The Best Way to Trade Momentum Stocks
There are many stock trading strategies that work for a while, and then stop working.
Momentum is not one of them.
Momentum was first documented as a stock market anomaly in the early 1990’s.
And it’s still working.
Once you learn how to trade momentum stocks, you will have a tool in your trader toolbox that you can use for the rest of your life.
So what exactly is a "momentum stock"?
It is any stock that keeps moving in a certain direction (whether up or down) for an extended period of time.
During the dot-com boom of the late 1990's, Yahoo, eBay, Oracle, and Cisco were momentum stocks.
They went straight up for a couple of years, and then straight down even more quickly from 2000-2002. These stocks had momentum on the upside and on the downside as well.
Buy and hold investors who held these stocks over this period saw their wealth soar, and then plummet.
As you might guess, a buy and hold investment strategy should never be used with momentum stocks.
There is a better way—one that is much less stressful.
It’s called “trend following.”
You probably have heard the expression "the trend is your friend."
But you may not have realized just how powerful trend-following can be.
John W. Henry used it to earn enough money to buy the Boston Red Sox.
Studies have shown that there have always been trends in the markets, even going back hundreds of years.
This makes sense, since human nature is a constant.
Trend following seeks to profit from this collective behavior of market participants, who move into and out of the market, driven by vast alternating waves of fear and greed.
In a trend-following strategy, you only buy stocks that are rising, and you sell them immediately if they begin to fall.
You don’t try to predict the future.
You simply use the price action itself to tell you what you should be doing.
As you will see, there are precise ways to measure this price action, so that you will never need to second-guess yourself.
The trading rules that you will learn here are quite simple.
You will learn exactly when to buy a stock, when to take profits, and when to exit a losing trade.
You will learn how to size a position.
And most importantly, you will learn what pond to fish in, if you want to catch the best momentum stocks.
I've been trading for over 20 years.
I’ve learned what works in the markets-- and what does not.
Trend-following is a strategy that works extremely well with momentum stocks.
Even better, it does not require you to be glued to your computer monitor all day long.
You will not need multiple charts, news feeds, or dozens of indicators.
You will never suffer from "analysis paralysis," where one indicator is telling you to buy while another indicator is telling you to sell.
You will have the freedom to put on a position, and then leave your computer and go to the beach for the day.
As a long-term trader, you will enjoy a much higher quality of life than a short-term trader.
As you will see, trend following is a simple, elegant method of extracting wealth from the markets.
For example, the trend-following system that you are about to learn bought Tesla (TSLA) in December 2012 and held it until July 2013 for a gain of 300%.
It bought Apple (AAPL) in May 2003 and held it until January 2005, for a gain of 300%.
And then a few years later, it did it again, buying Apple in May 2009 and holding it until February 2012 for another gain of 300%.
So where should we look to find the next Tesla or Apple?
The short answer:
Young companies that are rapidly growing their sales (revenues).
There is no point in trying to trend-follow the stock of a slow-growing company like Coca-Cola.
Coke has grown its revenues only 4.5% annually for the past 5 years.
By contrast, Apple has grown its revenues by over 36% annually for the past 5 years.
Coke is a fairly predictable, slow-growing company.
Not so, Apple or Tesla or Facebook or Netflix.
For these fast-growing companies, future revenues and earnings are quite difficult to predict.
As a result, their stocks are volatile.
Money flows in and out of these stocks in great waves that we can ride.
As we said, the best momentum stocks are associated with companies that are rapidly growing their revenues.
I like to group these companies into 2 main buckets:
1. New Technology Companies (NTC)
2. Formula Companies
New Technology Companies (NTC)
NTC are companies that are doing new things.
They are inventing or popularizing new technologies, like a Facebook or a Tesla.
They are often in high-tech industries like software, information technology, biotechnology, hardware, or other engineering-intensive areas.
Because they are disrupting the status quo (Tesla with its electric cars), or creating new markets (like Apple did for the smart phone), they are often able to grow sales quite rapidly.
Of course over time, new technology becomes the status quo, sales growth slows, and the company either becomes an established blue-chip company, is bought by another company, or goes out of business.
Microsoft, Oracle, and Cisco were momentum stocks in the late 1990’s, but now are dividend-paying stalwarts.
If a company pays a dividend, it is usually not a good candidate for the momentum stocks strategy.
That being said, if the company pays a dividend and continues to grow its revenues rapidly (like Apple), it might still qualify.
Formula Companies
Formula Companies invent a successful formula (like burgers and fries served under Golden Arches), and then replicate that formula across the country-- and eventually around the world.
These include lots of consumer, retail, or restaurant stocks like McDonald's, Home Depot, Starbucks, Panera Bread, Tractor Supply, and Ulta Beauty.
As in the case of New Technology Companies, all Formula Companies eventually saturate their consumer markets (how many Starbucks can you really have on one street?).
Their sales growth slows, and the company eventually becomes another dividend-paying blue chip.
Many years ago, McDonald's was a good momentum stock, but no longer.
For both NTC and Formula Stocks, it is important to see rapidly growing revenues.
There are many companies that are doing new and interesting things, but until it shows up in the revenues, we are not interested.
We want to see revenues, and we want to see them growing rapidly.
What qualifies as rapid revenue growth?
To answer this question, let's take a look at Facebook, obviously a New Technology Company:
Between 2008 and 2016, Facebook grew its revenues anywhere between 37% and 186% annually.
Three-year average revenue growth ranged between 50% and 143%.
This is clearly extraordinary sales growth, made possible by Facebook’s technical innovation and global reach.
Now let's turn to Ulta Beauty, a Formula Company:
Between 2009 and 2016, Ulta grew its revenues anywhere between 21% and 22% annually.
While not as high as Facebook, this revenue growth is still impressive.
Like all Formula Companies, Ulta tested its key selling strategies in a few stores, discovered what worked best, and then proceeded to roll out the strategy nationwide.
It currently operates 974 stores across the U.S.
We had previously asked, what qualifies as rapid revenue growth?
Having looked at Facebook and Ulta as typical examples, we are now in a position to answer that question.
For a trend-following candidate, we want to see annual revenue growth greater than 20%, as a rule of thumb.
Three-year average revenue growth should also be north of 20% ideally, though this can be a lagging indicator.
These are not a hard and fast rules, so we shouldn't quibble if we see annual revenue growth of 19%, or if growth temporarily falls off during a recession.
But good momentum stocks will often have revenue growth rates north of 30%, 50%, or even 100% in their early years.
For example, Tesla grew its revenues at 102% in 2012, at 387% in 2013, and at 59% in 2014.
To summarize, what pond should we be fishing in to find good momentum stocks?
The ideal candidate:
• is a New Technology Company, or Formula Company
• has an annual revenue growth rate north of 20%.
It is now time to learn exactly what constitutes a buy signal.
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