my primary thought process begins with “How much can I lose?” not just “How much can I gain?

”
During my 30 years as a stock trader, I’ve discovered that a “risk-first” approach is what works best
for me.

In the stock market, you can make excuses or you can make money, but you can’t do both.

As with any great achievement, superperformance is attained through knowledge, persistence, and
skill, which is acquired over time through dedication and hard work. Most of all, long-term success in
the stock market comes from discipline, the ability to consistently execute a sound plan and refrain
from selfdefeating behavior.

The reason most investors practice incorrectly is that they refuse to objectively analyze their results
to discover where their approach is going wrong. They try to forget the losses and keep doing what
they’ve always done.

This is the exact opposite of what we know to be a key factor for superperformance: a relatively
small number of shares in the float.

Richard Love’s Superperformance Stocks

Financial Analyst Journal titled “The Anatomy of a Stock Market Winner.”

Love’s findings convinced me of three empowering points:

1. There is a right time and a wrong time to buy stocks.

2. Stocks with superperformance potential are identifiable before they increase dramatically in price.

3. By correctly investing in these stocks, it is possible to build a small amount of capital into a fortune
in a relatively short period.

The Relative Strength Concept of Common Stock Price Forecasting by Robert A. Levy,

Edward S. Jensen’s Stock Market Blueprints,

William L. Jiler

How to Trade in Stocks. Jesse

The focus is not just on the magnitude of a price move—how much a stock goes up—but also on the
time element of the equation: how fast it goes up and what accounts for the rapid rise. In the stock
market, timing is crucial because time is money

The Five Key Elements of SEPA The basic characteristics are broken down into five major categories,
which make up the key foundational building blocks of the SEPA methodology:

1. Trend. Virtually every superperformance phase in big, winning stocks occurred while the stock
price was in a definite price uptrend. In almost every case, the trend was identifiable early in the
superperformance advance.
2. Fundamentals. Most superperformance phases are driven by an improvement in earnings,
revenue, and margins. This typically materializes before the start of the superperformance phase. In
most cases, earnings and sales are on the table and measurable early on. During a stock’s
superperformance phase, a material improvement almost always occurs in the fundamental picture
with regard to sales, margins, and, ultimately, earnings.

3. Catalyst. Every stock that makes a huge gain has a catalyst behind it. The catalyst may not always
be apparent upon a casual glance, but a little detective work on the company’s story could tip you
off to a stock with superperformance potential. A new hot-selling product that accounts for a
meaningful portion of a company’s sales may provide the spark to ignite a superperformance phase
in that company’s stock price. Approval by the FDA, a newly awarded contract, or even a new CEO
can bring life to a previously dormant stock. In dealing with small, lesser-known names, it often takes
some event to attract attention to a stock. I like to see something that gets investors excited.
Examples would include Apple (AAPL) reaching cult status with its Mac and “I” products, Research in
Motion (RIMM) with its BlackBerry (so habitforming for Internet and e-mail junkies that it’s been
nicknamed CrackBerry), and Google (GOOG), which became so synonymous with Internet search
engines that it made it into the dictionary as a verb. Each situation may be somewhat different
whether the stock is a classic growth company, a turnaround situation, a cyclical stock, or a biotech
trading on the promise of a new drug. Whatever the reason, behind all superperformance there is
always a catalyst driving institutional interest.

4. Entry points. Most superperformance stocks give you at least one opportunity and sometimes
multiple opportunities to catch a meteoric rise at a low-risk entry point. Timing the entry point is
critical. Time your entry incorrectly and you will be stopped out unnecessarily or lose big if the stock
turns around and you fail to sell. Time the entry correctly during a bull market and you could be at a
profit right away and on your way to a big gain.

5. Exit points. Not all stocks that display superperformance characteristics will result in gains. Many
will not work out even if you place your buys at the correct point. This is why you must establish
stop-loss points to force you out of losing positions to protect your account. Conversely, at some
point your stock must be sold to realize a profit. The end of what once was a superperformance
phase needs to be identified to keep what you’ve made.

The SEPA ranking process can be summarized as follows:

1. Stocks must first meet my Trend Template (see Chapter 5) to be considered a potential SEPA
candidate.

2. Stocks that meet the Trend Template are then screened through a series of filters that are based
on earnings, sales and margin growth, relative strength, and price volatility. Approximately 95
percent of all stocks that qualify under the Trend Template fail to pass through this screen.

3. The remaining stocks are scrutinized for similarities to my Leadership Profile to determine
whether they are in line with specific fundamental and technical factors exhibited by historical
models of past superperformers. This stage removes most of the remaining companies, leaving a
much narrower list of investment ideas for an even closer review and evaluation.

