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Is your bargain stock a lemon?
Will Kraa, July 16, 2007

When I first started trading last century (makes it sound a long time ago doesn’t it?) I opened an account with an online broker and proceeded to donate lots of my hard earned cash to persons unknown who were quite happy to sell me the stock they no longer wanted. I had been quite successful in business and property but discovered the share market was a whole new ball game and one where most of what I had learned previously simply did not work.

For instance in property it is a really good strategy to look for a genuine bargain, buy it and later sell for a profit or simply keep it as a long term investment. There are many who still follow this strategy in the share market and that is what I did. I found one share which was such a bargain that I thought it was just going to make me rich in time, in fact it was a ‘Star’ stock and trading on a PE of only 3! As the months went on it became more and more of a bargain as prices declined and it became even cheaper to buy. Naturally I bought more and invested quite a substantial amount of money in it.

It turned out to be a complete disaster and is now trading under a different name at next to nothing. In fact I still have a few in my original account as a constant reminder of my folly. This came to mind when I read an article by Robin Bowerman “Look beyond the index headlines” on this site. He writes about an investor who works hard at researching and studying companies and after all that hard work managed to underperform the market by 3%. Similarly I was doing much hard work at that time and had mostly losses to show for it.

Often this hard work means looking for stocks that are undervalued and buying them with the expectation that the market will in time realise its mistake and the price will improve to reflect the true value of the company. It also often means buying stocks that are in a downtrend or have recently suffered a drop in prices which then of course makes them ‘bargains’. And as we are already trained in life to buy bargains this seems to be an excellent thing to do.

It does happen at times that there are stocks which have dropped in price and thereby have become genuine bargains and can become very profitable trades. But it pays to be very careful in trading stocks where market sentiment is negative. Quite a number of ‘bargains’ turn out to be ‘lemons’.

In view of this natural desire to find bargains it might seem that it would not be a good idea to buy a stock which had just recently more than doubled in price and particularly if it was a stock you had never heard of before and it was trading at only a few cents. Yet that is what I find to be one of the most profitable ways of trading. In fact I don’t even have to work very hard at this strategy and I don’t have to trade very often! But psychologically it is hard to do.

As I mentioned I still have the Etrade account which I used when I frst started trading. Over time I did not use it much any more except for an occasional trade and I decided it might be good to use it as a demonstration account to show that it is possible to make good returns even with a small amount of money and not using derivatives, not working very hard and not trading often. As it is just a small account I am able to produce the statements to prove that these are genuine trades and that this way of trading is possible for those who do not necessarily have a large account.

As Robin shows in his article there is not much point in doing lots of work if you can’t do much better than the index. It turns out this account did outperform the market quite considerably by using a very simple strategy and not doing a lot of work. At the beginning of last financial year the account had only $14,750 in it and by 30 June this year had a total value of $38,595. This represents a return on the initial equity of 156% in one year and that takes into account all costs.

There were only 15 trades for the year so I only had to find a little over one trade per month. The trade in this account that I am now going to show you illustrates fairly well the way I go about selecting the trade and then managing it. Last week’s trade was also in this account.

Whenever I need to find a stock to buy using this strategy I scan the market to find stocks that have jumped up in price and volume as I mentioned last week. It only takes about an hour to do this using AmiBroker. In AmiBroker in one of the toolbars there is a spectacle symbol which stands for ‘Quick market review’. This can be set to scan the whole market or just part of it and I scan the whole ASX leaving out ETOs and Warrants. It takes only a couple of minutes to do this and when it is finished the result is displayed in a kind of spreadsheet. I click on the heading for ‘% change’ (in price) till the results are displayed in descending order.

The next step is to look for stocks which have had a large (usually more than 4%) change in price for the day (or part of the day when doing it intraday) and where the volume is such that there has been enough turnover for the day to be sufficient for my needs. I have the display of results reduced in size so that the charts are still visible. When I find a stock that interests me AmiBroker makes it very easy in that when I double click on the symbol of the stock in the display of scan results the chart comes up instantly.

It is now very simple to look at the charts till I find one that is suitable. I like ones that have been trading sideways and preferably showing a chart you would not want to trade but where suddenly the chart comes to life with a sustained increase in volume and price going up steeply.

Then I have a look at company announcements for the stock to see what caused the change. If the news is such as to justify what is happening to the price then the hard part starts. I have to buy a stock that now looks hopelessly overpriced. It’s really hard to do, anyone can see that there is no more room on the top right corner of the chart for prices to go any higher! Surely this throws all the learned habits of wanting to buy a bargain out the window. Many times I have looked at the chart and said, This just can’t go higher but then a few days later it has and I wished I had bought it.

