From the January 01, 2010 issue of Futures Magazine • Subscribe!

Invest by knowing what stocks to buy and what stocks to sell

Invest By Knowing What Stocks
to Buy and What Stocks to Sell
By Charles D. Kirkpatrick II, CMT
FT Press
167 pages, $22.99

Kirkpatrick aims this well-researched book directly at self-directed investors. Based upon his varied and extensive investing experience, he believes that individuals can craft better performing portfolios than by buying and holding mutual funds and listening to the so-called investment gurus. Furthermore, he points out that the average mutual fund performs at a level of about two percentage points below its benchmark on an annual basis.

First, he reviews how the stock market works, explaining how one’s emotions are involved in investment decisions, focusing on individual stock risk, and explaining the concept of randomness, diversification, law of percentages, drawdown and market risk. He follows this up with a brief comparison of fundamental and technical analysis. He believes that both evaluation techniques have unique faults, and that the Efficient Market Hypothesis (EMH) also should be avoided. He comments that the EMH is more of an academic theory than a practical approach. Therefore, investors should not really use EMH or technical or fundamental analysis to help them become better investors.

Kirkpatrick pinpoints the key factors that lead most investors to be unsuccessful which include: investing emotionally, lacking discipline, fear of losing money, and being wrong in the selection process. Instead, the author suggests that investors use only methods that have a historical track record of success. This approach is much preferred to buying stocks on rumors, listening to advisors and gurus with past good market calls who will likely fail to give good calls going forward.

Furthermore, he believes that predicting stock market outcomes is not only unnecessary, but also impossible to do with any degree of accuracy. Instead, the author provides investors with three strategies based on relative strength analysis where stocks are measured and then ranked against each other on a scale of 99 to 1 (strongest to weakest). The key concept is that the highest ranked stocks will continue to increase in price for a period of up to one year, thus providing investors with profitable results. Stocks are sold when they drop in rank to a pre-determined level based on back-tested results.

Kirkpatrick reviews selecting stocks using three approaches: value, growth and price strength. He tests each approach using this relative strength concept. For value, he selects the price-to-sales ratio, for growth he chooses reported quarterly earnings growth, and for price he uses the actual closing price of a stock today versus prior time periods. One of the main focuses of the book is to explain what and when to buy. That is where the relative strength comes into play. For example, in measuring value he uses price-to-sales ratio comparisons where he is trying to ascertain which firms are trading below market valuations. Each stock’s ratio is then ranked against all other companies. He discovered that of the three approaches, relative price strength had the best performance with price-to-sales coming in second. Growth did not add much value in generating
outperformance.

In using relative strength, he found that measuring it over the past six months had the best overall results in producing forward performance over the next three months to a year. His backtesting timeframe was 1998-2006, where he evaluated more than 8,003 stocks and more than 290,000 weekly observations. He provides testing results for each of the three approaches and the best ranking choices for buying and selling. Kirkpatrick also covers the criteria for selecting and deleting stocks, creating a portfolio of stocks, as well as an example of the investing process, and data sourcing.

Kirkpatrick provides an easy-to-use investing approach that makes logical sense and produces results that beat buy-and-hold with less risk. His research shows investors how to re-create his strategy, and his stock investing approach can be extended to ETFs using relative strength analysis.

Leslie N. Masonson is the author of “All About Market Timing” and “Day Trading on the Edge.” Reach him at lesmasonson@yahoo.com

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