How One Analyst Got It Right by Being Wrong

When I first began tracking investment newsletters, momentum investing had only recently made the transition from Wall Street’s quant shops to Main Street’s investment advisors.

The rise of the Internet probably had a lot to do with it. The resulting democratization of information meant that just about anyone could screen stocks according to thousands of data points.

Suddenly, you no longer needed a team of PhDs and reams of green-bar paper to ply your methodology. All it took was a modem.

In theory, that should have led to the proliferation of all manner of new techniques for momentum investing.

But in reality, it seemed like there were a lot of copycat strategies all employing the same tweaks on relative strength.

Investors use relative strength to see which stocks are performing best compared to their sector and the broad market over a particular time period. It’s really just a fancy way of gauging whether a stock can continue building upon recent gains.

Most strategies blend a stock’s relative strength over a number of short- and medium-term time periods to get a sense of whether it’s likely to continue heading higher.

In contrast to the old investor maxim, “Buy low; sell high,” these strategies are more akin to buying high and selling higher. After all, a stock already has to exhibit significant upward momentum before it will pop up on their screen.

The Herd Is the Word

As you might imagine, when dozens of services are essentially using the same strategy to mine the same universe of securities, they all end up piling into the same stocks at the same time.

Of course, retail investors don’t have the same buying power as financial institutions. However, many of these services focused on small- and mid-cap growth stocks.

For small companies with a limited public float, a little bit of buying can go a long way toward boosting their share price.

And when you’re talking about an artisanal soda company that most folks don’t know about, a new buy signal from dozens of services can create a self-fulfilling situation.

When I was monitoring newsletters at The Hulbert Financial Digest, we’d regularly see the same previously unknown stock suddenly appear simultaneously in the portfolios of dozens of momentum traders.

They would ride the stock as long as possible–generally three to six months. Then when it finally began to flag, they’d all dump it around the same time.

Occasionally, there would be one stock that would endure in their portfolios for a year or longer. But even it was eventually left for dead.

Every now and then, I’ll remember some former momentum darling of yore, and look up its stock out of curiosity. Inevitably, it’s just a husk of its former self.

Momentum Plus

Though these might sound like pump-and-dump schemes, I don’t think that was the case. In fact, some of these services posted respectable returns even though they churned their entire portfolios at least two or three times a year.

But the one thing that always bothered me about this approach was that it rarely involved any fundamental analysis.

While some market technicians believe that a stock’s share price tells you everything you need to know, I can’t shake the feeling that it can’t hurt to know more–a lot more.

And when it comes to smaller stocks, the market doesn’t always know everything.

That’s why Investing Daily’s Profit Catalyst Alert is such a special service.

In contrast to all the copycats out there, its chief investment strategist, Linda McDonough, honed her unique momentum-oriented strategy from her decades of experience as a hedge-fund analyst.

From Short to Long

Here’s the really interesting part about Linda’s career: Her primary specialty was recommending stocks to sell short.

Since the market goes up about two-thirds of the time, short-selling is only for the shrewdest traders and the savviest analysts.

That’s because even with all the research that goes into a short recommendation, the market can still delight in proving you wrong.

Sometimes, the target company makes a game-changing play that undoes a short-seller’s thesis. Other times, the market simply won’t cooperate.

When things change, a short analyst must revisit their original thesis to see if it’s indeed time to cover their short position.

This process helped Linda learn the telltale signs of when a small-cap stock is about to skyrocket.

To this end, one of the first things Linda does is look for stocks that are rising sharply on higher-than-average volume. Though price is important, trading volume reveals a lot more about the potential strength of a stock’s next move.

But while other services might be content to stop there, that’s only the beginning of Linda’s analysis.

Then, she rolls up her sleeves and starts poring over all the numbers to find profitable companies with minimal risk.

After that, Linda checks for signs of a catalyst–a new patent, a new product, or a big new customer–that’s about to push the company’s earnings and its share price to new heights.

In some ways, Linda’s strategy is the ultimate jujitsu move: She’s turned those rare occasions when she got it wrong into a highly profitable way to get it right.