The second most difficult challenge (after auguring the market’s future near-term direction) is to select the best stocks into which to put some money to work so as to maximize potential returns while keeping risk of loss acceptable. Most of the time, whenever you hear or read a comparison between two stocks, “talking heads” like Jim Cramer usually throw out such slogans as “buy best of breed” as the guide in making your choice. However, although “best of breed” is subjective and is boiled down fundamental factors like sales and earnings growth, great management or higher profit margins. Seldom does Technical factors such as stock volatility, institutional support or relative strength seldom enter a “best of breed” discussion.
For example, on January 26, 2012, Cramer’s theStreet.com had a piece on XLB, the basic materials ETF in which they claimed that “DuPont Company (DD) is the undisputed king of basic materials. From the 2009 rally, DuPont was the top performing Dow component.” However, PPG (PPG) wasn’t mentioned at all. PPG represented only 4% of the ETF as compared with DD’s nearly 10%. But which was actually the better stock to have bought more than a year ago. A comparison of the two shows that PPG actually appreciated 58% while DD declined nearly -3% (click on images to enlarge).
I’m now sitting on some cash trying to figure out if I should redeploy it in yesterday’s momentum stock leaders (who are still advancing nicely) or taking a gamble on stocks that have great charts and look like they may soon breakout and become tomorrow’s leaders.
In technically-based comparison like these, IBD’s rule is to only buy stocks that are within a few percentage points above what IBD labels their “buy point”, those breakouts or crosses above resistance trendlines which are top boundaries of a variety of chart patterns such as inverted hear-and-shoulders, ascending triangles or IBD’s cups-and-handles. This comparison might match up LKQ (automotive parts), a stock that’s advance 370% since 2009 in a near straight shot and, perhaps, may continue to advance higher against, for example, Williams-Sonoma (retail home furnishings).
Putting aside fundamentals and basing the investment choice strictly on a technical basis, the choice rests on how one evaluates two factors:
- Trading off the risk one perceives in buying a stock continuing to advance after having nearly doubled in each of the past four years vs. the risk that a stock will continue to languish for continued economic sluggishness.
- How important the psychic reward might be for you to have found a new “high flyer” before others vs. piggybacking on a winner that others continually discovered over the past four years.
I’ve always tended to chose the breakout but what say you? Would you catch the tail of a comet like LKQ or get on what you hope might be a future rocket? And why?