How to Pick Stocks on the Verge of a Breakout
After graduating college, I had a strong desire to learn the investment business. So I found an entry-level position supporting two of the largest retail and institutional brokers within the Merrill Lynch organization. They were incredibly successful, and the role allowed me a bird’s-eye view of a major swath of the business.
After a year, though, my position turned out to be mostly sales oriented, and my interests grew toward trading and investment management.
At the time, I was reading everything I could get my hands on regarding making money by investing. One of the books was the seminal work on growth investing, William O’Neill’s “How to Make Money in Stocks.”
The other book that left its mark on me was “Market Wizards,” a collection of interviews with top traders on how they found success. One trader spoke to me more than the others — Ed Seykota, one of the first traders to use a computerized trading system.
I was inspired by his simple and elegant description of trend following and felt I could learn a lot from him. I checked around and found that his office happened to be in the city next to where I grew up. So I sent him a letter asking for an apprenticeship. Fortunately, he agreed.
A year later, I graduated, having learned the fundamentals of successful trend following and applied technical analysis. I also helped Ed develop a relative strength/price momentum trading system.
As a Chartered Market Technician (CMT), my belief in trend following is the foundation of my investment process. In 20 years of managing money, I’ve found that trend following is the basis for profit, no matter the investment system.
When I became the chief investment strategist of Profitable Trading’s Alpha Trader service, I started employing my technical models to help determine which stocks were ripe for picking.
The main way I do this is by determining a stock’s Alpha Score. You may have heard us discuss the Alpha Score before. In a nutshell, every stock has one, and it can range from 0 to 200 — the higher the score, the better. It is based on two proven indicators — one technical and one fundamental — and it provides a way to rank every stock in the market from best to worst.
But finding the best Alpha Score stocks to recommend isn’t as easy as simply hitting a button and sending out a list of the three to five stocks at the top of the list. Each week, I start out with dozens of securities that meet the system’s criteria.
From there, I narrow down the list to a handful of stocks that are most primed to deliver winning results.
I like to think of the system as a tree that grows delicious fruit: While every fruit the tree produces will be large, sweet and juicy at some point in its life, it’s not all ready to eat at the same time. Some pieces will be hard and crisp, not quite ready to pick. Others may be starting to bruise and wrinkle, past their prime. Still others will be fresh and sweet, perfectly ripe.
I use my analysis to look at this tree and pick the fruit that is ready to eat right now.
My Alpha Trader sweet spot is the intersection of the strongest Alpha Scores with the best technical risk/reward setups. Adding these technical filters cuts my list from dozens to the handful of selections I recommend.
My favorite technical trend-following model is the basic uptrend, which is a series of higher price highs and higher price lows. I know this sounds like a simple concept, and that’s because it is. But it’s also a concept that has stood the test of time.
Hi-Crush Partners (NYSE: HCLP), an Alpha Trader stock that returned 66% in just shy of a year provides a clear illustration of what I’m talking about.
One of the ways to spot an uptrend is to look for a stock creating new all-time highs. These price points are critically important because they confirm the stock’s primary uptrend.
For example, tech giant Microsoft (NASDAQ: MSFT) went from a split-adjusted low of $0.18 per share at its IPO to nearly $54 at its 1999 peak, creating an uptrend with nearly 5,400 new all-time highs during its multi-decade move.
Here’s an historic chart from 1986 that shows Microsoft’s IPO and subsequent all-time new high breakout and uptrend. The portion of MSFT’s run marked with the green arrow garnered a 271% gain for investors in about a year. It clearly shows the importance of buying not only the all-time new high but the right one.
So what is the right new all-time high to buy? It’s the first all-time high after a longer-term consolidation of sideways price movement.
Longer-term consolidations build powerful launch pads for strong, persistent uptrends. Generally, the longer the consolidation, the more powerful and entrenched the uptrend that follows.
In the case of Microsoft’s IPO above, the stock went sideways for over six months before the big uptrend began.
You can also see this in HCLP’s price chart. After its IPO rally, the stock underwent a correction that created a long-term basing structure. Nearly a year later, in September 2013, the stock broke out decisively, and shortly thereafter it was added to the Alpha Trader buy list.
Alpha Trader is a longer-term system, and big trends derive their power from longer-term consolidation breakouts.
Notice how little time either stock gave investors to buy the first new all-time high. Both failed to give much in the way of pullbacks to their breakout prices. They just zoomed higher. Investors had to pay up to own the stock. Anyone waiting on the sidelines for a pullback continued to do just that — wait.
This is a key characteristic of great stocks. By definition, the strongest ones are in extreme demand. They are the hardest to buy, offer little opportunity to do so, and never look back once they break out.
You can see this clearly with HCLP’s uptrend.
We didn’t get out exactly at the top. Our sell rules are slow to trigger so that we avoid getting shaken out of an uptrend during a minor correction. We did get out well before the stock collapsed, though, booking a 66% profit in less than a year and beating the market by 47 percentage points during that time. Those who attempted a buy-and-hold strategy with Hi-Crush Partners watched all of their profits evaporate and then some.
Stocks breaking out of longer-term consolidation to new highs are the ones I hunt for in Alpha Trader. Of course, not every stock that follows this pattern works out. This is the nature of investing and exactly why we have rules in place to cut our losses.
But our Alpha Score system is aligned with trend-following principles and backed by a number of studies that helped develop this winning, quantitative approach. We have the ability to execute this process consistently, and it’s been successful at capturing stocks that undergo very large price trends.
If you’re interested in learning more about this system, I’ve put together a free report you can view here.