STP Algo Trader - The Method

Welcome to the latest issue of STP Algo Trader "The Method"!

Every Saturday, we will break down each of the inputs that go into our proprietary algorithmic trading system - Signal Trader Pro.

Not only do we want to share the inner workings of our system, but we want to educate you on how to become a better investor. Remember, our ultimate goal is to help you MAKE MONEY!

In last week's issue, we returned to the discussion of the core inputs to our system.

Remember that a "15" point-scoring system powers our platform. The higher the score, the greater the probability that the idea will be a winner. Our historical data shows a significant difference between the highest and lowest-scoring signals.

In that issue, we discussed the three different operating metrics from the companies we analyze – revenue, cash flow (as measured by EBITDA), and earnings (as measured by EPS).

Within these metrics, we look at the trends over the previous 12 quarters (three years). We want them to be "positive" at least three-quarters or 75% of the time.

Today, we are going to discuss the first of the measurements where we are looking for this positive trend. That measure is GROWTH.

The concept is simple and one of the most powerful in the stock market. Companies that grow see stocks that go higher.

As a practical matter, if you can find a company earning $1 today and earning $5 or $10 in the future, that stock will go up!

It may go up a lot or it may go up a little. It may go up as much as the growth, or it may go up more. It may go up sooner, or it may go up later. In all scenarios, though, it is going higher.

For example, look at the stock of Alphabet Inc. (NASDAQ: GOOG) or, as we all know, Google.

Here is the growth in EPS over the last decade…

Here is the price of the stock over that same period…

This is not an exception. It is the overwhelming rule.

The academic view of this relationship is that when you buy a share of stock, you own a share of the company. This means you own a share in the assets, operations, and – most importantly – future cash flows.

When you buy the stock, the academic argument is that the company's current assets and cash flows should be "discounted" into the price. This means that the stock is fairly priced based on the available market information.

This is referred to as the “efficient markets hypothesis.”

This idea implies that it is impossible to "beat" the market by identifying stocks that will go up more than whatever the overall stock market will go up.

As you can imagine – we do NOT agree.

There are many ways we could deconstruct this idea and show how it is both empirically and theoretically incorrect.

In this issue, though, we want to focus on the idea of growth.

While the hypothesis would argue that a stock should discount future growth, do we think a stock with earnings going from $1 to $5 will REALLY stay flat?

Sure, there are times when this could happen.

It could be that that $5 of future EPS is not sustainable for business reasons. This happens with highly economically sensitive or capital-intensive industries referred to as “cyclicals.”

For this subset of stocks, it is common for the share price not to move higher as the EPS grows.

When the stocks, though, go from losing money to making money, the share prices soar.

The market does a poor job of discounting the impact of periods where cyclicals lose money. We think the reality is that humans react emotionally and panic when they lose money.

Another instance could be that the stock trades at an elevated multiple. As the growth is realized, the multiple comes down towards a more average multiple. This also happens frequently.

What happens almost always is that if the company really posts extreme growth, the multiple does not compress nearly as much as the earnings growth. This means the stock goes higher.

Again, the market seems to do a poor job of discounting the impact of high growth.

We think the reason comes back to simple math and where, eventually, the real cash flow of a company will begin to intersect with the stock price.

At some point, if a company grows a massive amount, then it will produce a large amount of cash. They could return this cash to shareholders via buybacks or dividends if the stock price doesn't move.

This creates incremental demand for the shares (with the assumption of no increase in supply) and drives the price higher.

Eventually, growth intersects with the real world.

Ultimately, though, these are all academic arguments. Why do WE think that growth really matters?

It matters because the majority of the participants in the stock market have DECIDED that it matters.

One of our differentiated views of the stock market is the idea that stocks are NOT companies.

While you legally own a stake in the company, shareholders rarely see the benefits of the company's cash flow.

It doesn’t matter, though, because the market participants have decided this is the metric that counts.

Companies that GROW have stocks that go HIGHER.

For Signal Trader Pro, we are looking to identify stocks with strong market demand. We buy them when they get materially oversold.

High growth creates high demand for the shares, making them interesting to our system.

One last note – a concept we mentioned last week – is that the market primarily focuses on EPS. Companies that can post growth across all three of these measures, however, are showing the best fundamentals.

This creates the most interest amongst stock buyers and makes them the most interesting stocks for our system.

Identify growth and buy the stocks when they stumble, and you can change your financial future!

Click here for more information and to sign up for Signal Trader Pro.