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Process: Finding the Right Trade

by | Oct 1, 2019 | Research Process

A follower on social media highlighted this as an important topic to cover, and albeit broad, it is worth diving into as I have found that being selective as a stock-picker is one of the most important attributes.

We are in an era of explosive growth in data which is now being deemed the most valuable asset on the planet. Analytics is making huge strides and there is more data being collected than ever to crunch with the goal of providing a better outcome on decisions. This is quite apparent in markets where everyday investors now have access to an unprecedented amount of data but most do not know how to convert that data into a positive value contributor and instead fall into the trap of information overload.

There are more than 2000 stocks based in the US with market caps above $500M trading more than 100,000 shares a day, so many choices, yet many of us prefer to keep portfolio holdings under 30, so how do we narrow down these names in a modest turnover portfolio is a very important question to address.

On a broader perspective the majority of stocks on any timeframe move fairly correlated with broader markets, which in-turn are mostly driven by Macroeconomic influences. This is the upper level of thinking before making an investment because you want to be on the right side of the overall market moves so assessing current breadth, sentiment, technical analysis, and reward/risk on valuation measures all play a role into finding optimal entry and exit points. I can dive deeper into each of these topics and preferred indicators I use in the future.

The next level is at the Sector/Industry level where there can be certain factors in play that allow groups of stocks to deviate from broader market moves.  The moves at this level are mainly driven by institutional flows which are driven by a variety of factors including but not limited to foreign exchange, interest rates, thematic growth factors, risk-on/off environment, valuations, upcoming catalysts, alternative data, and many other factors. You want to be actively in-front or at least in-tandem with these sector/industry rotations.

The final level is at the company specific level where stocks move based on a number of fundamental factors that drives sentiment which drives technical/flow movement. At this level you can really drill down to being selective utilizing relative valuations and growth metrics in an effort to find the best of breed or best in class stock.

To summarize the above, if you have an internal conversation with yourself before making an investment, it would go as follows:

  • Is now a good time to be long in the overall market? What are key levels of the market to be aware and how is the current reward/risk for the expected timeframe of my investment? How does the Macro data look? Where are sentiment and breadth readings?
  • Which sectors and industries will attract investments from institutions based on the current and forecasted market environment? What companies are in these groups that are the most attractively valued given the growth, management, and future potential?
  • Which company is most worthy of my investment based on all the metrics? At what level is a good entry point and where is my expected exit point? Can I utilize options for protection and/or additional income opportunities over the expected term of this investment?

That may seem like a timely process at first but if you set up the infrastructure ahead of time it can become a near-instantaneous process, and I will share how I accomplish that feat.

The first step I take is narrowing down the large universe of stocks into “best of breed” which tends to leave me with around 300 to 400 of the top fundamentally positioned names. I took time to customize watchlists into Sector-Industry-Cohort to allow for easier comparisons of related companies. An example is for a company like Neurocrine Bio (NBIX) it would fall into Healthcare-Biotech-Neurological Diseases. This also allows for customizing exactly what metrics you want to see when flipping from one group to another because industry-specific metrics are very important and play a much larger role in valuation premiums/discounts than the more well-known metrics. In all cases I am looking at a combination of valuation, growth, profitability/efficiency, cash flows, and the health of the balance sheet. Once you have a curated list of stocks it makes it a lot easier to quickly make decisions and having a handful of names within a similar industry is fine and the final decision maker can then be a form of technical analysis for which stock offers the best reward/risk ratio in the current environment. I publish these names in our annual OptionsHawk Market Outlook release but also maintain the list fluidly by tracking earnings season closely and making additions/deletions as fundamental momentum can change, and being able to change your opinion when there is new information is crucial to being a successful investor.

A more arduous, but equally important, step is developing “playbooks” on the Macro/Industry level so you can make quick and decisive moves based on the changing Macro backdrop. This can be from a very broad scope such as a playbook for a rising interest rate environment or a weakening consumer environment to the very industry-specific. An example of the latter is we have seen a strong recent outperformance in Oil Tanker stocks like Scorpio (STNG), DHT Holdings (DHT) and others despite Oil prices being weak, solely driven by a continuous surge in freight rates to ship US crude to Asia. Maintaining an updated database of industry-specific news sources and data releases can keep you ahead of the curve. The goal of the entire process is to be better informed and in a timely manner which will improve your investment decisions. Knowledge/Information is power, and in-turn alpha, in the investment industry.

In regards to sources of information it requires an incredible amount of time to build out and organize the many information sources. Company websites are a good resources for investment presentations and transcripts from presentations at investment conferences. Twitter has become a great social media sources from creating lists detailing pertinent news from leading industry sources, I have a list set-up for each and every industry. I’ve spent many years building out and refining news resources and at OptionsHawk our focus is to make investors better informed and to do the leg-work so members can focus on analyzing and executing. Thematic investing is also a key influencer of many of my trades because you want to be long stocks benefitting from secular tailwinds.

Once you have identified the stock that fits the right trade at the right time mantra it is all about executing and managing the trade, a topic ripe for further discussion in the future.