Article provided by Lee Bohl. Lee provides research, commentary and actionable insights to Charles Schwab.
There are many ways to pick stocks. Traditionally, longer-term investors have relied on fundamental analysis, which focuses on things like a company’s management structure, competitors, industry position, growth rate, growth potential, income, and revenues to try to determine if it is a good value. Many key metrics such as earnings per share, price-to-earnings ratio, price-to-earnings growth, and dividend yield have been developed over the years to make it easier to compare two companies with different share prices, a different number of shares outstanding, or just different corporate structures, side by side.
Shorter-term traders often rely on technical analysis, which focuses on patterns within stock charts as a way to try to forecast future pricing and volume trends. Technical analysis is based on the assumption that future patterns and movement will often be similar to previous patterns and movement. Followers of technical analysis typically believe that charts reflect all the information that is publicly known about a particular company, by those who are trading it, and their activities are directly reflected in how chart patterns emerge.
Which of the two types of analysis takes on the greater importance is often determined largely by the time horizon of the strategy being considered; essentially the longer-term the strategy the greater the emphasis should be on Fundamentals; the shorter-term the strategy, the greater the emphasis should be on Technicals. Both forms of analysis are important and ignoring either potentially overlooks valuable information. Since the intended duration of a trade may change, employing both forms of analysis on every trade just makes good sense.
For shorter-term traders, the probability of success on even a short-term bullish strategy can sometimes be improved by narrowing the search to only those candidates that are also fundamentally sound. For longer-term investors, just because a stock is fundamentally sound, it doesn’t always mean that the current price will always be an ideal entry point, as shorter-term traders trading the same stock may create near-term overbought and oversold conditions.
Essentially, by using both fundamental and technical analysis, shorter-term traders and longer-term investors may be able to improve their chances of success by using fundamental factors to select the candidate and technical factors to dictate the ideal entry or exit price.
Focus on fundamentals first
Longer-term investors focused primarily on fundamental analysis may often be broken into two main categories: Growth Investors, who place a higher priority on the futureprospects of a particular company and Value Investors, who place a higher priority on whether the current stock price is aligned with the health of a particular company.
The sole purpose for the existence of corporations is to grow. And the reason they grow is to eventually turn a profit and return some of that profit to the shareholders. Very few new companies are immediately profitable, but if they are able to show strong revenue growth initially, even while losing money, growth investors will often invest in them with the hope that profits will eventually materialize. When enough investors are motivated in this manner, possibly because a company has an innovative product or a competitive advantage, the share prices of these companies will be driven higher by buyers; the more buyers, the higher the prices will rise. As a result, the historical and projected growth rates are typically the most important factors for investors buying shares of relatively new companies. Growth investors tend to be somewhat younger, with longer time horizons than value investors.
Value investors tend to seek out larger, more established companies that appear to be priced below the level that would be expected based on their revenues or earnings per share. Value investors often focus on companies that are leaders in their industry, even though their growth rates have slowed down, because they often pay steady dividends. Value stocks often have low price-to-earnings ratios and pay above average dividends, but trade at a price that is very low or below their book value. Sometimes value investing is described as investing in great companies at a good price, not simply buying cheap stocks. Value investors tend to be somewhat older, with shorter time horizons than growth investors.
Once you’ve identified whether you are looking for Growth or Value stocks, you can go to Schwab.com and create a stock screener to help narrow down the choices to a manageable list of quality candidates.
Source: StreetSmart Edge®
When screening for fundamental factors, consider limiting your analysis to only those stocks that have a Schwab Equity Rating (SER) of “A” or “B”, as these are considered buy candidates. In the example below, this criteria alone reduces the universe of choices down from about 2800 to just 824.
Source: StreetSmart Edge®
Since the SER rating already takes many fundamental factors into account, to keep things simple, investors searching for growth stocks should consider stocks that have a history of strong revenue growth as well as strong projected revenue growth and strong projected earnings in the future. In the example below, these 3 additional criteria reduce the universe of choices down from 824 to just 6.
Source: StreetSmart Edge®
After viewing the 6 matches from this screener, you can follow the Technical Analysis process to narrow down your choices even further.
For a similarly simple approach to finding value stocks, investors should consider stocks that have an above average dividend yield as well as a low price-to-earnings ratio and a price that is less than its book value. In the example below, these 3 additional criteria reduce the universe of choices down from 824 to just 5.
Source: StreetSmart Edge®
After viewing the 5 matches from this screener, you can follow the Technical Analysis process to narrow down your choices even further.
Focus on technicals second
People often spend too much time on stock selection. It doesn’t have to be a complicated process. You need to spend the bulk of your energy on managing risk and making sure that bad trades don’t turn into really big losers.
