announcement Drift – the tendency for a stock to drift in the direction of an earnings surprise for several weeks (even several months) following an earnings announcement. Earnings surprises are also one of the main ingredient in our equity selection process.

Source: THE PERFECT PORTFOLIO by Patrick O’Shaughnessy

The stock market is not a place, where for one party to win, another has to lose. It is a place, driven by cycles – periods, when almost everyone is a winner followed by periods, when almost everyone is a loser.

Everyone could make a lot of money during market rallies, when liquidity and performance chasing lift all boats and trump all bad news. Not everyone keeps that money when the inevitable correction comes.

Don’t get me wrong. Corrections are an important part of the market cycle. As legendary money manager, Peter Lynch once said:

It is not entirely clear what causes deep market corrections, but without them many of the best performing long-term investors would have never achieved their spectacular returns.

(the same notion applies to swing and position traders, too)

I have nothing against market corrections. I have a lot against giving back my profits during market corrections. Over time, I have learned to time my market exposure – there are periods, when I am barely invested and mostly in cash, followed by periods when I am very aggressive and using leverage to take advantage of a favorable market.

Earlier today, I tweeted a joke about the performance of $COH

If u had invested $1000 in Coach in 2006, today u have … $1000. Sometimes, it’s better to buy a bag. $COH

— Ivaylo Ivanov (@ivanhoff) Jun. 4 at 06:50 AM

And yes, I didn’t account for the dividend that Coach paid, but you get my point.

What is more interesting is some of the reactions I received on social media:

Growth stocks: A mug’s game MT @ivanhoff If u had invested $1000 in $COH in 2006, today u have…$1000. Sometimes, it’s better to buy a bag.

— Michael Santoli (@michaelsantoli) June 4, 2014

First of all, let me tell you that I love the fact that people have  a disdain towards growth stocks. The recent declines in many cloud, Internet and social media stocks have scared people out of story/momentum stocks. This sentiment is usually a good foundation for future outperformance of this asset class.

For a market approach to work in the long-term, it has to go through periods of underperformance, when most people lose faith in it. It is the law of the market and it applies to both value and momentum.

If your strategy is to buy and hold forever, growth stocks are not for you.  Go buy a few boring, dividend-paying consumer staples at a fair price and you will do well over time. It is not an accident that Buffett likes to buy only businesses, which circumstances are not going to change substantially in the next decade. Guess what – if a business doesn’t change too much in 10 years, it is very likely that it won’t do much better than the market itself.

If your goal is to trump the market averages, growth stocks are the place to be.

It is true that many growth names will go up 300-400% in a couple years, only to give back 50% to 90% of their appreciation afterwards. Does that mean that you have to ride those stocks all the way down? Does that mean that you have to look at the glass as half empty? No. If you have a proper exit strategy, you will protect the majority of your profits and then re-invest the proceeds in other emerging growth names.

Some trends last 3 months, some trends last 2 years; others last 10. Eventually, every price trend and every growth story comes to an end. This end could be very different, depending on your exit rules.