Penny Stock Trading Blog

By the time you are through reading this book you’ll probably be sick and tired of hearing the word “value.” But it is the most important concept an investor can use to gain an advantage in the game. Understand value and you will outperform not only the market but the vast majority of fund managers.

The idea of value has been around a surprisingly long time. This approach to investing most likely began with an article by Robert Weiss in 1930 that culminated with this commentary: “The proper price of any security, whether a stock or a bond, is the sum of all the future income payments discounted at the current rate of interest in order to arrive at present value.”

Samuel Elliott Gould added to the subject matter in 1931 with his article, “Stock Growth and Discount Tables” (Boston Financial Publishing). This author defined value as the average rate at which a company’s earnings grow over time, the dividend that would have been paid over that same time, the price-earnings ratio, and finally the internal rate of return the investor needed to achieve.

If the pundits and advisers of the late 1990s had simply read and taken to heart these writings from the 1930s they would never have put a penny into the stocks that decimated their customers’ long-term investments. So to that extent there are lessons from the past that do apply to our future.

The avowed father of fundamental analysis, Benjamin Graham, made an interesting comment in 1946: “In the years to come we analysts must go to school to learn the older established disciplines.” Half a century later market soothsayers are still trying to develop new lessons and new rules on the assumption there is a new economy. There isn’t. Obviously things change, and today’s economy is not yesterday’s economy. But value, like gravity, is always there regardless of what object we toss up in the air. Gravity doesn’t care if it is new or old; it always exerts the same force.

And so it is with value, which is why so many nonvalue investors were hurt so much, and are always hurt when markets decline. Value is the core of all investment success, while trend is the basis of all profits. Trend is a direct result of fundamental considerations—that is, value.

While investors are lured by the possibility of gargantuan returns, it goes without saying that the greater the potential reward, the greater the risk.

Speculating is about maximizing your return in the shortest time. That is not what investing is about; investing is about consistently making more than the guy next to you.

In my case I am more than willing to let the guy next to me make a killing every now and then because I know in the long run, since he is assuming undue risk, those rewards will have their setbacks along the way. This means on average I will outperform someone who does not have a strategy or program to approach the markets.

One needs to find the balance between risk and ample rewards. If your main goal in life is to escape worry, you will stay poor. Tranquility has advantages, but it doesn’t bring about monetary wealth. Given a choice between being worried and being poor, I’ll take worry every time. As Sigmund Freud replied, when asked about how to achieve a state of balance, “And for what? Balance can only achieve the happiness of quietness.”

Risk is a funny thing in that you have absolutely no hope of becoming wealthy in the stock market without taking on risk. But this is a two-edged sword, because that same risk can cause you to lose your wealth. Thus risk control becomes our key ingredient in long-term investment success. Risk creates and destroys wealth.

The evidence is pretty convincing, as you have seen. But why is this so? What is the function behind the index?

The driving force of the index is what the market has been doing. The stronger and longer a rally is, the more bullish these folks become. Only one thing makes these folks bullish, it appears: a strong market rally. Only one thing makes them turn bearish: a decline. There is a dichotomy at work here. True, the trend is your friend. But it is exactly that trend strength that gets these advisers to a bullish or bearish extreme.

Yet isn’t the first rule of trading not to buck the trend?

I think the sentiment index helps us understand the old adage, “The trend is your friend . . . until the end.”

The end of a trend, a moneymaking opportunity, comes when too many of these players have climbed aboard the bandwagon. In short, the sentiment data has as good a record of telling us when we are close to the end of the trend as anything I have seen in my 40 years of tracking stock prices.

Trend strength—that is, a strong rally—apparently has a hypnotic effect on market prognosticators. The greater the rally, the deeper their somnambulistic trance. Nothing gets these people more bullish than a rally. It is almost as though they stop thinking, and in lemminglike fashion, the closer to the end of a trend we are the greater the number wanting to jump off the cliff!

Should you take the time to study the index, you will see that near the end of the trend this camp is on the wrong side of the trade. They begin getting in phase with the trend around the midpoint, then become excessive in their view as the trend nears completion. In other words, the crowd can catch a trend and be correct, for a while. The stronger the trend the more committed to it these folks become.

Keep in mind that this group can and will be correct in their market outlook at the midpoint. It is when the crowd becomes extraordinarily one-sided, with readings above 75 percent as potential sells or below 25 percent as potential buys, that we are alerted to opportunity.

Our entire upbringing has been that the majority is right; they get to rule, they prevail. But the majority (or mob) rule can be a dangerous position. If there are three of us and two of us decide to kill you, should we have that right? The more I have seen the fallibility of the crowd the more I question how great the leaders we have voted into office really are! Since childhood we have been taught the majority is right. We decide the future based on a popular vote. If we are not certain, we take a survey!

