Company Growth Cycle

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The chart above is a random chart of a typical company's growth cycle. Unless you find the next AAPL or GOOG, you'll find that this cycle typically only takes about 2 to 3 years to run its course. The numbers on the chart do not correspond to the Stages (1,2,3 and 4) that we often mention when talking about what part of the growth cycle a chart is in. We just put them there to divide the chart into 3 phases to help explain what happens to the valuation of the stock as it makes its way through the cycle. All of the figures below are just a ballpark, and may vary widely from one specific stock to the next.

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In phase 1, a company hardly has a positive EPS. It may just be coming off of several negative quarters. Its market cap is low, and its volume may even be low. It's P/E, however, may be very high. This is the period when investors know that the company will be a huge success, but they aren't quite able to figure out just how large its potential really is. The stock may have an EPS of .17, but analysts are predicting that the company's EPS a year later will be anywhere from $1.10 to $1.45. Confident that the company will earn at least $1.10 during the next fiscal year, investors apply a P/E of 30 to this hypothetical future EPS, giving it a price tag of $40 or so. Of course a stock in this early stage with an EPS of .17 and a price of $40 appears to all of us to have a P/E of 235. This keeps all but the most daring of investors away, but it's actually a great time to discover the stock.

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In phase 2, enough time has passed that investors are better able to understand the size of the company's market, its competition, the potential for its technology, etc. At this point, the stock trades at a more reasonable valuation, as the future of the company begins to come into focus. Future earnings become more predictable. The company may be earning $1.50 a year, with prospects of earning $1.85 the following year. Its P/E may now be around 40, and it'll have a price tag of about $60. All of the math will now make sense, luring investors that seek a combination of growth and reasonable value.

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At the end of phase 2, when the stock hits about $75, something happens that makes investors realize that the earnings growth of the company is not sustainable. There are many reasons this may happen. The stock will start selling off strongly as investors start recalculating its valuation. During this phase, the stock is not only being valued with lower EPS forecasts, but a lower P/E as well. The company, currently posting an annual EPS of $1.80 may be forecast to make $1.95 the following year. Even though it is still growing, it will not be making the $2.20 investors had previously counted on. To make matters worse, its P/E now drops to 12 because it's expected that the company's annual growth rate will drop from 30% to about 10%. Consequently, the stock's price drops quickly to $23. From there, the company just becomes forgotten, and the stock slowly makes its way to 40 cents.

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This is what we can learn from the chart above...

-You should know that all of these realizations that investors have about a company come about 9 months before any of it is evidenced in the earnings reports or news reports.

-Ideally, you want to discover a stock when it's in the first phase. The P/E will seem outrageous during this phase, but the earnings will quickly catch up if investors are right about the company's prospects.

-If you find out about a stock during phase 2, you can still profit, but it's a more dangerous game. You must sell if the stock makes a simultaneous and decisive break of its trendline and moving average. This kind of explosive breakdown more often than not marks the start of phase 3.

-You should never fall in love with a stock. If you're one of the investors buying the stock after it enters phase 3 (thinking you're getting a great deal), you're in for a big suprise. When people say "buy low", they don't mean to buy a stock locked in a downtrend during a strong broader market. They mean buy a strong, uptrending stock during a selloff in the broader market.

-The time it takes for a stock to make its way through this entire cycle gets shorter and shorter with each generation. People do not have the attention span they had decades ago. Our guess is that all of the Ritalin-addicted kids today will soon control a market that completes this entire cycle in under a year's time.

-"Buy and hold" does not work. Unless you're lucky enough to find the next AAPL, holding a stock for the long term will destroy your portfolio, which leads us to a Snotism...

-All stocks eventually go to zero.

Relative Strength

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There are a myriad of ways to calculate relative strength. Many software packages have their own formulas for scanning through charts and assigning relative strength values to them. Investor's Business Daily (IBD, also short for inflammatory bowel disease) includes a figure for relative strength in its listings.

