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Safe Stocks
Our aim is to buy stocks with low downside risk. In order to do this, we check the stock’s price trend.
We look for market verification of our stock picks. The surest sign of this is an upwardly trending chart.
If you’ve decided to use PEND as a stock-screeing method, you could say you are adding a TREND constraint to PEND.
A chart trending upwards tells us that buyers are more assertive than sellers. They are willing to bid the stock higher because they are confident of its prospects. No negative news is spreading quietly through the market, news that would bring sellers out in strength.
Is Warren Buffett A Secret Trend-Follower?
Many readers will have read that the world’s best known investor, Warren Buffett, is well-known for shunning stock price charts. His apparent disdain for “Mr Market” is well-known.
On the face of it, requiring ‘market verification’ of our stock choices may sound blasphemous to a dedicated Buffettologist.
So why go against Buffett? The answer is, in this case, we’re not really going against him. In looking for market verification, we’re doing something rather similar to Buffett.
One of the rules Buffett sets before he buys a stock is “increasing market value”. This rule requires that for every dollar per share a company has reinvested in itself, the share price should have increased by at least one dollar too.
Buffett, therefore, does require “market verification” of his stock-picks. Buffett is insisting that, long-term, the trend of a stock’s price should be upwards. In fact, we would say Buffett’s increasing market value rule is a long-term proxy for trend-following.
Is There Any Scientific Evidence That Trend-Following Works?
There is good scientific evidence that trend-following works. John Mauldin reports that, in 1991, fund manager Gary Hirst began looking at all aspects of technical analysis. Hirst used a large research budget to investigate the effectiveness of various forms of technical analysis such as Elliot wave, stochastics and chart patterns. Hirst found no evidence that these methods outperformed random trading strategies.
Amidst all the negatives, however, Hirst found a positive. Markets produce profitable trends.
Investingator’s in-house analysis of historical data from a range of US, UK, Australian and New Zealand stocks over the last ten years is in accord with Hirst’s conclusion.
We found that consistently buying stocks whose price was trending downwards produced a negative return. Consistently buying upward trending stocks produced a positive return. The evidence supports the view that medium and long-term price trends are not random.
The logic behind this conclusion is robust. When companies have a successful product or service, they often maintain their advantage for several years. During this time the information reaching the market, from both legitimate briefings and insider leaks, is positive. The stock’s price rises and continues to rise.
Then things start to go wrong. Experienced fundamental investors will be familiar with the situation in which a company’s recent financial reports continue to look impressive but the stock’s chart turns downwards. Some weeks or months later bad news emerges officially from the company. The truth becomes evident to all. The chart had been trending down because people in-the-know were selling their shares and “outsiders” were not buying enthusiastically enough to stop the price falling.
Before they buy a stock, wise investors require an upward trend to confirm there has been no leak of negative information about the company. In doing so, the improve their chances of buying a safe stock.