This is an awesome guest post from my good friend Josh over at CNA Finance. I’m actually a regular contributor to CNA Finance if you didn’t know (my work there). Read more about Josh at the end of the post. Write for us.
If you have been active and following the markets through the first quarter in 2015, you will no doubt have heard of the amazing run in the biotechnology sector. The stocks that compose the biotech sector have had some of the hottest win streaks seen all year, with some being many hundred percent winners.
It’s easy to get caught up in the hype and feel the need to chase some of these monster movers, but as a trader, I prefer to dig down into the details and find the next big opportunity that I can ride for a monster win. The smarter play here is to recognize the opportunities before they become known to everyone else…
What to Look For Using Macroeconomics
When searching for a long term investment that you suspect could breakout, I recommend taking a top down approach. What I mean by that is, finding a stock after first evaluating macroeconomic conditions. The first and easiest determination to make is, are we in a bull or bear market? Should we be long or short biased? Well, given the overwhelming impact of the Quantitative Easing program the FED has had in place for the past 6 years, it is safe to say we are in a secular bull market. So, we should be long biased until that changes. The dips in the broader markets have been getting bought up on every pull back across nearly every sector.
The second area of focus is your sector analysis. Which sector has been outperforming the others and which sector shows the most strength? This is where you will find your stocks making the largest percentage gains year to date. One example of a hot sector in play for 2015 is in biotechnology. Take a look at the chart for IBB, the Nasdaq biotechnology sector ETF. The chart shows a monster up trend going back to 2010. That tells us, that year after year, biotech stocks are ripping to new highs and keeping the sector in play.
What to Look for Using Microeconomics
After we have narrowed down the sector, we need to find and evaluate a stock that can produce for us. It is the most critical part of finding that next big mover and investment opportunity. As investors, we don’t want to chase the stocks that have already made their 10-20-30% moves up in recent history. While those may offer additional upside, the cost and any fundamental catalysts that may be in play will likely already be priced into the stock price. We want to find the underdog. A real stock, devoid of pump and dump manipulation, from a real company that trades on legitimate volume on a rather average basis. I consider legitimate volume to be at least 200 thousand shares a day.
Whenever I am looking for a long term investment opportunity that is somewhat more speculative than a traditional trade, the last thing I want to do is risk a bunch of capital on it. So, in keeping with that philosophy, I search for stocks that are considered “cheaper” or under-valued. Generally, when seeking these opportunities, we will look to the lower priced, lower float stocks. These tend to be the next logical candidates for a breakout move. By focusing on these opportunities, we are confining our smaller capital risk to an area of a hot target sector with explosive growth. Essentially, we are getting more bang for our buck.
How Do We Know Which is the Right Choice?
When looking for these smaller, off the radar stocks, I like to find trade ideas with catalysts in play. A catalyst can come in many forms, but generally, smaller companies working on big things. Examples can include cancer research, diabetes treatments, breast cancer scans, and liver disease or hepatitis treatments. Look at what the Ebola craze did for stocks like Tekmira Pharmaceutical (TKMR), Alpha Pro Tech (APT), Lakeland Industries (LAKE), and Inovio Pharmaceuticals (INO), just to name a few examples.
The point is, it doesn’t really matter what you are looking for, so much as it does that the company has some sort of potential catalyst in play in a much larger market. The second biggest thing that we have to reference is, historical price action. This is where technical analysis plays its role. So, we can find a company that says it is working toward the cure to mortality, but that doesn’t mean squat if investors hadn’t previously thought what the company was doing was amazing. How do we determine this? Well, if you look at the stock charts for a company going back several years, do you see the price action trading in a range? Is it something that has barely made a move one way or the other? If the answer is yes, we should pass on this. Not because they aren’t working on the miracle cure and will never get it, but because they don’t have a track record of sparking investor interest.
The best chart setup you want to find, is something that has a history of making big, volatile moves up, followed by a short consolidation period, and another big and quick sharp move up. My favorite trade idea in the biotech sector right now, comes from Durect Corporation (DRRX). This company has been around nearly 15 years, and was once worth $18 a share. For the past several months, it has been trading in obscurity under $1. They are working on liver disease drugs and are making progress on several fronts, announcing said catalysts in the recent weeks. The chart, indicates that this stock is capable of explosive moves on large volume. After the recent handful of announcements, it has already moved up 192% in a few months. Is that insider buying and savvy investors picking up on a bigger opportunity? And, for the first time in over a year, we are trading at new highs. Couple the bullish signals on the chart, with the bullish fundamental catalysts in play, and the sector and broader market, macroeconomic analysis, and I think we could have a huge turn around play on our hands here, as well as an amazing, low priced and lower risked investment opportunity.