4. The final stage is a manual review. A narrowed list of candidates is examined individually and
scored according to a “relative prioritizing” ranking process that takes into consideration the
following characteristics:
  Reported earnings and sales
 Earnings and sales surprise history
 Earnings per share (EPS) growth and acceleration
 Revenue growth and acceleration
 Company-issued guidance
 Revisions of analysts’ earnings estimates
 Profit margins
 Industry and market position
 Potential catalysts (new products and services or industry- or company-specific
developments)
 Performance compared with other stocks in same sector
 Price and trading volume analysis
 Liquidity risk

The SEPA ranking process is focused on identifying the potential for the following:

1. Future earnings and sales surprises and positive estimate revisions

2. Institutional volume support (significant buying demand)

3. Rapid price appreciation based on a supply/demand imbalance (lack of selling versus buying)

Probability Convergence

I developed SEPA to identify precisely the point at which I can place a trade to have the lowest risk
and the highest potential for reward. My goal is to purchase a stock and be at a profit immediately.
To accomplish this, I take into account all the relevant fundamental, technical, and market factors
and pinpoint the position at which there is a supportive convergence. I execute a trade only at the
point of alignment across the spectrum with regard to company fundamentals, stock price, and
volume activity as well as overall market conditions. I want to see these factors converge like four
cars arriving at the same time at a four-way intersection. The SEPA method stacks supporting
probabilities to produce that alignment. Virtually every big winning stock exhibits very specific and
measurable criteria before making its big moves. In their superperformance days, these stocks have
distinguishing characteristics—whether a new product, an innovative service, or some kind of
fundamental change—that enables the company to make money at a superior or accelerated rate
and in some cases for an extended period. As a result, the shares of these companies experience
significant price appreciation by attracting institutional buying. You don’t have to know everything
about a company or the market; however, you need to know the right things. By putting all these
elements together— fundamental, technical, qualitative, and market tone—and demanding that
stocks be able to cross multiple hurdles, you will be far more likely to identify something exceptional.
The collective value of these parameters is greater than the sum of their parts.

Superperformance Traits

Over the years, I’ve concluded that most superperformance stocks have common identifiable
characteristics. In the majority of cases, decent earnings were already on the table. In fact, the
majority of superperformance stocks already had periods of outperformance in terms of
fundamentals as well as technical action before they made their biggest gains. More than 90 percent
of superperformance stocks began their phenomenal price surges as the general market came out of
a correction or bear market. Interestingly, very few stocks had superperformance phases during a
bear market.

Superperformers Are Youthful

Generally, a superperformance phase occurs when a stock is relatively young, for example, during
the first 10 years after the initial public offering (IPO). Many superperformers were private
companies for many years before going public, and when they finally did, they had a proven track
record of earnings and growth. Some superperformance companies already established successful
product lines and brands before coming public. During the bear market correction of the early
1990s, I focused on stocks that were holding up well and then moved into new high ground first off
the market’s low. Most of the names I traded were relatively unknown at the time. These stocks
were propelled by characteristics such as big earnings growth and strong product demand. One
example was US Surgical, which pioneered products such as the surgical staple and laparoscopic
surgery. Software, computer peripheral, and technology-related stocks also performed well during
that period, fueled by the boom in personal computing. Most investors shy away from names they
have never heard of. This is exactly the opposite of what you should do if your goal is to find big
stock market winners.

Size Matters

Most companies have their high-growth phase when they’re relatively small and nimble. As they
grow older, larger, and more mature, their growth begins to slow, as does the rate at which their
stock prices appreciate. Superperformance stocks are often small-cap companies, although
occasionally a big-cap name could see a surge in price after a turnaround or a period of depressed
stock prices resulting from a bear market. Most of the time, however, it is a small-cap or a mid-cap
stock that hits a period of accelerated growth, which in turn creates a superperformance price
phase. Investors interested in superperformance should keep a constant lookout for small to
medium-size companies in the growth stage of their life cycle (accelerating earning and sales). On
balance, the growth of earnings and sales and, more important, the stock price is usually more rapid
for a small to medium-size company than for a larger, mature company. Large companies usually
have proven track records of execution. With smaller companies it’s important in most cases to
confirm that they’re already profitable and have proved that their business model can be scaled and
duplicated. Look for candidates with a relatively small total market capitalization and amount of
shares outstanding. All things being equal, a smallcap company will have the potential to appreciate
more than a large-cap, based on the supply of stock available. It will take far less demand to move
the stock of a small company with a comparatively small share float than a large-cap candidate. This
realization can also help you develop realistic expectations about the profit side of the equation.
Large-cap companies are not going to make large-scale price advances the way a younger, smaller
company will. There are times when a big-cap stock will be depressed because of a bear market or a
temporary economic hardship, which may provide the opportunity to buy a company such as Coca-
Cola or American Express or Walmart at the beginning of a decent price move as it recovers.
Generally speaking, though, if a large-cap company advances rapidly in a short period, I’m inclined to
take profits on it more quickly than I would with a smaller, faster-growing company that may have
the potential to double or even triple in a number of months.
Stock Screening

