Want To Bag More Winners? Here’s Why Fundamentals Aren’t Everything…
When it comes to investing, you should always stick to the fundamentals. This refrain, or some version of it, is what many new investors are taught.
In our opinion, that’s terrible advice. In fact, it could be costing you money every single day.
How? Well, let’s take for example a metric such as the price-to-earnings (P/E) ratio. It is often cited as a way to measure the fundamental health of a stock. A low P/E ratio is thought to signify stocks that are “cheap” or are trading at an attractive valuation relative to peers.
But the goal of investing and trading is not to own “cheap” stocks. Same goes for “fundamentally healthy” stocks. It’s to make money. That means finding stocks that are likely to appreciate in value — and quickly.
Fundamentals Aren’t Everything
Now, don’t get it wrong… We are not saying that fundamentals such as P/E ratios (especially when using the forward, rather than the traditional trailing variety) are completely irrelevant or should be ignored. We are also not saying that fundamentals such as earnings growth should be cast aside as immaterial.
What we are saying is that these factors don’t matter unless the stock is likely to move higher. And relying solely on such metrics is a “fundamental flaw” made by many traders.
In “How to Make Money in Stocks,” Investor’s Business Daily founder William O’Neil writes, “Our ongoing analysis of the most successful stocks from 1880 to the present shows that, contrary to most investors’ beliefs, P/E ratios were not a relevant factor in price movement.”
By only looking at fundamentals, many investors ignore what we consider to be one of the most important metric for identifying potential winners.
That metric is relative strength (RS).
In a nutshell, relative strength gives us a quick and easy way of determining how a stock is performing relative to the rest of the market. The belief is that stocks that have outperformed in the past will continue to do so, while those that have been the weakest will continue to underperform.
In other words, those “cheap” stocks can stay cheap for a long time. Of course, this will not always be the case. But relative strength is one of the few technical indicators that is proven to work.
Professor Eugene F. Fama of the University of Chicago was awarded the 2013 Nobel Prize in economics. In one of his most well-known studies, he showed that relative strength was one of the most important factors in a stock’s future price movement.
Separately, James P. O’Shaughnessy, author of “What Works on Wall Street,” calculated that using a relative strength-based system would have beaten the market by an average of 3.65% per year over the past 83 years.
Some of the world’s top investing minds have looked at the data. They’ve concluded that relative strength is a much better way to screen for potential winners. Of course, if you can find stocks with attractive fundamentals and a strong RS ranking, that’s even better.
Over at Maximum Profit, our colleague Jimmy Butts uses RS as a key component for his premium service to deliver many winners over the years.
If you want to make double-digit gains in a relatively short amount of time, relative strength is one of the best tools available to select your trading candidates.
We’ll save the details of RS for another day. But think of RS as a way to quantify momentum. It may sound counterintuitive, but the fact is that stocks that have strong momentum are likely to continue going up. It’s that simple.
The bottom line here is that if you are screening for stocks strictly based on traditional metrics like P/E, then reconsider. You may have missed out on some big winners by solely looking for something “cheap”. This can cause you to miss out on substantial gains.
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