CHAPTER 7
L = Leader or Laggard: Which Is Your Stock?

People tend to buy stocks that make them feel either good or comfortable. But in a bull market populated by dynamic leaders that just keep surprising on the upside, these sentimental favorites often turn out to be the dullest laggards.

Suppose you want to own a stock in the computer industry. If you buy the best performer in the group, and your timing is right, you have a crack at real price appreciation. But if you buy a stock that hasn’t moved much, or that has even fallen to a price that makes it seem like a bargain and therefore safer, chances are that you’ve picked a stock with little potential. There’s a reason, after all, that it’s at the bottom of the pile.

Don’t just dabble in stocks, buying what you like for whatever reason. Dig in, do some detective work, and find out what makes some stocks go up much more than others. You can do it, if you work at it.

Buy Among the Best Two or Three Stocks in a Group

The top one, two, or three stocks in a strong industry group can have unbelievable growth, while others in the pack may hardly stir.

The great computer stocks in the bull market of 1979 and 1980—Wang Labs, Prime Computer, Datapoint, Rolm, and Tandy—had five-, six-, and sevenfold advances before they topped and retreated. But the sentimental favorite, grand old IBM, just sat there, and giants Burroughs, NCR, and Sperry Rand were just as lifeless. In the bull market of 1981–1983, however, IBM sprang to life and produced excellent results.

In the retail sector, Home Depot advanced 10 times from 1988 to 1992, while the laggards in the home-improvement niche, Waban and Hechinger, dramatically underperformed.

You should buy the really great companies—those that lead their industries and are number one in their particular fields. All of my best big winners—Syntex in 1963, Pic ‘N’ Save from 1976 to 1983, Price Co. from 1982 to 1985, Franklin Resources from 1985 to 1986, Genentech from 1986 to 1987, Amgen from 1990 to 1991, America Online from 1998 to 1999, Charles Schwab from 1998 to 1999, Sun Microsystems from 1998 to 1999, Qualcomm in 1999, eBay from 2002 to 2004, Google from 2004 to 2007, and Apple from 2004 to 2007—were the number one companies in their industry space at the time I purchased them.

By number one, I don’t mean the largest company or the one with the most recognized brand name. I mean the one with the best quarterly and annual earnings growth, the highest return on equity, the widest profit margins, the strongest sales growth, and the most dynamic stock-price action. This type of company will also have a unique and superior product or service and be gaining market share from its older, less-innovative competitors.

Avoid Sympathy Stocks, Buy New Innovative Leaders

Our studies show that very little in the stock market is really new; history just keeps repeating itself.

When I first bought stock in Syntex, the developer of the birth-control pill, in July 1963 off a high, tight flag pattern (and it then rapidly shot up 400%), most people wouldn’t touch it. The stock had just made a new price high at $100 on the American Stock Exchange, and its price plus its P/E ratio, 45, made it seem too high and scary. No brokerage firms had research reports on it then, and the only mutual fund that owned it—a Value Line fund—had sold it the prior quarter when it began moving up. Instead, several Wall Street investment firms later recommended G. D. Searle as a “sympathy play.” Searle had a product similar to Syntex’s, and its stock looked much cheaper because it hadn’t gone up as much. But its stock failed to produce the same results. Syntex was the leader; Searle the laggard.

A sympathy play is a stock in the same industry group that is bought in the hope that the luster of the real leader will rub off on it. But the profits of such companies usually pale in comparison. The stocks will eventually try to move up “in sympathy” with the leader, but they never do as well.

In 1970, Levitz Furniture, the leader in the then-new warehouse business, became an electrifying market winner. Wickes Corp. copied Levitz, and many people bought its shares because they were “cheaper,” but Wickes never performed and ultimately got into financial trouble. Levitz, meanwhile, appreciated 900% before it finally topped.

As steel industry pioneer Andrew Carnegie said in his autobiography: “The first man gets the oyster; the second, the shell.” Each new business cycle in America is driven by new innovators, inventors, and entrepreneurs.

If our government really wants to create jobs and not welfare packages, the most powerful way would be to provide strong tax incentives for the first two or three years to people who want to start new, small entrepreneurial businesses. Our data show that in the last 25 years, small businesses in America were responsible for creating 80% to 90% of all new jobs. This is a significantly higher percentage than that shown in government data, where new jobs are not accounted for in a realistic, comprehensive manner.

For example, the Small Business Administration defines a small business as one with fewer than 500 people. Yes, when Sam Walton started Wal-Mart and Bill Gates started Microsoft, each company had maybe 30 or 40 people. A year later they had maybe 75, the next year 120, then 200, then 320, then 501. From that point on, they were no longer considered to be small companies. But over the next 10 or 15 years, one of them created more than a million jobs and the other 500,000 jobs. Those jobs were all created by a dynamic entrepreneur who started a brand-new company, and they should be recognized and counted as such.