Since the 1980s, I have been using computer assisted screening as a way to narrow down a
tremendous amount of information—as many as 10,000 stocks daily—to produce a manageable list
of candidates that meet some minimum criteria to be studied further. Today, there are many
screening tools available for the investor. Here are a few suggestions on screening. When you are
conducting quantitative analysis (stock screening), keeping it simple will serve you better than using
a complicated model. You must be careful not to put too much into each screen. Otherwise, you may
inadvertently eliminate good candidates that meet all your criteria except for one. For example, let’s
say you want to select stocks that exhibit a certain level of earnings, market cap, estimate revisions,
and so forth, until you have 12 lines of criteria. If a stock meets 11 but misses by a hair on the
twelfth, you will never see that stock. Remember, if you have 100 items in your criteria, a stock
needs to miss only 1 to be filtered out even though the other 99 are met. A better approach is to run
separate screens that are based on smaller lists of compatible criteria, for example, one screen for
relative price strength and trend and a separate fundamental screen that is based on earnings and
sales. Often, as you run isolated screens, you will see some of the same names recurring, whereas a
few names will appear on only one list. Remember, computers are great for weeding out noise and
pointing your research in the right direction; however, if you want consistent superperformance, you
will need to roll up your sleeves and do some old-fashioned manual analysis. That’s the interesting
part of trading, and that’s what makes it fun and rewarding.

In the stock market, what appears cheap could actually be expensive and what looks expensive or
too high may turn out to be the next superperformance stock. The simple reality is that value comes
at a price.

Although it may come as a surprise to you, historical analyses of superperformance stocks suggest
that by themselves P/E ratios rank among of the most useless statistics on Wall Street.

Shares of fast-growing companies can trade at multiples of three or four times the overall market. In
fact, high growth leaders can command even higher premiums in times when growth stocks are in
favor relative to value stocks. Even during periods when growth is not in favor, they can sell at a
significant premium to the market. In many cases, stocks with superperformance potential will sell at
what appears to be an unreasonably high P/E ratio.

However, stocks with high P/E ratios should be studied and considered as potential purchases,
particularly if you find that something new and exciting is going on with the company and there’s a
catalyst that can lead to explosive earnings growth. It’s even better is if the company or its business
is misunderstood or underfollowed by analysts.
Most of the best growth stocks seldom trade at a low P/E ratio. In fact, many of the biggest winning
stocks in history traded at more than 30 or 40 times earnings before they experienced their largest
advance.

If you want to buy a high-performance car such as a Ferrari, you’re going to pay a premium price.

If a company can deliver strong earnings as fast as or even faster than its stock price appreciates, an
initial high valuation may prove to be very cheap.

Value doesn’t move stock prices; people do by placing buy orders. Value is only part of the equation.
Ultimately, you need demand.

If tomorrow the price of a stock you own fell 25 percent from your purchase price, would you feel
better knowing that the P/E had fallen below its industry average? Of course not. You should be
asking yourself: Do the sellers know something I don’t?

The bottom line: value investing does not protect you.

Crossing a stock off your list because its P/E seems too high will result in your missing out on what
could be the next great stock market winner.

As a rule of thumb, I’m very reluctant to buy shares of a company trading at an excessively low P/E,
especially if the stock is at or near a 52-week low in price.

A stock trading at a multiple of three, four, or five times earnings or at a number far below the
prevailing industry multiple could have a fundamental problem.

I would rather own a stock that’s reporting strong earnings trading at a relatively high P/E ratio than
a stock showing signs of trouble trading at a very low P/E.

Major market declines always plunge to deeply oversold readings, and roaring bull markets storm
through early overbought conditions while advancing much farther.

When a leader tops, more often than not the stock price is discounting a future slowdown in growth,
which makes it no bargain at all.

This is why many growth stocks experience P/E expansion during the growth phase; expectations
keep getting higher as the company’s performance expands.
I use the P/E ratio as a sentiment gauge that gives me some perspective about investor expectation.
Generally speaking, a high P/E means there are high expectations and a low P/E means there are
lower expectations.

The current P/E ratio at which a company trades is only a minor consideration compared with the
potential for earnings growth. Growth stocks are driven by growth.

The price/earnings to growth (PEG) ratio is calculated by dividing the P/E multiple by a company’s
projected earnings per share growth rate over the next year. For example, if a stock is trading at 20
times earnings and has a growth rate of 40 percent, the PEG ratio will be 0.5 (20 40). The company is
trading at half its growth rate. The theory is that if the resulting value is less than 1, the stock may be
undervalued; if the PEG ratio is over 1, the stock may be overvalued.

Like its P/E cousin, the PEG ratio can exclude some of the most dynamic and profitable companies
from a candidate buy list.

Historical study of superperformance stocks shows that the average P/E increased between 100 and
200 percent on average (or two to three times) from the beginning until the end of major price
moves.

Though it’s always prudent to look for sell signals, pay extra attention once the P/E nears 2 and
especially around 2.5 to 3 or greater. It could top soon afterward. If this occurs, look for signs of
decelerating growth and signs of weakness in the stock price as your signal to reduce your position
or sell it out.

The bigger point is that the P/E ratio doesn’t have much predictive value for finding elite
superperformance stocks. There is no magic number when it comes to the P/E. In fact, the P/E is far
less important than a company’s potential for earnings growth.

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