Click chart to enlargeThe 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.
----------
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.
----------
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.
----------
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.
----------
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.
31 comments:
Nice, clear explanation, Snot. As for the whole market, it appears to me that there is limited upside for the next few months and that there is much potential for downside -- if the Euro explodes, Greek debt, Spanish debt, etc., etc. I'm retreating to the relative safety of cash, bonds, and fed-tax free munis. Instead of sell in May and go a-way, only to return in late September, I'm selling in June. How do you feel about the overall market?
Thanks, Joe. We feel neutral about the broader market, with a slight bias to the downside. We're not running for the hills. We don't really believe in timing the broader market with the exception that we're willing to wait on the sidelines during bear markets (marked by all sectors being in a simultaneous Stage 4 decline).
As long as there are pockets of strength (stocks making new highs), we'd rather stay invested. This is because strong stocks can go up in a flat market. It's long been our belief that after the great bear market of 2008, the market would trade in a wide range (8,000 to 11,000?) for several years. We believe we're in that period of indecisiveness now. The tug of war between the bulls and the bears in the broader market ideally will have minimal impact on the intermediate term performance of the stocks we hold. There is a danger of missing the entire LED movement if we sit on the sidelines out of fear of what the broader market could do. It's better over the long run to stay invested in bull markets and flat markets as long as your capital is always chasing the highest relative strength issues.
Your post is especially excellent. So good, in fact, that it tells me, perhaps incorrectly, that you are a seasoned investor; you have been around the block more than a few times.
I hope your readers recognize the good, sensible market understanding you share, and that your readership grows accordingly.
Best wishes,
David, thanks, that's quite a compliment! We're trying to get the readership up again. It used to be higher before the crash. We posted very infrequently once we sold everything, as we had no interest in catching any falling knives. But we're back and we're determined to get this blog hopping again! Thanks for your support -Snot
I pray we can collectively find the next hot sector after LED sector dribbles along... My goal like snotwheel is to find the hot sector and ride those stocks in that sector to the moon..
Thanks for the time you put into this post. It was a great read.
Jay
Great post snot. A few questions although I don't know how to word the first one:
1)Are these great growth stock finds all found at the same time? With their behavior being greatly influenced by the broader market? For example would this RBCN stock price stunt not have existed if it was during the 2008 crash? Or does it have to be a sideways or bull market for these little guys to show through? If so this takes amazing discipline, like taking years off if need be. I suppose you could piggy back this method with smaller buys of inverse ETFs if th world seems like its ending again.
2) Another poster brought up PPO. Do you think that is in a similar stock growth stage as RBCN?
Also is RBCN in your opinion at the end of your stage 1, or beginning of stage 2? Or neither
Snot and others, any recommendations on stock screeners to hunt for stocks with certain characteristics (ROE, P/E, growth %). I tried the one on Yahoo and it doesn't work, or it wouldn't for me.
Anon/s,
A full fledged bear market is no time to be long anything. During a bear market, everything more or less reverts to whatever it would be worth based on its current EPS. There is little speculation. Therefore, stocks of companies that have low EPS's usually do very poorly. You should sit out the bear markets, or go with the trend... short.
We spent the last bear market buying Ultralong index ETF's, but we weren't willing to buy individual stocks. Our bet was simple... America would someday come back. Investing does take a lot of patience, though. One thing that you always find is that people look at a stock chart and say, "if I had bought there and sold there, I'd have made 100%". They're looking at a chart that spans a year. Yet each time they trade, they only hold a stock for 3 weeks. People know patience is required, but actually practicing it is a real discipline.
We looked at PPO breifly... must admit it looks very good. We're going to look into it further.
RBCN, with its high current P/E, is somewhere in Phase 1. That's not to say that it will double from here, but that it's definitely at a point in its growth cycle where people aren't quite able to quantify its future. It may be a dud, or it may be one of the best investments of your life. No one knows yet, only time will tell.
As for a stock screener, TD Ameritrade's Advanced Analyzer is pretty good. It picks out breakouts and such. If anyone knows of another one (particularly a free one that does not require an account), please post it here.
Snot, If RBCN is possibly in a stage 1, then why would all the insiders sell right now? http://greenstockscentral.com/rubicon-technology-rbcn-insider-selling-ceo-cfo-liquidate-entire-position-3329.html
As a relatively new investor, I am wondering how likely heavy insider selling is to negatively affect a stock price.
Thanks.
John
Wow. Granted, insiders have been selling for a year now. We usually cant say for certain it is bearish, because insiders could be selling their stakes to raise money to buy call options or some other leveraged instrument. So sometimes what looks bearish can actually be quite bullish. In this case given that they dumped their entire positions, its either very bullish or very bearish. I bet we're going to find out in the next few weeks!
Of course they had to know that moves like this are going to reflect badly for investor and public sentiment. They knew that full well, yet they did it anyway. And we already know that stock didnt fall, and it should have fallen by now if it was going to. Maybe they sold during this period of high demand so that they could step in later and pump the #$%^ out of this stock when it needs it? It's not unheard of.