The majority view is not always wrong; it is not a given it will be incorrect. But the evidence shows, and rather markedly so, the crowd is more likely to be wrong than right at the extremes. Thus we are given an advantage, a window of opportunity, when our odds for success are increased. What more could a speculator want?

Even then we should recognize that we might still be early, so we most likely need additional confirmation or a short-term entry technique to enter the trade. There are myriads of entry techniques, but without the proper setup, such as what the sentiment index provides, most are doomed to fail.

There are all sorts of things that might change in terms of the entertainment business. Consider this: Currently on television, we see many reruns of yesterday’s movies. Movies are not cheap to produce. A good movie now costs $50 million. But consider the possibilities of having a really good movie done with major stars and showing it as a first-run feature, not in theaters but on television. How many homes could you sell a movie to starring Mel Gibson, Julia Roberts, and Tom Hanks if the price was $2 for the movie? I suspect it would be a snap to sell to at lease 25 million homes and recap your investment all in one night.

The couch potato crowd would love this; they don’t even have to go out and rent the movie at the local Blockbuster. They simply get a first-run movie, never seen before, with major stars for two bucks. Fifty million homes in the first month nets $100 million—not bad. The beauty of television is it can deliver so much, to so many people, so cheaply. I suspect we’re going to see a switch in television from the traditional news, game shows, and junk shows to making it more similar to traditional entertainment, filling the role that movies, stage, and concerts have had in our lives.

In any event, this is an industry we should pay close attention to. Certainly stocks like Disney, MGM, the cable television giants, and such need to be monitored by savvy investors.

Analysts have conventionally used seven ways to measure the fundamental aspect of a stock and its potential future returns

1. Price-to Earnings Ratio—The most widely known measure of value is the price-to-earnings ratio, which is arrived at by dividing the current price of the stock by current earnings. The higher this number is, the more investors are paying for what the company is earning. A high P/E number therefore suggests difficulty in further advance of price. Traditionally, analysts have said the lower the P/E ratio is, the more positive future market activity should be.
2. Price-to-Book Ratio—Price-to-book ratio is arrived at by dividing the current price of your stock by the book value per share. The notion is that a low value would indicate an investor is paying close to the liquidating value of the assets of the company. The lower the ratio is, the more bullish should be the future prospects of your stock.
3. Price-to-Cash Flow Ratio—The next common way of looking at the value of an issue would be what is known as the price-to-cash flow ratio. This ratio is obtained by simply dividing the market value of the stock by the cash flow of the company. Analysts who prefer this approach point out that earnings can be manipulated by accounting techniques and crafty green-shaded gnomes, while it is much more difficult to obscure total cash flow. What one looks for here is again a low value on the assumption that therefore the stock should perform better in the future.
4. Price-to-Sales Ratio—A relatively new innovation in measuring value has been the price-to-sales ratio. It is similar to the price-toearnings ratio but compares the price of a stock to the total annual sales instead of earnings. High price-to-sales ratios are typically bearish, low ones bullish.
5. Yield—Dividend yields are yet one more measure of value. Here the question is what return an investor gets from directly holding the stock. There is always the potential for market appreciation, but what about the dividend the company pays? The theory is that high-dividend stocks are good values. The mere fact the company can pay a dividend tells us it is making money and gives us the best of both worlds, potential upside appreciation coupled with a return on our investment.
6. Return on Equity—Return on equity is a value marker that has been used for many years. It is arrived at by dividing the equity of the stock into income (after all expenses excluding dividends). This number is multiplied by 100 to place it in a percentage basis. Here, the higher the number the better.
7. Relative Strength—The last measure that is widely used by funds and money managers received its notoriety in the 1960s when many analysts said the relative price performance of an issue compared to another issue had predictive value. This is called relative strength and usually looks at the price change of all stocks today versus where they were 12 months ago. By and large it is assumed that stocks with high relative strength numbers, the ones that have been going up, will continue going up.

Now let’s turn our attention to these values. Each has merit in helping us select stocks that have the highest probability for upside appreciation. The more you understand these techniques, the better you should be able to implement them in your own investment decisions.

Since the sack attack of the Nasdaq, investors and friends have asked me what I think of this market, which translates to “When will my stocks come back?” I’d prefer not to answer the question, because I know they’d prefer not to know the answer. “The best analogy,” I tell them, “may come from looking at what has happened in Japan. Here,” I continue, “look at the long-term chart of the Nikkei. Notice how similar it is to the Nasdaq. See how it had that exponential rise in 1989 (notice the decennial nine year pattern there, too). Gee, does that look to you like the Nasdaq?” I ask.