There are three key pieces to stock selection based on technical analysis: stock screening, chart scanning, and the trade setup. With stock screening, your goal is to quickly sort through thousands of stocks using a set of technical criteria and end up with a list of 20 or 25 candidates. You then try to narrow that list down to three or four candidates by scanning the charts for possible entries. Finally, you perform a more detailed chart analysis and choose the one you’ll trade.
To illustrate this process, let’s assume I’m a swing trader looking for my next trade. Swing traders tend to hold a stock for a few days to a few weeks.
For the screening step, I could start with a few basic criteria such as market capitalization or price. If I never trade stocks priced over $100, for instance, I could rule them out right away. Next, as a top-down trader, I need to include the strong sector and industry groups if I want to go long, or the weak ones if I want to go short.
For technical criteria I want strong, uptrending stocks for my potential buys and weak downtrending stocks for my shorts. I want to trade with the trend in my time frame. To find them I’ll use moving average analysis. Moving averages are trend-following indicators that smooth out the day-to-day price movements to give you a sense of the trend. They can also act as support and resistance levels. A simple moving average is calculated by averaging the closing prices over a period of time giving equal weight to each close.
For the longs, I will require that the stock be above its 20-day moving average and that its 20-day moving average be above its 50-day moving average. For the shorts I’ll require that the stock be below its 20-day moving average and that its 20-day moving average be below its 50-day moving average. For liquidity, I’ll require that the stock trade at least 200,000 shares a day.
Now I need to go on to step two, scanning the charts of the candidates generated from my screen and looking for stocks setting up with good entries. There are two main entry strategies for swing trading: breakouts in the direction of the trend (new highs or lows) and pullbacks.
For breakouts on longs, I am looking to enter on the first new high, or maybe the second after the stock has traded sideways for a few days. For breakouts on shorts, I am looking to enter on the first or second new low after a few days of sideways movement. With the pullback strategy, I want the stock to correct for a few days in the direction opposite the trend, then buy into that short-term weakness on the longs and sell into that short-term strength on the shorts.
For the last step, the trade setup, I need to more closely examine the charts of the stocks that passed step two and pick the one stock I will trade the next day. We’ll assume for sake of discussion that I prefer pullback entries and have narrowed my choices down to two buy candidates, stock A, (figure 1) and stock B (figure 2). To help me decide I am going to use price patterns, volume, moving averages and one additional tool, the stochastic oscillator.
The stochastic indicator compares where a security’s price is relative to its price range over a given time period. One version consists of two lines, %K (fast line) and %D (slow line.) Values can range from 0 to 100, with a reading over 75 showing that the stock may be “overbought” and possibly overextended on the upside and readings under 25 showing that the stock is “oversold” and possibly overextended on the downside.
When a stock is in a trading range and the stochastics values move into the overbought or oversold, you should be looking for a price reversal. This is especially true when the fast line is crossing from below to above the slow line for an upward reversal and from above to below for a downward reversal. It doesn’t quite work this way in trends, however. In an uptrending market for example, the oscillator can reach overbought and stay there for extended periods as the stock works its way higher.
When evaluating pullbacks, I am looking for signs that the pullback is simply a pullback and not a reversal. Although you can never know for sure, chances of a reversal are diminished if the stock has pulled back to a support level, such as a moving average or old low. Also, if the stock can exceed the high of the previous day, it can be a sign that the pullback is ending and that it’s ready to resume its uptrend. Both stocks A and B have pulled back and held their 21-day moving averages. So far, so good.
Now, look at the last trading day for each. Stock A was unable to trade above its previous day high either on an intraday or closing basis. Also, it closed about where it opened and did so in the middle of a narrow range, all signs that buyers lacked conviction. The %D line indicates that the stock isn’t oversold, which is very good and typical of an uptrend. However, the stochastics lines haven’t crossed either. %K is still below %D. If %K had crossed %D, that would show a little more upside strength. On the positive side, the volume was relatively light. Heavy volume when the stock moves in the opposite direction of the trend can be a danger signal.
The last trading day on stock B tells a different story. The stock not only was able to trade intraday through the previous day’s high, it also managed to close above it. Note also that it had a wide-range day with a close near the top. These are all signs that the buyers have gained control and that the pullback could be over, especially since this price action was achieved on higher than average volume. Also, stochastics show that neither %K nor %D are oversold, indicating strength. In addition %K has crossed %D which is another bullish sign. Stock B, then looks like the stronger candidate for the next day.
Figure 1: Source: StreetSmart Edge®
Figure 2: Source: StreetSmart Edge®
Stock selection doesn’t have to be difficult, but you do need to be flexible. Don’t worry about whether the market is going up or down. Instead, look for markets that are moving and be willing to go short as well as long. Finally, and perhaps most importantly, you need to be disciplined. Don’t let the inevitable bad trades turn into disasters. Keep your losses small and live to trade another day.