By: Francisco Bermea
The moment the market opens, my inbox gets flooded with alerts I've set up to notify me when a holding makes a big move, hits a stop-loss, releases important news, etc.
The other week, I was inundated with messages telling me several of my holdings hit 52-week highs. In fact, in just one day, I received 11 different alerts of stocks hitting new highs.
To a huge portion of the investing community, a stock hitting 52-week highs strikes a Pavlovian response... they immediately start thinking about selling. After all, one of the first lessons investors are taught is to "buy low, sell high."
This can turn out to be a huge mistake.Think about this... How many times have you made the mistake of selling a big winner way too early -- right before that stock makes another big move in the days and weeks after you've sold? If you're like so many investors, I suspect that the answer is more times than you care to admit.
There's more than just anecdotal evidence that proves the thesis that investors sell too early. A study done in 1997 by Terrance Odean shows that stocks investors sold actually outperformed the stocks investors held by roughly 3.4 percentage points in the 12 months following the sale.
And considering that the average individual investor generated annualized returns of 2.1% from 1992 to 2012 -- the 3.4% most investors leave on the table is huge.
Now before I go any further, keep in mind that I'm not saying you should go out and chase momentum. Simply chasing stocks that are hitting 52-week highs without any further reason is a great way to lose money.
The key is selecting the right kind of stock with momentum -- meaning its share price is soaring for good reasons.
So rather than simply chasing price momentum, you also need to select companies that have serious operational momentum. In my premium newsletter, Alpha Trader, we do just that with something I call an "Alpha Score."
Every stock has an "Alpha Score," and it can range from 0 to 200. It is derived by combining two of the market's most effective triggers -- relative strength (RS), our indicator of price momentum, and an important fundamental trigger -- cash flow growth. The higher the score, the more likely a stock is to move higher in the coming weeks and months.
In Alpha Trader, we specifically look for stocks with a RS rating above 70. This means the system only recommends stocks that have outperformed 70% of the stocks in our database during the past six months. Having this parameter ensures we're only buying the market's best-performing stocks.
Cash flow, our fundamental trigger, is one of the most important measures of a company's financial strength. It can't be manipulated as easily as earnings, so it gives investors a more clear-eyed look at a company's health. Cash flow is necessary for a company to be able to reinvest into its business so it can continue to grow, pay the bills and reward shareholders with dividends and buybacks.
In other words, we only purchase stocks with strong momentum and cash flow growth and sell when momentum starts to fade.
That's why I welcome price strength in my holdings. When my stocks are outperforming the market, I know the move is backed by strong fundamental reasons... and feel confident that they will continue to outperform.
By using a proven, rules-based system to time our buys and sells, we remove emotion, conditioning and other bad psychological factors from our decision-making process. Frankly, I think every single trader in the market should be using a rules-based system like this.
Take a look at some of our biggest gainers over the past few months...
Now, out of fairness to my subscribers, we had to blur out the names of our current open positions. But you get the idea. And this week, we have several new buys on tap. Not surprisingly, many of them trade at or near their 52-week highs.
If you take away one thing from this essay, it's this... Don't be afraid of momentum -- even when you see a stock trading at or near a 52-week high. Don't let emotions dictate when you buy and sell. As long as the company has good fundamental reasons to trade at highs, you can feel confident about pulling the trigger (or staying along for the ride).
In the past year, Street Authority recommendations on individual stocks have gained +72%, +26% and +60% all in less than six months... and recently, their trades could have made you +26% in 42 days and +42% in less than one month. Click here to get the free trading advisory -- Trade of the Week.