We have a huge database on all public companies. In the past 25 years, big business created no net new jobs. When a big business buys another company, thereby instantly padding its payrolls, it doesn’t create new jobs. In fact, it usually consolidates and lays off people in duplicative positions. Many such companies also downsize over time. Our inefficient, bureaucratic government needs to start counting all jobs created by new or small businesses during their first 15 or 20 years in business.

How to Separate the Leaders from the Laggards: Using Relative Price Strength

If you own a portfolio of stocks, you must learn to sell the worst performers first and keep the best a little longer. In other words, always sell your mistakes while the loss is still small, and watch your better selections to see if they progress into your big winners. Human nature being what it is, most people do it backwards: they hold their losers and sell their winners, a formula that always leads to bigger losses.

How do you tell which stock is better and which is worse? The fastest and easiest way is by checking its Relative Price Strength (RS) Rating in Investor’s Business Daily.

The proprietary RS Rating measures the price performance of a given stock against the rest of the market for the past 52 weeks. Every stock in the market is assigned a rating from 1 to 99, with 99 being best. An RS Rating of 99 means that the stock has outperformed 99% of all other companies in terms of price performance. A RS of 50 means that half of all other stocks have done better and half have done worse.

If your stock’s RS Rating is below 70, it is lagging the better-performing stocks in the overall market. That doesn’t mean that it can’t go up in price. It just means that if by some chance it does go up, it’ll probably go up less.

From the early 1950s through 2008, the average RS Rating of the best-performing stocks before their major run-ups was 87. In other words, the best stocks were already doing better than nearly 9 out of 10 others when they were starting out on their most explosive advance yet. So the rule for those who are determined to be big winners in the stock market is: look for the genuine leaders and avoid laggards and sympathy plays. Don’t buy stocks with Relative Strength Ratings in the 40s, 50s, or 60s.

The Relative Price Strength Rating is shown each day for all stocks listed in Investor’s Business Daily’s stock tables. You can’t find this information in any other daily business or local newspaper. Updated RS Ratings are also shown on the Daily Graphs Online charting service.

A stock’s relative strength can also be plotted on a chart. If the RS line has been sinking for seven months or more, or if the line has an abnormally sharp decline for four months or more, the stock’s price behavior is highly questionable, and it should probably be sold.

Pick 80s and 90s That Are in Sound and Proper Base Patterns

If you want to upgrade your stock selection so that you’re zeroing in on the leaders, restrict your purchases to companies showing RS Ratings of 80 or higher. There’s no point in buying a stock that’s straggling behind. Yet that’s exactly what many investors do—including some who work at America’s largest investment firms.

I don’t like to buy stocks with Relative Price Strength Ratings less than 80. In fact, the really big moneymakers generally have RS Ratings of 90 or higher just before they break out of their first or second base structure. The RS Rating of a potential winning stock should be in the same league as a pitcher’s fastball. The average big-league fastball is clocked at 86 miles per hour, and the best pitchers throw “heat” in the 90s.

When you buy a stock, make absolutely sure that it’s coming out of a sound base or price consolidation area. Also make sure that you buy it at its exact buy, or pivot, point. As mentioned before, avoid buying stocks that are extended more than 5% or 10% above the precise initial buy point. This will keep you from chasing stocks that race up in price too rapidly and makes it less likely that you will be shaken out during sharp market sell-offs.

The unwillingness of investors to set and follow minimum standards for stock selection reminds me of doctors years ago who were ignorant of the need to sterilize their instruments before each operation. They kept killing off patients until surgeons finally and begrudgingly accepted studies by researchers Louis Pasteur and Joseph Lister. Ignorance rarely pays off in any walk of life, and it’s no different in the stock market.

Finding New Leaders during Market Corrections

Corrections, or price declines, in the general market can help you recognize new leaders—if you know what to look for. The more desirable growth stocks normally correct 1½ to 2½ times the general market averages. In other words, if the overall market comes down 10%, the better growth stocks will correct 15% to 25%. However, in a correction during a bull, or upward-trending, market, the growth stocks that decline the least (percentagewise) are usually your best selections. Those that drop the most are normally the weakest.

Say the general market average suffers an intermediate-term correction of 10%, and three of your successful growth stocks come off 15%, 25%, and 35%. The two that are off only 15% or 25% are likely to be your best investments after they recover. A stock that slides 35% to 40% in a general market decline of 10% could be flashing a warning signal. In most cases, you should heed it.

Once a general market decline is definitely over, the first stocks that bounce back to new price highs are almost always your authentic leaders. These chart breakouts continue week by week for about 13 weeks. The best ones usually come out in the first three or four weeks. This is the ideal period to buy stocks . . . you absolutely don’t want to miss it. Be sure to read the chapter on general market direction carefully to learn how you determine it.

