Tracking the mood of the market can open your eyes to profit

Stock-picking isn’t in fashion. Most people are buying index-tracking funds because the overall market is increasing and has been since 2009.

Many active-fund managers do not beat the indices by picking individual stocks, so investors figure that if a fund manager cannot beat the market, then how can they? When everyone is doing the same thing, however, it usually pays to do the opposite.

In early 2000, when the world couldn’t get enough of the Nasdaq and tech shares generally, many unloved stocks did well during the bursting of the dotcom bubble, also known as the “tech wreck”.

For example, a rigid value screen would have turned up Philip Morris, among other consumer durable, mortgage and real estate stocks, in January 2000. Shares in the tobacco company gained more than 150% from January 2000 to January 2002, not including dividends. In the same period, the Nasdaq index lost more than 50% in value.

The value investor Ben Graham once said: “Price is what you pay, value is what you get.” Take Google: it’s a great company, but would you rather pay a price-to-earnings ratio of 30 for an earnings growth rate of 21% currently, or 21 for an earnings growth rate of 28% in 2010?

In other words, you would pay 30% more for Google now than you would have seven years ago. The more value you get, the more likely you are to generate good returns in the future.

We are likely not at a point of the cycle where you can expect to generate positive returns in the near future by owning an index. So stock-picking is in play, and it is important to understand how its different genres relate to you.

There are three main genres: value investing, growth investing and income investing.

Value investing is the strategy of selecting stocks that trade for less than their intrinsic values. The market overreacts to good and bad news, say value investors, which results in stock-price movements that don’t correspond with a firm’s long-term fundamentals. The result is an opportunity to profit by buying when the price is deflated.

In growth investing, investors seek stocks they believe have good growth potential. A growth stock is usually defined as a company whose profits are expected to grow at an above-average rate compared with its industry or the overall market.

Income investing is one of the most straightforward strategies, where the investor aims to choose companies that provide a steady stream of income. When investors hear “steady income” they often think of fixed-income securities, but stocks can provide a steady income via a solid dividend.

From there, it is about focusing on the style that best suits you and learning how to apply time-tested strategies that have consistently beaten the market in the long run.

Great resources are available online cheaply, or for free, to give you the tools that were available only to professionals 20 years ago.

Graham advocated buying cheap stocks, so look at historical data of the cheapest 10% of a 13,000-stock universe based on his book value metric. Cheap stocks tend to do better, and the cheapest usually do the best. You need to know how to screen for stocks and establish backtested proof about what works.

Sentiment measures are also critical. John D Rockefeller once said that when the shoeshine boys give you stock tips, it’s time to sell everything with both hands. Baron Rothschild believed you should buy assets “when there’s blood in the streets”.

Today, online tools such as let investors track attitudes in simple ways. If classic underperformers — known on Wall Street as the dumb money — are aggressively optimistic about stock prices at the same time as classic outperformers — the smart money — are aggressively pessimistic, you want to go with the latter.

We need to know how to harness sentiment measures, not only to help us outperform the market but also to avoid periods when investors are exposed to significant potential loss.

Sentiment indicators are a wonderful complement to any investing strategy. They can make you aware of significant opportunities that most participants do not see; they can make you aware of significant risk that most participants do not see; and they can help you avoid significant losses in a way that fundamental analysis cannot.

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