That’s about the time their mouths drop open; then they say, “Yeah, the up move looks like the one here, but that was 14 years ago. Are you telling me that’s what’s going to happen to my stocks?”

“Probably,” I say as I try to get away from them, “especially if the companies you have invested in don’t have any earnings or the price of the stock is relatively high compared to the company earnings.”

That’s when they start mumbling about these being growth companies, part of the future, that they will go back where the once were—that these companies won’t go out of business.

I shake my head as I give them my last two cents of advice: “Bite the bullet—these sad sacks are not coming back. The Nikkei, gold, and commodities are your model to study.”

Should you decide not to try to pick individual stocks, there is still an easy way to beat the market by beating the funds.

The concept is simple; since the funds are not that great themselves, and are always subject to sizable down moves, all we need to do is develop a timing system or technique that allows us to buy and sell mutual funds so we are with them for the up moves and in cash, on the sidelines, when the funds decline.

This is a most interesting concept—we leave stock picking to supposed experts! Our effort will be to select funds that advance rapidly in market up moves, then liquidate our positions before a substantial decline.

We have three challenges in this case. First, instead of finding a hot stock, we will want to find mutual funds that have historically done very well in market up moves. Second, these funds will charge us no, or a very low, commission or fee for moving from a long position to cash. Third, we will need some sort of system or tool to tell us it’s time to lock up our profits when trouble in the way of a down move may be just around the corner.

There are several rating services of mutual fund performance, but the sad truth is that their ratings have very little to do with a given fund’s future performance.

Take the hugely successful Morningstar service. If you have ever read advertisements of the funds you will see them displaying four or five stars as a sign of a high ranking, a sign of being above average, from the service. These stars as a form of ratings mean nothing! In fact, almost 75 percent of the funds Morningstar follows get such four- and five-star rankings while only 25 percent receive the lower one- or two-star rankings.

The plot thickens. Wharton professor Martin Blume recently revealed that these four- and five-star rankings can be given to funds that have been in business for only three years. This is far too short a time to have confidence in how a fund will perform. The window is just too tight. Given a good three-year lucky upswing in the market, a new fund will look great, but have no experience in declining markets (or track record to pull down the hot three years’ performance), as have the older funds, which are not as apt to get the high star ratings.

A recent chart in Investor’s Business Daily, “Leading Funds over the Last Year,” illustrates this point. The yearly results are of eight funds in 1994, a year the stock market was up 1.3 percent. Of the supposed top funds, five of the eight lost money that year!

For 1995 we have another fascinating set of cold, hard facts; the S&P 500 was up 37.6 percent. Only one of the eight mutual funds beat the market. Then along comes 1997, posting a 35.1 percent gain, yet only two of the funds did better. Perhaps there’s more, or should I say less, to mutual fund performance than you thought or were told/sold.

Forbes magazine and Value Line also rank funds, and Hulbert’s number crunching arrives at the same conclusion; these rankings have no ability to spot the best funds in the next time period. The bottom line is that the well-ranked funds underperformed the market in the future, in some cases by almost 5 percent a year.

Knowing that even the pros cannot pick the hot funds for the coming year leads us to ask, “Is it possible to time the funds?” If so, in theory, we could miss the big slides that hurt the funds’ performance and we could sidestep bear markets.

The answer is a clear-cut: “Yes, you can beat the funds with a simple mechanical rule or two. It is possible to be out of the markets when the big crashes come.”

Sure, it will take a little work to time the funds you are holding. It may take 15 minutes a week at the most, and many weeks there will be nothing to do.

As always, I’ll first prove my point, then give you the formula you need to pull this all off.

Our first step will be to buy a mutual fund. Which one? It may not matter too much, based on the evidence I’ve just presented. The old reliable funds would include Kaufman, Oppenheimer Quest A, AIM Funds Aggressive Growth, Fidelity Low Priced, Fidelity Contrafund, Fidelity Inv., Destiny l or 2. Most brokerage firms have funds that have decent performances as well. What you are looking for is a growth fund that you can get in and out of for no fee (called a load) or a very small fee. Charles Schwab, Dean Witter, and Merrill Lynch all have funds you can throw your money at, and we know rankings, ratings, and the like don’t mean much about future performance. Indeed, the only way we can buy the best-performing fund of the next time period is . . . to get lucky!

Several funds have “families of funds” that allow you to switch from their growth fund to a less aggressive fund or even a cash equivalent fund. Fidelity is perhaps the best example of this.

