Simple Trading Strategies – 5 Rules for Buying Great Stocks

by Jeff Reeves | June 9, 2010 2:37 am

Trading strategies for many sophisticated investors involve technical analysis, exhaustive investment research and years of experience in the stock market. But there’s no reason that everyday investors just looking to plan for retirement or protect their 401(k) investments have to feel like second-class citizens on Wall Street. Investing money in mutual funds or stocks is a serious business, but that doesn’t mean it has to be overly complex.

Yes, online stock trading can be affected by a host of variables. And yes, all trading strategies need to adapt to the current stock market conditions. But by following these five simple rules for buying stocks[1], you can dramatically improve your chance of  investing your money wisely. Simple trading strategies, after all, can sometimes be the most effective.

1 – Buy What You Know

Each investor forms their own trading strategies and rules for buying stocks based on personal goals and risk tolerance. And similarly, each investor buys and sells stocks and mutual funds based on what makes sense to them, right?

Not necessarily. The problem is that many investors fall victim to the latest fads on Wall Street and are eager to buy the stocks everyone else is talking about. This is how traders got taken for a ride by the tech bubble, as folks piled into stocks that hadn’t yet turned a profit and with no realistic way to make money.

Remember Flooz.com, which pitched a kind of online currency that would serve as an alternative to credit cards? It sounds like a crazy concept, but somehow the company raised somewhere between $35 million and $50 million from investors and enlisted a few retail giants such as Barnes & Noble to join in. But at its core, Flooz was a glorified gift card company with limited partners. Three years after going public, Flooz was bankrupt – which shouldn’t have surprised anyone who took a hard look at the company’s business model.

On the other side of the coin, take Amazon.com (AMZN[2]) and its Kindle e-reader – heralded by early adopters as a revolution in book publishing. They were right. AMZN stock is up 130% since January 1, 2009 – compared to a mere 15% in the broader market. If you know anyone who bought a Kindle during the last two years and listened to them rave about it, chances are the success of AMZN stock is no surprise to you.

Never under estimate the power of your personal experience. If you notice consumer trends or new product with big potential, chances are other folks will too. This will help you anticipate investment trends and profit from them, instead of chasing other people’s stock picks.

2 – Buy Stocks Great Investors Own

Of course, there’s a pitfall to relying on personal tastes alone. It’s always valuable to have an outside perspective on your stocks to make sure you’re on the right track. And if you want a second opinion, why not go right to the top and pick the brains of the best traders on Wall Street?

There’s a reason Warren Buffett is a bit of a rock star to individual investors – because his trading strategies and ways to invest money seem almost superhuman. Buffett’s Berkshire Hathaway Inc. (BRK[3]) continually makes timely and very profitable investments. In March Berkshire showed its stuff yet again in a powerful earnings report as year-over-year results improved, and the stock’s book value was up nearly 20%.

So how can individual investors enjoy similar success? Simple: Buy what Buffett buys.

While it may be impossible to reproduce Warren Buffett’s investment strategy and highly unlikely you’ll ever get the chance to pick his brain for stock picks one-on-one, many of Warren Buffett’s investments are public record. Berkshire Hathaway must report its holdings quarterly — investments in equity securities are a regular feature of BRK holdings. And any stock that sees an influx of cash from Warren Buffett and company often can’t keep it a secret even if it wanted to due to the insatiable appetite for all things Buffett.

Take Wells Fargo (WFC[4]), a longtime member of Berkshire’s portfolio. As of the latest quarter Buffett and company owned roughly 319.5 million shares. That’s up from 313.3 million in Q3 of 2009, 302 million shares in Q2 of 2009 and 290 million in Q1 of 2009.

As for WFC stock performance? The company is up about +240% from the March 2009 lows, and is up +8.5% year-to-date in 2010 despite a downtrend for the broader market.

There is, of course, a danger to groupthink — and even Warren Buffett gets it wrong sometimes. But as the saying goes, “If you can’t beat ‘em, join ‘em.” It’s worth noting that while Buffett may be America’s favorite investor, there are a host of others with investment strategies worth watching. John Bogle, founder of the Vanguard group and creator of the first S&P 500 index fund, is one. Hedge fund managers Julian Robertson of Tiger Management Corp. is another, famously turning $8 million in 1980 into over $8 billion in the late 1990s. Michael Steinhardt, George Soros, Peter Lynch and Carl Icahn are other big names in the pantheon of Wall Street investment icons.

3 – Buy Stocks for the Future, Not the Past

Sifting through quarterly reports and past performance for a company can provide insight into the health of a prospective investment. But whenever you look at these numbers, it’s important to realize that they are lagging indicators. When you look for the best stocks to buy, you should put a premium on future growth trends over previous successes.

Consider changing demographics, such as the fact that China is now the #1 automobile sales market in the world thanks to an emerging middle class in the People’s Republic and flagging consumer confidence in the United States during the recession. The result has been wild profits for China auto parts stocks such as China Automotive Systems (CAAS[5]) and Sorl Auto Parts (SORL[6]), both of which are up over 225% in the last year.

