December 27, 2014
Everything You Thought About These Stocks is Completely Wrong
By David Sterman
Over the course of my career as a Wall Street analyst, I had to continually pitch my best ideas to hedge fund, pension fund and mutual fund managers. And they all stressed the same constraint: "Tell me only about very liquid stocks."
These managers often had massive sums of money available to invest in particular stocks, and any attempts to buy stocks that trade just 20,000 or 30,000 shares a day would simply push that stock price up too fast to make it worth the effort. That's why most fund managers own stocks like Apple (NASDAQ: AAPL). When more than 50 million shares trade each day, it's easy to get in and out of a big investment position.
Over the years, I've tended to follow the view of these fund managers, avoiding any stocks that trade less than 100,000 shares a day. But a recent study helped me realize that these off-the-radar stocks are precisely where individual investors should be focusing.
Recently, Roger Ibbotson, who has generated a long track record of ground-breaking investment analyses, has been focusing on the returns of popular stocks (ones with high trading volume) and unpopular stocks.
He found an unusual performance gap: Stocks in the lowest quartile of popularity returned 15.5% annually from 1972 to 2013. The returns slowly diminished as stocks were ranked as more popular. He found that the top quartile of popular stocks delivered a mere 8.3% annualized return. Though that study ran through 2013, the popularity effect has been especially pronounced this year. A recent analysis performed by Morningstar found that a basket of the 20 most actively traded stocks this year have, collectively, lost half of their value. Stocks such as Twitter (NYSE: TWTR), Groupon (NASDAQ: GRPN) and Pandora (NYSE: P) have dominated the volume leaderboard this year, and all are now much lower than their multi-year highs.
My ideal low-volume stocks are those that are starting to see rising volume. Let me give you a few examples:
Blonder Tongue Laboratories (NYSE: BDR) is an obscure micro-cap cable TV equipment manufacturer. The company kept popping up on my investment screens as shares traded at a deep discount to book value. But on any given day, just a few thousand shares traded hands. Yet in early November, this tiny stock saw its daily trading volume soar above 300,000 (while shares were trading at around $1.20). Just a few weeks later, more than one million shares were trading hands, and the stock went on to double in just seven weeks.
The key takeaway: It's wise to track a group of low volume stocks you believe hold promise. Keep an eye on daily volume and price action, and as soon as these two data points start to grow, it's time to pounce.
You can also scan various websites, such as Nasdaq.com, to spot companies seeing unusual volume spikes. These stocks may have been unpopular in the past, and you don't necessarily want to own them once they are truly popular (according to Ibbotson's trading volume logic), but catching them as they shift from low volume to rising volumes has been a winning approach in my experience.
To be sure, a spike in volume may also be accompanied by a price spike. But that doesn't mean it's too late, just because you didn't get shares at a bottom.
For example, I had been tracking the trading action in medical software provider Merge Healthcare (NASDAQ: MRGE). More than a year ago, I predicted that the stock had 100% potential upside. Such a prediction was premature, as shares subsequently dropped roughly 20%. Yet in late October, the daily trading volume surged. This is now a stock with solid momentum (and in my view, ample more upside).
The Insider's View
As a corollary to Ibbotson's theory, stocks that aren't popular with Wall Street analysts also tend to deliver superior returns. A study conducted by the University of Chicago looked at companies that have seen a reduction in the number of analysts following them and found that, for each analyst a company lost, returns reaped by insiders increased. That shouldn't be a surprise. As companies move off the radar, they are more likely to slip through the cracks and fall into value territory. Insider buying is often a clear sign that such benign neglect has led to an oversold condition.
Risks To Consider: Low-volume stocks tend to have fewer market makers, which tends to lead to unacceptably large bid/ask spreads. The best way to offset this is to place your trade with limit orders. If a stock has a $25.15 bid and a $25.30 ask, you should place a limit order at the lower end of that range. More often than not, the order will eventually get filled. The same strategy should be employed when exiting a stock: Place the limit price near the upper end of the bid/ask spread.
The other issue for lower-volume stocks: They are extremely volatile. As Ibbotson found, they can deliver superior long-term returns, but they can also gyrate wildly while you own them.
Investors often make the mistake of buying stocks that they have not heavily researched. Quick action on a hot tip rarely ends well. Instead, investors should be devoting ample time to finding and then following potentially winning stocks. As Ibbotson has shown, such stocks don't need to be in the mainstream of investor popularity. In fact, the less popular, the better. Yet I like to pair that approach with an inflection point, such as an initial rise in trading volume. You may not be the first to arrive at the party, but rising volume means that many more will be joining you in coming days and months.
Rising trading volume can be a good indicator of whether a stock has strong momentum. Academic studies have shown that this is one of the only indicators that has consistently outperformed the market. In fact, over the past year, one little-known indicator that relies on momentum spotted 29 stocks right before they jumped double digits in a month. Now, it's tagged another stock as an immediate "buy." In fact, it's flashing the same kind of buy signal as a stock that rose 266% in a year. Get its name here, including all the details on this indicator. | |
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