After you put your money down, one of two things will happen: The price or asset value will go up, or it will go down! The ups we don’t worry about. We know stock prices, on average, move higher to the tune of about 9 percent a year.

The downs are what we have to worry about. In the long run a carefully selected growth-oriented mutual fund will make money for us. The problem is that in the long run—out there someplace—is a bear market just waiting to happen that will lop off 20 percent or more of the fund’s value, seemingly stealing one-fifth of your money.

Our object, our desire, is to beat the funds by having a safety valve or off ramp to get us out before such an onslaught of selling tramples the growth our investments have made.

As you can tell, I’m a pretty down-to-earth guy. I don’t act on whims and fancy rumors. I want, need, things documented as fact to stir me to the point of shelling out my hard-earned dollars. So should you.

Most investors get it all wrong: They think investing is about finding one or two hot stocks or a great piece of real estate, buy it, then cash out for a huge gain. That’s not how money is really made in the world of investments. Far from it, this is a business of getting a return on your money. It is a business of making an amount of money worth more later than it is now. It is not about finding one-hit wonders or stocks that may zoom up in the future.

That, as we have seen earlier, is very much a game of Russian roulette. It’s a bit like baseball—home run hitters strike out a lot. Isn’t it interesting that despite the huge success of Mark McGwire, Sammy Sosa, and Barry Bonds when it comes to hitting home runs, their teams don’t get to or win the World Series? They don’t even win their divisions. So much for home runs! While they are spectacular and awesome things to see, almost as awesome as a stock that triples or quadruples in a six-month period, investing in this fashion becomes very much a hitor- miss approach. You will strike out. Lots. And that’s an expensive thing to do in this business. In baseball you get to bat again, but that may not be so easy for an investor.

In their search for investment profits people focus on the spectacular, forgetting that the way to long-term objectives is reached by having a campaign of action that includes goals, a theoretical understanding of what you hope to achieve, and a precise way of accomplishing those goals.

In the long run stocks move up and down for real reasons—things like earnings, debt, insider buying, and the like. They really matter, as any long-term viewer of stock market history realizes. In fact, I believe these fundamentals to be among the best ways of isolating long-term position plays in equities.

However, on a shorter- or intermediate-term basis, prices fluctuate, and sometimes quite wildly. Many of these gyrations are undoubtedly random and defy prediction. Yet, the vast majority of these intermediate-term highs can be found to shape up at the precise moment my sentiment index is telling us there are too many buyers.

Market lows are just the reverse. The majority of them are formed when there are too many people thinking or advising others to sell, clear evidence that the market seems destined to prove the majority of people wrong the majority of the time.

An equally interesting point is that it does not seem to matter what the company does, or in the current market environment, doesn’t do. What clearly does matter is that when too many of the crew get on one side of the stock market boat it’s going to tip back the other way (unlike a real boat), just as when the majority think they have it figured out that the trend is up, its predestination is to change.

It will pay big dividends to study the fundamental underpinnings of a company to select long-term investments. But when it comes to timing the entry into these issues I certainly want to be doing what the majority of others are not doing.

Thanks to today’s communications and Internet sites, it is possible to track and tabulate the mind-sets of many of the players in this game so that we, hopefully, do not get caught up in the peer pressures that make for market turning points.

The infamous speculator Jesse Livermore summed it up best when he wrote, “I believe it is a safe bet that the money lost by short-term speculation is small when compared with the gigantic sums lost by so-called investors who have let their investments ride. The intelligent investor will act promptly, thus holding his losses to a minimum.”

You may want to think of it in this fashion: Betting on tomorrow is a dicey deal full of risk and chance. Now, imagine making that same bet on a day 20 or 30 years into the future. Can you see the craziness of thinking you can see that far into the future? People are lured into the idea of long term investing because they don’t have to make many decisions, don’t have to work at it, and love the idea of a long-term nest egg. Thinking they have some type of long-range plan gives people a cozy, warm feeling—they have their lives all figured out.

A good investment can turn into a long-term investment, which is why each and every investment we make needs to be constantly reevaluated in light of changing circumstances in your life as well as the marketplace.

So, the time frame an investor chooses is equally important to the vehicle he or she chooses to invest in. If you recall, when we looked at the seasonal patterns of the Dow Jones Industrial Average, we saw that it has major ups and downs usually lasting from six months to a year or so. But clearly, there’s no straight up path to stock market investing. Never has been, never will be. Thus it seems to me that the purpose of our investing should be to get in at the right time and get out at what is also the right time.

Admittedly, we can never do this in a perfect fashion, but the data is very clear that even partially succeeding at this on an intermediate
time frame is much more successful than the long-term “buy and pray” strategy.