Now I have learned that if my criteria are met I buy regardless and seldom lose. So let’s have a look at the first chart of Fermiscan (FER).



As you can see it hardly traded before August 2006 but then started trading at reasonable volume at about 30 cents. It came up in my scan on 8 December last year and it looked like the kind of chart I would like to trade. So I had a look to see what had happened to drive up the price and volume. This part only takes me a few minutes and I soon found out the company was in the process of validating a technique of detecting breast cancer using hair samples.

Yes, hair samples and it worked very accurately too using a synchroton. Now you all know what that is of course so I won’t bother to explain any further except to say that I bought 5,000 shares at 80 cents which used up the available spare cash in the account at the time.

You can see that on the day I bought the shares the chart looked rather scary. Already prices had more than trebled in the last couple of months and prices had climbed so steeply that you would think they were quite overextended. Very hard to buy. Definitely not a bargain. Never mind, by the end of the day I had already made a profit.

The price jumped again next day (second chart) but then took the rest you might expect so my profit disappeared but the stop (blue line as explained last week) was not breached and prices again accelerated upwards and by late February had reached a high of over $2.80. As you can see they then wildly fluctuated around my stop - something these biotechs eventually do as people begin to realise there won’t be any profits for some time yet. This to me is a sign the party is over so I left at $2.19, nowhere near the high but at a time when there did not appear to be any prospect of further rapid gains that I like to see in these trades. As the chart shows it has largely traded sideways since then.



The proceeds of the trade were over $10,000 for a profit of almost $7,000 (see below for the exact figures). I had made a lot of money compared with the initial outlay and it had not taken much work at all. Once this trade was in place, except for a look at the chart each day to see the prices of open trades had not breached the stop line, I did not do anything in this account for nearly another month.

There are a few lessons to learn from this. In the first place hard work does not necessarily lead to better results which is quite the opposite to what is almost ingrained in us in daily life. This is a trap which leads many people to trade too much and their results suffer. Once a trade has been placed, let it run till the signal to exit is given. Do not think that getting in and out of trades constantly is the way to success – it will just make your broker rich but if that is your purpose in trading then go for it.

Secondly, when money seems to come too easily by trading we may even feel guilty and unconsciously start to sabotage our trading. Our work ethic is that only hard work brings rewards so that when we are rewarded without apparently doing much hard work there is an internal conflict. One thing that may help here is to donate some of the proceeds of trading to worthy causes as it may help to relieve the guilt and in any case is a great thing to do.

Then of course there is the bargain hunting tendency ingrained in all of us. This is not easily fixed and I know traders who consistently fail to do well because of this problem. They just can’t buy stocks which have made a considerable advance in price.

But I know for myself that I make most money from trading stocks making new highs or in good uptrends unless of course I am looking for short trades. And I don’t have to spend untold hours scouring through fundamental data to find ‘undervalued’ companies. Keep in mind that when a company is undervalued there may be a reason for its being undervalued and it will most likely not be in the company records. Think of HIH and such likes.

Now just a note of caution. This strategy is used for microcap stocks which usually cannot be traded using CFDs. It can be a very profitable strategy and uses price data to find companies where some new fundamental data is driving price. To find stocks to trade with CFDs different strategies may need to be used and if you do decide this strategy is suitable for you then you need to be very sure you know what you are doing since there are many of these stocks that can be very risky to trade.

Calculations for this trade:

Entry Price $0.80 and stop at $0.56 so risk per share is 24 cents.

The cash available in the account meant I would be able to buy 5,000 shares which would give a risk for the trade of $1,200. This represented a risk of 8% of the account and if I had been trading CFDs this level of risk would be too high.

However experience has shown me that these trades are very low risk when properly selected so the risk was acceptable even for this size of account.

Initial trade size 5,000 shares @ $0.80 = $4,000

Trade value at exit 5,000 x $2.19 = $10,950 for a profit of $6,950

Commission each way was the minimum of $32.95.

Net profit $6,950 - $65.90 = $6,884.10

Percentage profit was $6,884.10 / $4,000 x 100 = 172%.

I will continue trading this account and see how this strategy works as market conditions change. It will be interesting to see if these very high levels of returns can be sustained using this strategy.

Next week I will show you a trade where I used what I call a ‘market madness’ exit. These exits are very useful occasionally.

More articles from this week's newsletter:

ANZ: will the new CEO sing in tune?
Companies to benefit from the rise of the grey nomads
What is the ideal mix of companies?
Investing in a toppy market
Are investment clubs good for your wealth?
Stock of the week: TPI
Inflation: when is 'core' not so core?
CFDs: the best time to trade
Analyst report: gold bull seasonals
Investing: Paying the cost of confidence