One of the tenets of fundamental analysis is that you should buy stocks when they are undervalued and sell them when they are overvalued.
When I began investing in the stock market, this is the method I chose. I didn’t do very well because I wasn’t very good at judging the value of companies.
I bought companies that looked undervalued only to read an announcement within weeks or months showing why the stock had been trading so “cheaply.” I realized I’d developed a talent for finding “lemon” stocks.
Ben Graham’s Voting Maching – The Lemons’ Enemy
I’m keen on Jesse Livermore’s methods because they’ve helped me make better decisions. For several years now, I’ve enjoyed much more success based on trend-following than I did using fundamental analysis on its own. I think one of the reasons for this is that I’m no longer dependent on reading out-of-date and occasionally downright mendacious company reports in order to decide which stocks to buy and sell. Several years on, I’ve learned enough to avoid lemons and my fundamental analysis has improved. I NEVER rely on fundamental analysis alone though. I ALWAYS allow the market to confirm my choices.
After all, who am I to assign a true price to any stock? In the real world it’s supply and demand that determine price. In saying this I’m aware of Ben Graham’s famous dictum that markets, in the short term, act like voting machines while in the longer term they act like weighing machines. I’ve discovered I’m perfectly happy to take profits on short term or (preferably) medium term trades using the results from the “voting machine” (trend) to guide me.
Stocks and Childish Fads
Remember Cabbage Patch Dolls? Or Furbies? – toys worth a few bucks each. A few Christmases ago some parents were paying hundreds of dollars for these toys. Later – once the fad was over – the same toys could be bought in second hand stores for no more than a few cents.
The parallel with stocks is exact. Once the market gets it into its head that a stock is hot, prices reach heights that horrify traditional fundamental analysts. Our job is not to sell these stocks too early. Just because a stock is trading at twice what we think it’s worth, there’s no reason that it won’t reach five times that. Hang in there until the trend is over. Then get out.
In How To Trade In Stocks, Jesse Livermore wrote:
“As long as a stock is acting right, and the market is right, do not be in a hurry to take a profit. You know you are right, because if you were not, you would have no profit at all. Let it ride and ride along with it. It may grow into a very large profit, and as long as the action of the market does not give you any cause to worry, have the courage of your convictions and stay with it.”
Similarly, don’t buy a stock just because it looks cheap on the basis of fundamental analysis. Wait for THE MARKET to recognize that it’s cheap. Let other people take the risk of buying too early. Jesse Livermore always said that the most profitable trades resulted when he entered a trade soon AFTER the market had confirmed his belief that prices were going to move in a particular direction. That’s been my experience too.