Tuesday, August 23, 2011

Market Leaders; a Double Edge Sword - Part 1

Just as the leaders lead on the upside, they also lead on the downside. Why? After an extended rally or bull market, the market’s true leaders have already made their big moves. The smart money that moved into these stocks ahead of the curve will move out swiftly at the first hint of slowing slow. When the leading names in leading industry groups start to falter after an extended market run, this is a danger signal that should heighten your attention to the more specific signs of market trouble or possible trouble in a particular sector or industry group.

Most stocks experience a relatively severe decline in price after a phenomenal advance has run its course. This is normally due to profit-taking and the anticipation of slower growth ahead. A weakening general market is often the cause for subsequent price declines.

There will come a point when leading stocks stop making new highs, start to churn, or, even worse, buckle and reverse direction. This often happens before the overall market tops and gets into serious trouble. For example, in mid-1999, I started to point out the divergences and negative signals that specific stocks were flashing. At the time, some of the market’s key leaders were starting to top out, while the indexes continued to accelerate higher. For months I saw evidence that the ice was melting beneath the market, based on the action of leading stocks. Institutional clients kept asking me if I was sure about my opinion, because while the divergences were clear, the market averages kept powering upward. I was asked repeatedly, are you being too cautious?

F5 Networks - Stock Tops Before Market

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Bull markets sometimes roll over gradually whereas bottoms often end with a sudden sell-off, followed by a strong rally. As the leaders start to buckle, the indexes can move up farther or start to churn, moving sideways. That's because cash stays in the market and rotates into laggard stocks. The indexes hold up or even track higher on the backs of the stragglers. Watch out! When this happens the end is near and the really great opportunities may have already passed.

Most investors miss these subtle signs, mainly because they become conditioned by the market’s previous persistence upward during the bullish phases. What’s the big deal if a few stocks start to crack, they tell themselves, as long as the Dow keeps heading higher; Right?

A bull market is always dominated by at least one sector and several sub-sectors. Within the top sectors leading a new bull market, the relatively few leading names that dominate the leadership during a bull market eventually attracts the attention of institutional money. The excessive, concentrated buying enthusiasm for those leaders can push their prices far above realistic valuations. As a result, those same issues tend to decline the most during the subsequent bear market. For those investors who hold on to the former leaders for too long, the results can be devastating.

Mark Minervini

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MARK MINERVINI'S STOCK SELECTION STRATEGY

Specific Entry Point Analysis® -SEPA®

Specific Entry Point Analysis® - SEPA® was developed by Mark Minervini. The methodology’s foundation is built upon historical precedent analysis of past stock market “SUPER PERFORMERS.” To determine what characteristics make a stock likely to advance significantly, historical models of top price performers and industry leaders are archived in the Minervini confidential database. These models are based upon sets of characteristics prevalent in exceptional winning stocks.

PATTERNS OF EXCELLENCE
On-going efforts are focused on identifying in detail the characteristics of the most successful performers of the past to determine what makes a stock likely to outperform its peers in the future. Based on these attributes, current investment candidates can be compared and scrutinized for criteria in-line with our proprietary Leadership Profile®. This success blueprint is the fundamental basis for our stock selection. The database and profile is continually updated to account for market dynamics and new available data. The SEPA® model takes into account thousands of historic company profiles going back over many market cycles spanning numerous decades. In order to find rapidly growing companies with the ability to sustain above average appreciation, a unique combination of quantitative screening, fundamental research and qualitative analysis serve as core selection criteria for the SEPA® investment process.

Additionally, the SEPA® ranking process scores each company based on earnings surprises, estimate revisions and company issued guidance in order to determine the probability for future price performance catalysts. A unique component of the SEPA® process is a focus on “where” a stock is within its earnings maturation cycle. Each day, computers systematically analyze thousands of stocks for specific data items using a proprietary series of absolute, relative and time dimension calculations. The extensive fundamental research ranks each investment candidate for probable earnings surprise.

Specific Entry Point Analysis® focuses on identifying, company-by-company, the precursors of inefficient pricing in order to distinguish appropriate entry points. Utilizing SEPA® Technology, stocks displaying the potential for significant price appreciation are identified and pinpointed. While nothing is perfect, the proven SEPA® Technology consistently highlights many of the best investment ideas and stock market leaders before they’re widely recognized by Wall Street.
The SEPA® screening process can be summarized as follows:

1. Stocks are screened through a series of "filters" based on earnings, sales, profit margins, relative price performance and price trend characteristics. Approximately 95% of all stocks in the market are eliminated in this first screen leaving roughly 1,000 initial contenders.

2. These remaining stocks are scrutinized and ranked for similarity to a proprietary Leadership Profile® in-line with specific fundamental and technical factors exhibited by historic models. This second stage of qualifiers removes most of the remaining companies, leaving a narrowed list of investment ideas for further review and evaluation.

3. The final stage is a comprehensive manual review. The narrowed list of candidates are examined individually and scored according to a “relative prioritizing” ranking process which considers the following characteristics:

- Reported earnings and sales
- Earnings surprise history
- EPS and sales acceleration
- Company issued guidance
- Earnings estimate revisions
- Profit margins (historic & projected)
- Industry and market position
- Potential "catalysts" (new products, services or industry changes)
- Performance compared to other stocks in same sector
- Price momentum, price trend and trading volume analysis
- Liquidity

The SEPA® ranking process is focused on identifying three key elements:

1. The potential for future earnings and sales surprises
2. The potential for institutional volume support
3. The potential for rapid price appreciation based on a supply/demand imbalance

Profiting from the Earnings Cycle

Individual stocks can go through extended periods of underperformance, in some instances for decades – Eastman Kodak’s stock price took twenty-four years (1973-1997) to just break even while the S&P 500 Index advanced 500%. While some stocks languish, companies with superior improving fundamentals can perform exceptionally well.

Large institutional buyers (mutual funds, pension plans, hedge funds, etc.) have the greatest buying power to influence a stock’s share price. So, what do they look for? Earnings and sales surprise and estimate revisions contribute to valuation model changes and thus impact buying and selling pressure. The subsequent buying pressure that comes from an earnings surprise or a company materially raising guidance generally leads to a higher stock price, which in turn attracts momentum buyers.

An understanding of how Wall Street works and identifying what specific characteristic will attract institutional buyers into a stock is our daily focus. The graph below illustrates a typical earnings maturation cycle and where we focus our efforts on buying and selling within the cycle
Summary of the SEPA® Process

HISTORICAL PRECEDENT ANALYSIS
-Study of the best performing stocks over each market cycle
-Characteristics defined and archived in our database
-Blueprint is constructed based on attributes of winners

COMPUTER SURVEILLANCE
-Computers screen 8,000+ stocks daily
-Narrows down the top 1%
-Companies displaying specific characteristics are identified

LEADERSHIP PROFILING
-Data is compared to all stocks
-Results are compared to a Leadership Profile®
-Profile is continually updated to reflect new information

RANKING AND SELECTION
-Candidates are monitored for specific criteria convergence
-Catalyst such as earnings surprise, company issued guidance
-Entry point defined based on risk/reward

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