If you were to randomly buy stocks just because you got a “hot tip” or a “gut feel”, your chances of being profitable will be 50% at best. Since a stock either goes up or down, you only have a 50/50 chance of being right.
Of course, with some luck, you could still make money. However, money that is made from a lucky streak never ever lasts. Eventually, luck will run out and you will end up losing everything and much more. This is why people who gamble at casinos or try their luck at the stock market will end up losing everything.
But when you have a method that gives you an edge over the market, you can confidently be right 70% – 80% of the time. (You can never be right 100% of the time because many factors in the world of investing that are out of our control – e.g. a sudden economic crisis can cause stock prices to fall temporarily.)
A winning method of investing should consist of 3 key components:
- What to buy
- When to buy
- When to sell
Let us go through all three in detail.
1. What to Buy
When you buy a share of stock, you are actually buying a share of a public listed company. You become a part owner (albeit a very small one) of a business.
We only want to invest in shares of very good businesses. Using fundamental analysis, we need to learn how to study the financial reports of companies to determine which are the most profitable and valuable ones.
There are many factors that make a company’s stock a good investment. Let me highlight two important ones:
- Consistently increasing sales revenue and net income
- Positive long-term growth rate
I only invest in companies that have a track record of consistently increasing sales revenue and net income, together with positive future growth potential. When a company has these fundamental qualities, its share price will have a greater potential to rise over time.
Similarly, I avoid buying stocks of companies with inconsistent or declining sales revenue and net income. Stocks of companies that have weak revenue and net income growth usually have flat of declining stock prices.
Of course, there are many more financial data and ratios we can look at to determine that it is a great company. I also look at stuff like:
- Insider activity
- Return on equity
- Statement of cash flows
- Debt-equity ratio
- Current ratio
- Gross and net margins
- Working capital versus revenue growth
- Cash conversion cycle
It is essential to do enough research on the right company’s stock to buy. They have to meet all the critical fundamental criteria!
2. When to Buy
It is not good enough to know which companies’ stocks to buy. You need to also know exactly WHEN to make your investment. I know many people who invest in great stocks.
Unfortunately, they buy it at the wrong time and see their investments go down in value for a long time before it starts recovering. Knowing WHEN to buy is even more important than knowing just WHAT to buy.
Buy Below Intrinsic Value
So, WHEN is it a good time to invest? Well, you should only buy a stock when its price is below its intrinsic value. This means that the stock is selling at a price below what it is actually worth.
I use an intrinsic value calculator to determine the true value of a stock, based on the company’s cash flow from operations, growth rate, total debt and cash holdings. The intrinsic value of a stock will also give you an indication of where the share price can potentially reach in the short term.
For example, I made an investment in Google (GOOG) on Jan 2012, a stock that has delivered consistent growth in revenue and net income. Although it seemed pricey at $575, it was actually way below its intrinsic value of $1,065. The intrinsic value of GOOG gave me the confidence that I could potentially double my investment when GOOG reaches its true value.
Wealth Academy Intrinsic Calculator
Sure enough, a year later (2013), Google (GOOG) reached $1,100 per share, giving me a nice 91.3% gain!
Chart: Think or Swim – Prophet Charts®
Buy on an Uptrend
Besides analyzing a stock’s intrinsic value, it is also very important to only buy a stock when its price is on an uptrend. Never buy a stock when the price is on a downtrend, no matter how good the stock is or how cheap the price may seem. When a stock’s price is on a downtrend, you never know how low it can go before it starts to recover. A cheap stock may become even cheaper in the short term.
An uptrend is characterized by a series of stock prices making higher high points and higher low points. On an uptrend, stock prices still go up and down. However, every time prices go down, they move up even higher subsequently.
Chart: Think or Swim – Prophet Charts®
When a stock is on an uptrend, it means that investors are getting more optimistic about it. This causes upward price momentum that drives the stock higher and higher. This will keep happening until a major news development changes the trend. It definitely makes sense to only buy a stock when it is on an uptrend because the probability is that it will keep going higher. This is why there is an old Wall Street saying, “the trend is your friend”.
3. When to Sell
Knowing when to sell your investment is the most important part of your strategy. Many investors lose money or fail to maximize their profits despite knowing WHAT to buy and WHEN to BUY. This is because they failed to know WHEN to SELL.
No matter how great a stock is, it will not go up forever. Nothing great lasts forever. If you fall too much in love with a stock and fail to sell it when it reverses to a downtrend, all your profits could be wiped out!
Winning investors strictly follow their sell rules without compromise. They understand that if they do not sell at the right time, mistakes can turn into huge losses and potential winning investments can turn into losing ones.
Two investors who buy the same stock at the same time can get very different results depending on WHEN they sell.
You should hit the sell button when…
Sell when stock reverses to a downtrend
This is to protect the profits we have made. A downtrend is characterized by a series of stock prices making lower high points and lower low points. On a downtrend, stock prices still go up and down. However, every time prices go up, they move down even lower subsequently.
When a stock is on a downtrend, it means that investors are getting more and more pessimistic. This causes downward price momentum that drives the stock lower and lower.
Price falls 5-8% below your purchase price
This is known as your stop loss price. It is an important strategy to limit your losses when you are wrong. I always use an automated stop loss order for this. Remember that no matter how great your strategy is, you can never be right 100% of the time. A stop-loss ensures that losses are limited in those instances when the stock price does not move up as expected.
If you consistently follow these three keys, WHAT to buy, WHEN to buy and WHEN to sell, you will be able to achieve a high probability of success in the stock market.