Pros Make Many Mistakes Too

Many professional investment managers make the serious mistake of buying stocks that have just suffered unusually large price drops. Our studies indicate that this is a surefire way to get yourself in trouble.

In June 1972, an otherwise capable institutional investor in Maryland bought Levitz Furniture after its first abnormal price break—a one-week drop from $60 to around $40. The stock rallied for a few weeks, then rolled over and broke to $18.

In October 1978, several institutional investors bought Memorex, a leading supplier of computer peripheral equipment, when it had its first unusual price break and looked to be a real value. It later plunged.

In September 1981, certain money managers in New York bought Dome Petroleum on a break from $16 to $12. To them, it seemed cheap, and a favorable story about the stock was going around Wall Street. Months later, Dome sold for $1.

Institutional buyers snapped up Lucent Technologies, a Wall Street darling after it was spun off from AT&T in the mid-1990s, after it broke from $78 to $50. Later that year, it collapsed to $5.

Also in 2000, many people bought Cisco Systems when it dropped to $50 from its early-year high of $82. The maker of computer networking equipment had been a huge winner in the 1990s, when it soared 75,000%, so it looked cheap at $50. It went to $8 and never got back to $50. In 2008, eight years after those buyers saw value at $50, Cisco was selling for only $17. To do well in the stock market, you’ve got to stop doing what got you into trouble in the past and create new and far better rules and methods to guide you in the future.

Suppose Joe Investor missed buying Crocs, the footwear company, at a split-adjusted $15 as it came out of the perfect cup-with-handle pattern in September 2006. Suppose he also missed the next cup pattern in April 2007 at 28. Then the stock roars up to $75 by October, with earnings up 100% every quarter. A month later, however, the stock drops to 47, and Joe sees his chance to get into this big winner that he missed all the way up and that’s now at a cheaper price. But the stock just keeps falling, and by January 2009 it’s trading at $1. Buying stocks on the way down is dangerous. You can get wiped out. So stop this risky bad habit.

How about buying a blue chip, a top-flight bank that’s a leader in its industry—Bank of America? In December 2006, it was $55 a share, but you could have gotten it cheaper a year later at $40. Another year later, however, it had plunged to $6. But you’re still a long-term investor, getting your 4-cent dividend.

This is why I say don’t buy a supposed good stock on the way down and why we recommend cutting all losses at 7% or 8%. Any stock can do anything. You must have rules to protect your hard-earned money. We all make mistakes. You must learn to correct yours without vacillating.

None of the pros or individual investors who owned or bought Cisco, Crocs, or BofA when they were falling recognized the difference between normal price declines and highly abnormal big-volume corrections that can signal potential disaster. But the real problem was they relied on stories they’d heard and a method of fundamental analysis that equates lower P/E ratios with “value.” They didn’t heed the market action that could have told them what was really going on.

Those who listen and learn the difference between normal and abnormal action are said to have a “good feel for the market.” Those who ignore what the market says usually pay a heavy price. Anyone who buys stocks on the way down in price because they look cheap will learn the hard way this is how you can lose a lot of money.

Look for Abnormal Strength on a Weak Market Day

In the spring of 1967, I remember walking through a broker’s office in New York on a day when the Dow Jones Industrial Average was down more than 12 points. That was a lot in those days, when the Dow was around 800 compared with 8,000 in 2008. When I looked up at the electronic ticker tape moving across the wall and showing prices, I saw that Control Data—a pioneer in supercomputers—was trading at $62, up 3½ points on heavy volume. I bought the stock at once. I knew Control Data well, and this was highly abnormal strength in the face of a weak overall market. The stock later ran up to $150.

In April 1981, just as the 1981 bear market was getting under way, MCI Communications, a telecommunications stock trading in the over-the-counter market, broke out of a price base at $15. It advanced to the equivalent of $90 in 21 months. This was another great example of highly abnormal strength during a weak market.

Lorillard, the tobacco company, did the same thing in the 1957 bear market, Software Toolworks soared in the down market of early 1990, wireless telecom firm Qualcomm made big progress even during the difficult midyear market of 1999, and Taro Pharmaceutical late in 2000 bucked the bear market that had begun that spring. Also in 2000, home builder NVR took off at $50 and rode steadily lower interest rates up to $360 by March 2003. The new bull market in 2003 uncovered many leaders, including Apple, Google, Research in Motion, Potash, and several Chinese stocks.

So don’t forget: It seldom pays to invest in laggard stocks, even if they look tantalizingly cheap. Look for, and confine your purchases to, market leaders. Get out of your laggard losers if you’re down 8% below the price you paid so that you won’t risk getting badly hurt.