But you really are better off without all of the fancy formulas and calculations. Because we're honing in on just one or two hot sectors at a time, we find it far more reliable to just watch the top 5 stocks in the sector/s on a daily basis. This gives you a feel for the stocks, which you don't get by relying on relative strength figures.

Relative strength, in its purest form, is simply a comparison of a stock's performance relative to a baseline. The baseline should be diversified, so the indexes are used. A quick glance at a group of stock charts is all you need to pick the relative strength leader. Times of broad market weakness are not only the best times to compare relative strength, they're also the times when you'll do your buying. So while you may not like market corrections, they are an essential part of your success, and you should eagerly await them.

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We've posted 4 charts above. The first is our baseline, the Nasdaq. You could use any index for this, but we chose the Nasdaq because its moves have been textbook, from its nearly perfect S-curve to its nearly identical double bottom.

The S-curve started off this whole "Big Fat Greek and then some BP worst environmental disaster in U.S. history" correction. Once we were in it, we had no choice but to use it as a way to ferret out the highest relative strength LED issue.

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In chart #2, the chart of CREE, you'll see that CREE's bottoms roughly align with the bottoms of the Nasdaq. That is, they are all kind of in the same area. CREE's relative strength is flat. In other words, it is just mirroring the moves of the market, nothing less & nothing more. Of course it will move at a higher percentage than the index, but relative strength does not factor in percentages, it merely distinguishes between which stocks have buyers and which don't.

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The chart of VECO shows a stock with weak relative strength. Each low was lower than the last, despite the broader market being able to hold its bottom. Once our top holding, we sold VECO when its relative strength came into question. With Friday's performance, VECO is redeeming itself. We will only know in hindsight if VECO's severe correction was just a panic, or company-specific problems. Its fundamentals still appear strong, but we feel that we're better safe than sorry... where there's smoke there's fire. We may repurchase VECO at some point, but are still concerned that its weakness during the correction may be a window into some "behind the scenes" issues.

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The last chart is a chart of RBCN, which swept us off our feet during the correction. Each low was higher than the last. Charts that exhibit this kind of strength during periods of market weakness are the first to make new highs when the market turns around. They also most often do tremendously well during the subsequent bull run. The mechanics of it are simple... there are few sell orders during the months of the correction. For whatever reason, people want to hold this stock. So when buyers return to the market, the buy orders overwhelm what few sell orders exist, and the stock rallies strongly. The reason people don't want to sell this stock (or any other stock with high relative strength) is typically not known to the retail investor for several quarters. We are not privvy to the boardroom discussions, factory visits, wildly complex formulae, and other shenanigans that go into determining which companies are poised for explosive growth. Despite being left out of all of this, they do inadvertently give us a very valuable treasure map... the chart.

"Professional" Performance

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We feel like Andy Kaufman on the set of Saturday Night Live... "Do Latka, Do Latka!"

So here's your token chart of RBCN's breakout, complete with volume. Our guess is that as long as the market doesn't tank, RBCN will retrace a bit and then take off again.

But this post isn't about RBCN... it's about actual "professional" stock market performance.

The market has been flat over the past 10 years, trading at or about 10,450 in June 2000 and in June 2010. This makes it the perfect time frame to compare mutual fund performance, against an unchanged index. So here's what the "pros" have done with your money over the past decade...

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Vanguard Life Strategy Growth Fund

+ 1.48%

Vanguard Life Strategy Moderate Growth Fund

+2.75%

T. Rowe Price Growth Stock Fund

+.77%

T. Rowe Price Midcap Growth Fund

+5.94%

Fidelity Blue Chip Growth Fund

-1.84%

Goldman Sachs Capital Growth Fund

-2.20%

Goldman Sachs Strategic Growth Fund

-2.67%

Goldman Sachs Structured Large Cap Growth Fund

-5.29%

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So there you have it, a random sampling of growth fund performance over the past 10 years. Those burdened with the inclination of trusting the "professionals" to manage their money over the past 10 years have done exactly what the market has done, on average. These are the lucky ones. Others burdened with the same inclination found themselves invested with Bernie Madoff and similar cretins.

