How to Know When to Buy Hot Stocks

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Red-hot stocks are a bit like the giant, gooey, double-fudge brownies of the investment world. Once we see them, we can't get them out of our minds. We have to have them - even though we have been told time and time again that they are not good for us.

With the brownies, all sorts of food-related survival instincts that are hardwired into our brains are of course telling us to stuff our faces with chocolatey goodness. But you might not realize that the wiring of our brains is also what draws us to those hot stocks. We want these high-flyers because they appeal to us on an instinctual level. They play into our innate desire to follow the crowd, and our ability and need to recognize patterns.

Thousands of years ago, those instincts helped us avoid danger, find food, and survive. When our ancestors saw a group of people sprinting out of the jungle with looks of terror on their faces, those who had the instinct to follow the crowd increased their chances of survival, for example. Similarly, if every time it rained, a river overflowed into the surrounding area, those who recognized the pattern and avoided that area when it started to rain increase their chances of survival. These characteristics thus were passed down to us in our DNA.

The problem is that, in the stock market, stocks that "the crowd" is buying can get incredibly overpriced compared to the underlying value of the businesses they represent. Eventually, the apparent pattern we have latched onto - the stock rising and rising - becomes an illusion, and the overvalued stock comes crashing down to earth.

That's why investors are told time and time again, "Don't chase hot stocks". Generally it's good advice -- throughout history many investors have been pummeled because they tried to ride the momentum wave, and jumped on hot stocks just before the wave crashed. (Just ask those who went headlong into tech stocks around 2000.)

But the "don't chase hot stocks" advice is, in fact, incomplete. The full version should be more like this: "Don't chase hot, expensive stocks".

It's a key distinction. High-flying, overpriced stocks often lose steam and then come crashing down from great heights. But high-flying inexpensive stocks can continue to fly high for some time -- and they don't have as far to fall if their momentum wanes. If used alongside valuation metrics, momentum can thus actually be a very helpful part of your stock-picking approach.

A great example of that is my Motley Fool-based strategy, which is inspired by an approach that Tom and David Gardner, co-creators of the Motley Fool investment website and community, laid out in The Motley Fool Investment Guide. The approach looks for stocks with good momentum -- those that have outperformed at least 90% of all stocks in the market over the past year (i.e., which have a relative strength of at least 90). But, it makes sure that it isn't paying exorbitant prices for these high-momentum plays. It does so by using the P/E-to-growth ratio that mutual fund legend Peter Lynch made famous, targeting stocks with PEG's (P/E ratio divided by long-term growth rate) of about 0.5 or lower.

Since I started tracking my guru-based models more than 12 years ago, my 10-stock Fool-based portfolio has been my best performer, gaining more than 15% annualized during a period in which the S&P 500 has gained less than 6% per year.

The Gardners aren't the only gurus who used relative strength in their strategies. James O'Shaughnessy, another of the gurus upon whom I base my models, has made relative strength a key part of his growth-stock-picking approach -- along with a key value component. The model I base on his writings looks for stocks that have high relative strengths, but which also have price-to-sales ratios less than 1.5. Like my Fool-based portfolios, my O'Shaughnessy-based 10-stock portfolio has been a strong performer.

What sort of stocks currently boast that desirable combination of value and momentum? Recently, I used my models to see which companies fit the bill. Here's a look at a handful that stood out.

Western Alliance Bancorporation ( WAL ): This Phoenix-based firm provides a range of deposits, lending, treasury management, and online banking products and services through its banking subsidiary, Western Alliance Bank. It operates in Arizona, Nevada, California. The $3.7-billion-market-capitalization firm has a 12-month relative strength of 88.

Western Alliance gets strong interest from my Motley Fool-based model. The approach likes Western's strong recent growth - 38.5% for sales and 26.1% for earnings-per-share last quarter - as well as its high and rising profit margins (35.5%, vs. 31.7% a year ago, vs. 22.8% two years ago). And while the stock has been quite hot, the Fool-based model thinks Western still offers value: the stock has a PEG ratio of just 0.36.

TrueBlue Inc. ( TBI ): Tacoma, Wash.-based TrueBlue provides temporary blue-collar staffing services to a variety of industries, including construction, manufacturing, transportation, aviation, waste, hospitality, retail, and renewable energy. It operates about 700 branches in all 50 states, Puerto Rico and Canada, and has taken in about $2.6 billion in sales over the past 12 months.

TrueBlue ($1.1 billion market capitalization) gets strong interest from my O'Shaughnessy-based growth model. The strategy likes that the firm has increased EPS in each year of the past half-decade, and likes its combination of a 12-month relative strength of 82 and a dirt-cheap 0.44 price/sales ratio.

Enterprise Financial Services Corp ( EFSC ): This Missouri-based firm is the holding company for Enterprise Bank & Trust, which offers banking and wealth management services to individuals and business customers, primarily in the St. Louis, Kansas City and Phoenix metropolitan markets. Enterprise has a $560 million market capitalization and gets high scores from my Fool-based approach, in part because of its stellar 90 relative strength over the past 12 months. This strategy also likes Enterprise's 24.4% after-tax profit margins, and its price tag: With a P/E ratio of 16.8 and a 30% long-term EPS growth rate, the stock sports a PEG ratio of 0.56.

Aceto Corporation ( ACET ): This firm operates in the US, Europe, and Asia, and distributes over 1,100 chemical compounds used principally as finished products or raw materials in the pharmaceutical, nutraceutical, agricultural, coatings and industrial chemical industries. It has a market capitalization of about $775 million.

Aceto has just the kind of value-momentum combination that my O'Shaughnessy-based growth model likes. It has a 12-month relative strength of 83, and a price/sales ratio of 1.4. In addition, the firm has increased EPS in each year of the last half-decade, another reason that it gets strong interest from this model.

Valero Energy Corp ( VLO ): While it has had its up and downs, this manufacturer and marketer of transportation fuels, petrochemical products, and power has overall been red-hot over the past 12 months, with a relative strength of 91. It has a market capitalization of about $34 billion.

Valero is a favorite of my Lynch-inspired model. The strategy likes Valero's 34% long-term EPS growth rate and 7.5 P/E, which make for a PEG of just 0.22. Given what's gone on in the energy sector, it is unlikely that Valero will continue to grow at a 34% clip. But even if we use the analysts' projected growth rate about 12.5%, it would still pass the Lynch PEG test.

Lynch also liked conservatively financed firms, and the model I base on his writings targets companies with debt/equity ratios less than 80%. Valero's D/E is 35%, another good sign.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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