This goes for product life cycles and market relevancy as well. Major pharmaceutical companies may still be seeing decent earnings and sales, but investors in Merck (MRK[7]) had darn well better be aware that as much as 30% of Merck’s sales could dry up due to patent expirations and generic competition in the next few years.

Obviously, if investors could tell the future than it would be easy to play the stock market. There is no crystal ball that will provide easy answers as to which companies will see success and which ones won’t. But if you want to invest wisely, your rules for buying stocks should include focusing on future trends more than past successes.

4 – Buy Stocks with Great Leadership

At the end of the day, the success or failure of a company in large part relies on the leadership and vision of its top executives. Growth comes from the top, not from random successes at a smattering of stores that trickles upwards. When you buy a stock, you have to realize that you’re buying its management too.

Consider the successes and failures of Apple Inc. (AAPL[8]) over the last two decades. In the early 1990s, Apple was considered a second-banana to Microsoft (MSFT[9]). Windows rolled out cheaply and on a massive scale as Apple clung to high profit margins and a controlling, proprietary outlook. On July 9, 1997, after three years of poor stock performance and crippling financial losses, the Apple board of directors placed Steve Jobs at the helm as CEO and began restructuring the company’s product line. What followed over the next 10 years was a parade of Apple successes – the iMac, the iPod and iTunes, Apple retail stores and the iPhone.

A more recent example is Southwest Airlines (LUV[10]), headed by CEO Gary C. Kelly since 2004. Kelly’s leadership has made Southwest an anomaly in the airline industry, with the ticketing almost all its berths directly over the phone or online at the company’s website. Unlike other major airlines, Southwest also allows passengers to change reservations without additional cost and has refused to charge fees for many items, such as checked baggage, despite industry trends. The result has been unparalleled success for the airline over its competitors. Southwest Airlines has carried more customers than any other U.S. airline since August 2006 for combined domestic and international passengers according to the U.S. Department of Transportation. LUV stock is up almost 90% in the last year, compared to a gain of just 25% for the broader market.

Sure, there are stocks that succeed because they manage to cut costs and boost margins. But such a strategy can not keep a stock healthy and growing for long. If you want to invest smartly, make sure your simple trading strategies [11]include investing in smart leadership with a proven record of success and a willingness to challenge industry norms to get ahead.

5 – Buy Stocks with a Clear Plan to Sell

You would think it goes without saying that the purpose of buying a stock is to sell it for a profit, but many investors run out and buy “great stocks” without a clear plan on what their investment goal is and when they want to sell. This can be brutal on your portfolio.

Because after all, what is a “great stock?” Trendy footwear manufacturer Crocs (CROX[12]) was a great stock to buy in early 2007 at $23 a share — but only if you sold by October of that same year when prices were pushing $70, locking in your 200% gain. If you held on for much longer, things don’t look as cheery. Crocs stock is currently around $10. Whether or not CROX was a good or a bad stock depends on your investing horizon and what you expected to get out of the stock.

But short-term traders who get greedy and refuse to sell can be just as bad as buy-and-hold investors panicking and selling too quickly. Many traders who sold off their stock when the market crashed in March 2009 not only locked in historic low valuations for the equities they sold, they missed out on one of the biggest rallies in the market’s history in mid-2009. Some big-name stocks like Ford (F[13]), Colgate-Palmolive (CL[14]) and General Mills (GIS[15]) are actually trading higher now than they were before the market’s meltdown two years ago.

Whatever your tactics — simple trading strategies[16] or not — keep your goals clearly in mind before making any purchase. Set a reasonable price target or holding time for any asset, and use this investment strategy to color your decision. Simply knowing a company is a “great stock” provides little consolation if you sell your shares too early or too late to actually make any money.

As of this writing, Jeff Reeves did not own a position in any of the stocks mentioned here.

Endnotes:
  1. rules for buying stocks: http://investorplace.com/experts/jeff_reeves/trading-strategies-rules-for-buying-stocks.html
  2. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  3. BRK: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK
  4. WFC: http://studio-5.financialcontent.com/investplace/quote?Symbol=WFC
  5. CAAS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CAAS
  6. SORL: http://studio-5.financialcontent.com/investplace/quote?Symbol=SORL
  7. MRK: http://studio-5.financialcontent.com/investplace/quote?Symbol=MRK
  8. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  9. MSFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=MSFT
  10. LUV: http://studio-5.financialcontent.com/investplace/quote?Symbol=LUV
  11. simple trading strategies : http://investorplace.com/experts/jeff_reeves/trading-strategies-rules-for-buying-stocks.html
  12. CROX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CROX
  13. F: http://studio-5.financialcontent.com/investplace/quote?Symbol=F
  14. CL: http://studio-5.financialcontent.com/investplace/quote?Symbol=CL
  15. GIS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GIS
  16. simple trading strategies: http://investorplace.com/experts/jeff_reeves/trading-strategies-rules-for-buying-stocks.html

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