You need to read the prospectus
http://sec.gov/Archives/edgar/data/1410172/000119312510140776/d424b5.htm
There are several worrisome things going on. The insider selling, the all-time resistance level at $35, and the broader market possibly looking to revisit its lows. But the stock is holding up, and that's all that matters to us. It is said that even in the best of times, the market climbs a wall of worry. We'd all be better off if we just didn't read news reports or watch CNBC. It would make it easier to stay invested through all the trickery and deceipt that has become Wall Street's greatest modern day legacy. We haven't wacthed CNBC in years, nor do we read financial news. Just watch the chart, that's all that matters. Less stress = greater profits. Only when the chart breaks down should you take action.
"We are offering 1,800,000 shares of our common stock and the selling stockholders identified in this prospectus supplement are offering 834,000 shares of our common stock. We will not receive any proceeds from the sale of the shares by the selling stockholders." "
thats 2,634,000 shares total. looks like they were put in circulation on june 14-18:
http://finance.yahoo.com/q/hp?s=RBCN+Historical+Prices
so here's the question- have the 2.6+ million shares actually been sold, other than my merely speculating here?
Anon, we're still looking into the insider selling thing. Seems at this point the whole thing may be part of a restructuring of the company in which the insiders will wind up with more shares at the end of the day.
http://biz.yahoo.com/e/100624/rbcn8-k.html
As for what an investor should do with their shares, our take on it will never change... just let the chart tell you if the stock is in demand or not. Don't let the media affect your trading. The chart contains many times more information than the news reports do.
Snot would you say your investing method is more profitable than the average day trader? Someone that moves into and out of stocks within a day? Or a swing trader? Do you chose your method because their is much less maintenance involved, or because historically its just a winning method?
RMBS' deal with GE to create LED lighting solutions can't bode well for the rest of the stocks in this sector.
Snot, how far must the market drop before you buy more?
To the Anon who asked if RBCN could go down, I think you got your answer!
Alcoa just put in a new 11 month low. Since I'm seeing potential support here at 10.47, I am cashing out most of my jul 11 puts at 83 cents (a dubious 4 bagger). I will continue to hold some as a hail mary.
My bonds sure are nice today. It would be a whole lot nicer if all of my portfolio were bonds, though. Ouch! What are you folk doing? Buying or selling or holding tight?
Closed under the 200 month MA today. One day left. Scary Scary Scary...
RBCN got slapped around pretty hard today resting right on its 50 day MA. Look back historically its been bouncing off this line. However, I can't see RBCN doing that if the market continues to blow up on us. Snot what do you think? being 50% invested must put you in a tricky situation. Do you buy here? Or when do you abandon ship?
Nice trade there Icon. So you think this is near a bottom?
Oh for crying out loud. This stinks. I'm slightly underwater with RBCN, and wondering.... Do I hedge this with a short term inverse like QID, or just sit tight? Do I buy some more at this price, or wait a bit. Right now, I just don't know.
The magnitude of today's smackdown in the LED sector has me wondering, though. Why so inordinately affected?
Undecided on what to do. It looks like the market may break support and begin its next leg down. We're just going by relative strength, so we'll only judge RBCN relative to the market. We don't care that it goes down when the market does, but if it continues to underperform, then we'll trade it in for other LED names. In other words, if the correction gets worse, we'll buy into it, but will pick up shares of CREE, VECO, and RBCN, with an emphasis on whichever one holds its ground. This is a tricky market. It may not be for intermediate or long term investors. It may be best suited for short term traders. We still believe that the market will be rangebound for many years. If this turns out to be true, profits are going to come very slowly... five steps forward, four steps back. It's all good.
Given today's action so far, it's obvious that shares of RBCN are in strong demand below $30. The reason for it is irrelevant. We're staying long RBCN, and hoping to pick up CREE below $50 in the coming weeks.
For those that wonder why we'd be interested in a stock that has broken down and appears to be in a Stage 4 downtrend, it's because the LED stocks have not seen the top of their growth cycle. LED bulbs will not be commonplace for another 3 to 4 years, giving their growth cycle at least another year to play out.
I guess if you get a thrill out of rollercoasters, RBCN is a great match for your personality.
The Market is SHOT. Break last support today? RBCN was quite impressive through it all
$SPX is starting to form a pretty nice channel. I drew 4 lines, so it should be quite clear where my "buy" and "sell" target ranges are.
Here is a png version of the previous link. From now on my snapshots will all be png.
Sb, we really don't like rollercoasters, but it comes with the territory (small companies in early part of growth cycle).
Would rather it just go straight up:)
Thanks for the chart Icon, the channel is very clear. The support line of downtrending channels are less effective than the support line of uptrending channels, though. They are often broken because when a stock approaches them, it's during a time of great fear. We would feel ok buying at your line, but don't be afraid if there's further capitulation afterwards. Keep some cash to average down after you buy at the line. The snap back rally should be as impressive as the fall.
Post a Comment