If your purpose is to buy stocks for gains of six months to a year or so, I think you’ll do far better than short-term traders or long-term holders.

What this formula did for my trading results was phenomenal. In a very short time I became a real-life legend as very small amounts of money skyrocketed. Using the percent of the money in the account based on the Kelly formula, divided by margin, was my approach. It was so good that I was actually kicked out of one trading contest because the promoter believed the results could not be accomplished without cheating! To this day, people on the Internet claim I used two accounts, one for winning trades and one for losers! They seem to forget, or not know, that in addition to such a practice being highly illegal, all trades must have an account number on them before the trade is entered, so how could the broker, or myself, know which trade should have the winning account number on it?

But what would you expect when no one, to my knowledge, had turned in that type of performance ever before in the history of trading? To make matters worse, I did it more than once. If it wasn’t a fluke or luck. The losers lament is that it must have been done by pinching some numbers or trades along the way.

What I was doing was revolutionary. And, like with any good revolution, some blood flowed in the streets. The blood of disbelief was that first the National Futures Association and the Commodity Futures Trading Commission commandeered all my account records, looking for fraud!

The CFTC went through the brokerage firm’s records with a finetoothed comb, then took all my records and kept them for over a year before giving them back. About a year after getting them back, guess what, they wanted them back again. Success kills.

All this was due to market performance that was unheard-of. One of the accounts I managed went from $60,000 to some $500,000 in about 18 months using this new form of money management. Then the client sued me, her lawyer, saying she should have made $54,000,000 instead of half a million. Now my believers were willing to put me on a pedestal, if they could collect some money. The revolution was more than anyone could handle.

What a story, huh?

But there are two edges to this money management sword.

My extraordinary performance attracted lots of money for me to manage. Lots of money, and then it began to happen . . . the other side of the sword flashed in the sun. Amidst trying to now be a business manager (i.e., running a money management firm), with precious few skills at doing something I’m no good at anyway, my market system or approach hit the skids, encountering a cold streak that saw equally spectacular erosions of equity. While I had been making money hand over fist, I was now losing money hand over fist.

Brokers and clients screamed. Most took the off-ramps—they simply could not handle this type of volatility in their account balances. My own account, which had started the first of the year at $10,000 (yes, that is $10,000) and reached $2,100,000 (yes, that’s $2.1 million) got hit along with everyone else’s. It too was caught in the whirlpool, spiraling down to a meager $700,000.

About then everyone jumped ship, except me. Hey, I’m a commodity trader; I like roller coasters. Is there another form of life? Not that I knew, so I stayed on trading the account back to $1,100,000 by the end of 1987.

What a year!

Watching all this over my shoulder every day was Ralph Vince, while we were working together on systems and money management. Long before I could see it, he saw it, saw there was a fatal flaw in the Kelly formula. I was too dumb. I kept trading it while Ralph, being the math genius he is, began intense research into money management, the culmination of which are three great books. His first was The Mathematics of Money Management, followed by Portfolio Management Formulas, and my favorite, The New Money Management, all published by John Wiley & Sons, Inc. These are must-reads for any serious trader or money manager.

Ralph noticed the error of Kelly, that it was originally formulated to assist in implementing the flow of electricity, then used for blackjack. The rub comes from the simple fact that blackjack is not commodity or stock trading. In blackjack your potential loss on each wager is limited to the chips you put up, while your potential gain will always be the same in relation to the chips bet.

We speculators don’t have such an easy life. The size of our wins and losses bounces all over the place. Sometimes we get big winners, sometimes minuscule ones. Our losses reflect the same pattern; they are random in size.

Now the reality is that this system may not hold up in the future exactly like this. You will probably not want to trade up to 5,000 bonds, which this test allowed. In that case one tick, the smallest price change bonds can have, would cost you $162,500 if that one tick is against you. I’ve been there . . . that’s real pressure. Let me add, it is not unusual for bonds to open 8 to 10 ticks against you. Every morning, that’s $1,625,000! So, don’t get carried away with the profits. Focus on the impact of the results money management can produce.

As soon as Ralph realized this, he could explain the wild gyrations in my equity swings, that they came about because we were using the wrong formula. This may seem pretty basic as we have a new century, but back then we were in the midst of a revolution in money management and this stuff was not easy to see. We were tracking and trading where, to the best of my knowledge, no one had gone before. What we saw were some phenomenal trading results, so we did not want to wander too far from whatever it was we were doing.

Ralph came up with an idea he calls Optimal F. It’s similar to Kelly, but unlike Kelly it can adapt to trading markets and gives you a fixed percent of your account balance to bankroll all your trades.