We don't have 10 year figures for our own performance, but using what we do have thusfar, we're up 17.9% over the past 2 years, for an average of approx 9% annually. If you believe it's not fair for us to compare our 2 year performance with their 10 year performance, you only need to look at what the market has done over the past two years. It's not flat as it was for their period. It's down about 17.5%.

So there you have it... the "pros" that haven't been caught are serving up flat returns and making huge fees for their "services". Those that have been caught are serving life.

Can anyone give us any good reason why someone would invest with the "pros"?

RBCN Breaks Out

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All of the relative strength (resistance to decline) that RBCN has been displaying over the past several months has proven to be an overwhelming force, exposing itself in an incredible breakout to new highs today. To say the least, these highs are coming long before the market posts its own new highs. The theory we have that relative strength is the most important indicator of a stock's intermediate term success has been shown to have real predictive value with RBCN's breakout.

We bought more RBCN this morning at just under 29, putting our portfolio at a point where we're just about 50% invested. There's no guarantee that the broader market has seen its lows yet, hence the other 50% we hold in cash.

For those of you thinking you've "missed" RBCN... think again! Today's action is a very strong signal of the health of the stock (and the company), and bodes very well for its near term (3-4 month) performance. If we did not already own RBCN, we would buy 25% of our intended position here on the breakout and wait for a pullback (approx 50% of the breakout's magnitude) to buy another 50%. The last 25% would be bought if the broader market corrects to new lows, pulling RBCN back below resistance.

We may still buy more on the pullback ourselves. Conversely, there is a point at which we'd sell some of our shares if the stock continues to rally strongly over the next 2 to 3 sessions. This is unlikely, but it does happen.

In almost every case we've seen where a stock breaks out to new highs strongly while the market is just beginning a turnaround from a correction, it has been just the beginning of a very impressive bull run for the stock. It should be noted, though, that the breakout is almost always met by a retracement which can be substantial, as momo traders buy and sell the breakout without any intention of holding for several months, or quarters, the way intermediate term investors do. This retracement of the breakout is often reversed very quickly, as would-be buyers see it as a second chance to get on a train they thought they had missed.

As long as the broader market doesn't sell off significantly, it's our guess that RBCN will rise steadily for the forseeable future.

RBCN

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RBCN looks as if it's inside an ascending triangle, perhaps at the top of a high-flying flag. We don't put much emphasis on recongnizing all of the several thousand various chart formations because people that do so lose credibility very quickly. There are really only a small handful of formations a chartist should be aware of, and the triangles are one of them. Even if you want to shy away from putting a fancy name on them, you should note when a chart is bound by resistance and support levels, particularly when either of the two are ascending or descending. These patterns are merely a map of current investor psychology (sentiment), which is why certain formations appear time and time again.

Right now, the chart of RBCN is telling us that each time the stock sells off, traders are hell bent on not missing the next bottom. So much so, that each bottom is higher than the last. In other words, they'd rather pay up for the shares than miss the train. Most ascending triangle patterns break to the upside. Not always, but most of the time this is the case. If RBCN shows signs of an imminent breakout, we may be buying more of it despite having to average up. This is because during this current period of great instability in the broader market, RBCN's performance has thusfar been unwavering. If everything we preach on this blog about relative strength is true, stocks like RBCN that resist the decline make the best investments when the market turns around.

Relative Strength

Any questions?

Tony Hayward

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BP CEO Tony Hayward:

"The overall environmental impact will be very, very modest."

"We will mount, as part of the aftermath, a very detailed environmental assessment."

_________________

Facts:

-The Exxon Valdez spilled 11M gallons of oil, contaminating 1,300 miles of Alaska's coastline.

-The BP Gulf of Mexico oil leak is estimated to have spilled anywhere from 20M to 175M gallons of oil thusfar.

-The coasts of Texas, Louisiana, Mississippi, Alabama and Florida are expected to be impacted by the disaster. This includes the Everglades, along with 7 other national parks.

-The BP Gulf of Mexico oil leak is already being called the worst in U.S. history.