Leaders: Leading Stocks Are Leaders For A Reason
The stocks outperforming the market tend to continue performing well, while lagging stocks are likely to remain underperformers. Here, you'll see why this is an important lesson for investors and how to identify the leading stocks.
The Best-Performing Stocks Continue Performing Well
How many times have you concluded a stock's best days are behind it, only to watch it soar as you stand on the sidelines? This assumption has often come back to haunt investors. In reality, the stocks that are doing best tend to keep doing well, while those slumping likely will continue to do poorly. Why? The great companies manifest their strength through superior performance in terms of earnings, sales, profit margins and, yes, even the performance of their stock.
A study of the greatest stock market winners found that all-star stocks had, on average, outperformed 87% of the market before they began their most dramatic price advances. In other words, they were already in leadership positions. This concept is contrary to the popular bargain-hunting mentality, but is based on historical facts.
How To Find The Leaders
If you want to find next year's winning stocks, look at the better-performing stocks today. Remember, the biggest winning stocks historically have been, on average, in the top 13% of stocks at the time they began their major advances. To help you identify today's leaders, Investor's Business Daily developed the Relative Price Strength Rating, or RS Rating. This rating compares the price performance of each stock over the last 12 months, with extra emphasis on the three most recent months. Stocks are rated on a scale of 1 to 99, with 99 representing the top 1% in terms of price movement. So an RS Rating of 85 means that stock is outperforming 85% of all stocks in terms of price performance. An RS Rating of 25 means the stock is being outperformed by 75% of the market and should be avoided.
"Sympathy Plays" Don't Play Well
Another common temptation among investors is to seek out stocks that resemble leading stocks in terms of having similar products or services, but are trading at lower prices than the leaders. Usually, though, you're better off sticking with the leader of the industry, even if its share price is higher. Take the chipmaking industry. Intel dominated the field, sending its stock up about 485% from 1996 through 1999. Advanced Micro Devices, maker of Intel-clone chips, went up only about 55% in the same span of time. This is not a rare example, for any industry. The moral: stick with the leading stocks in a leading industry group.
Rounding Out Stock Selections
No investor should pick stocks based on a single factor. You must weigh the full picture, including a company's earnings, industry group performance, institutional sponsorship and chart patterns. (Institutional sponsorship, chart patterns and other important elements will be explained in detail in subsequent lessons.)
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