Stars vs. Meteors: A model for spotting tomorrow's hot stocks

February 27, 2016 01:00 PM

In general, there are two ways to put your speculative resources to work: Investing or trading.

Each has the same goal — superior returns with as little risk as possible — but each is an entirely different approach. Investors look to buy shares in companies that display excellent fundamentals, such as earnings and growth. 

Traders are quick to point out that excellent fundamentals are no indicator of long-term success and, that while growth and earnings are good starting points, price action is the ultimate barometer of success. Ultimately, in trading, price movement determines share value, not fundamentals. After all, what good is it if a company has great earnings and sales growth but the stock never increases in value?

That said, we acknowledge that some who consider themselves traders will insist they trade on the fundamentals, and there are long-term self-described investors whose only concern may be price; however, in general terms and for purposes of this discussion, the previous differentiation holds.

There are pros and cons to both trading and investing, but for most it simply comes down to which is the more effective way to use their money. Or, is there a better way altogether to achieve outsized returns?

Universe of possibilities

In the universe of stocks, the goal is to find a listing that can emerge as a market leader. The ones that do are the ones that you should devote your capital to, and the ones that don’t should be ignored.

Like panning for gold during the great Gold Rush, you sift through charts and scans to find the nuggets of opportunity in a sea of slush. Soon, these precious nuggets reveal themselves as different industries that rotate from strength to weakness and weakness to strength. It’s in the strongest industries that you find a fertile field of potential winners.

But, as winning stocks begin to rise and show their strength, it’s important to realize that there are two classes of stocks in play: Meteors and fixed stars.

Meteors

Each decade, new companies begin to emerge and attract the attention of Wall Street. Often, these stocks are touted as the “next big thing” and become fads that transcend the financial community.

This type of stock was labeled as a “meteor” by Marc Boucher, hedge fund manager and author of “The Hedge Fund Edge.” He described them as tending to lead the overall market during bull markets but ultimately flaming out (see “Shooting higher,” below).

In the beginning, they start off slowly and, at first glance, are pretty unremarkable. But, there are three common themes that they develop before taking off:

  1. Strong, consistent earnings.
  2. Explosive price moves.
  3. High relative strength.

Meteors have the potential of 100% to 300% returns in a one- to three-year period, giving you several chances to catch a winning move. As a result, they begin to attract the attention of institutional investors who start to buy up the available stock, resulting in rising share price and trade volume. These two traits — rising share price and trade volume — attract other investors, and a noticeable price trend develops.

But, eventually, the stock’s new shine begins to lose its luster, and investor enthusiasm for what is now perceived as a “fad stock” begins to wane. This becomes the warning signal that the stock’s days are numbered. As the stock reaches its tipping point and its trend begins to lose strength, it falters and reverses.

Occasionally, another type of stock emerges among the meteors that resists completely burning out, and it ultimately displays real staying power.

Fixed stars

Like meteors, fixed stars emerge from the same beginnings, starting small and then snowballing into high returns. With ever-impressive growing earnings, fixed stars show the same high-growth prospects as meteors but with one distinct difference: They do not become wildly overvalued.

As a result, they shine brightly and consistently for years, even decades, like a fixed star set in the sky. This is an important point because fixed stars reveal themselves by continuing to maintain consistent earnings of 40% or more, even after their popular following begins to cool. Whereas the market moves on to the “next big thing,” fixed stars keep marching forward with reliable performance, consistent earnings and price/earning expansion without the overvaluation (see “Bust and boom,” below).

Having a position in a fixed star means you don’t have to be as active in trading but manage your existing positions instead. This can lead to improved compounding returns and a better risk/reward ratio for your capital.

In recent decades, you’ve seen both fixed stars and meteors emerge at different times, in industries as diverse as the Internet, oil, real estate, gold stocks and computers.

In the Internet boom and bust of the late 1990s, Amazon.com emerged as the clear-cut winner in the ecommerce space. In the battle of the search engines, Yahoo was the dominant force in the late 1990s, but today, in comparison with market leader Google, it barely registers among consumers. With Google the clear winner in the search engine war and the fixed star heir apparent, many wonder if Yahoo will even survive much longer.

The way to profit

So, how do you discern which of the meteors will emerge as a fixed star? Truthfully, there is no way to tell.

But, you can put the odds in your favor by understanding that there will be more meteors than fixed stars. That said, you want to continue to discover emerging leaders before Wall Street does by using the following filters:

  • Consistent five-year annual earnings growth of 25% or higher.
  • Three years of successive higher annual earnings.
  • Trading near or at an all-time price high.
  • Less than 10% of a company’s shares owned by institutions.
  • No new positions in a company owned 40% or more by institutions.

Early on, meteors and fixed stars share common traits, including consistent five-year annual growth of 25% or higher and three years of successive higher annual earnings. As the company begins to show stronger earnings, major trading institutions begin to take larger positions and share value begins to rise. As share value increases, it attracts the attention of more institutional investors, who then begin to buy up more of the stock, causing a further increase in share value.

As share value increases, you want to observe price for technical strength and then enter as the stock trades through its all-time high.

Finally, it’s critical to note that both types of stocks start out with institutions owning less than 10% of their available shares before being discovered by the rest of Wall Street. It’s when the stock comes up on Wall Street’s radar that growing institutional accumulation fuels the increase in share value. For the individual, it is a huge edge by selecting stocks that are under-owned, possessed of increasing earnings and technical strength before being discovered by funds and institutional traders.

However, if a meteor is going to transition into a fixed star, over time the stock will avoid being over-owned by major institutions while still generating annual earnings of 40% or greater and maintain that as a baseline (see “Core strength,” below). 

Exercise caution when institutional ownership approaches 40% and beyond because at these ownership levels major institutions can begin to dominate the trading of the stock. In general, most institutions look at the same criteria for selling a stock, particularly when a stock falls short of earning expectations. If a stock’s earnings expectation does fall short, then it could cause a chain reaction leading to a severe price decline.

Enter on technical strength as the stock trades at an all-time price high, but don’t add to the position once institutional ownership reaches 40%. At that point, sell part of your position, take profits and manage the remaining position with a trailing stop, or manage the entire position by using a trailing stop. Options are a good risk management tool for these stocks. When meteors fall from grace, short put positions can both protect downside and provide profit opportunities. 

Two schools

Classifying stocks as either meteors or a fixed stars forces you look beyond the surface and then adapt as needed. It makes you understand that there are a lot of shared traits responsible for fueling their rise. It also answers the question as to why some stocks soar to breathtaking heights only to fail miserably later on, while some stocks are literal juggernauts that march higher over long periods of time.

For investors, you will have to stretch your skills and realize the importance of technical factors, not just fundamentals, to take advantage of these opportunities. Likewise, for traders, you have to look beyond price to find the subtle fundamental keys that translate into strong price action and trends.

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.