Ask Colin

You recommended five industrial stocks in February 2004 Shares. To what extent is the success of these recommendations dependent on the market being strong and they being in strong sectors?

You recommended five industrial stocks in February 2004 Shares. To what extent is the success of these recommendations dependent on the market being strong and they being in strong sectors?

I must stress that I did not recommend the five stocks. I wrote an article showing a method of finding hot prospects based on a fundamental ratio screen. There is no way I could recommend these for any reader, because I do not know their investment plan, financial circumstances or needs. All I was doing was highlighting some stocks that came out of a selection process that identifies cheap stocks, which are therefore prospects for re-rating by the market. Each reader has to assess these ideas with their financial adviser and act on any of the ideas that survive their own research and which fit into their financial plan. Having clarified this element of your question, we can get to the rest of your question.

All stocks will tend to rise and fall with the overall market. This is very frequently omitted in books about trading. If you are trading very short term, then perhaps you can ignore the overall market much of the time, but it might come back and bite you at some point. My own approach, which is medium term, recognises the importance of the overall market. It represents one of the major risks that a trader or investor has to deal with. I call it market risk and I have a detailed strategy for dealing with market risk in my investment plan. This was outlined in Shares Charting Guide No 2 and has been further refined in my book, which I am progressively publishing on my subscription website.

In addition to the movements of the overall market, every stock will to some extent move with its sector. It will not be as marked in the case of smaller stocks in a sector, because the index for the sector is capitalisation weighted and therefore driven by the major stocks. However, every stock in a sector will be driven by business conditions in the sector and therefore move with the other stocks in the same business. This is less reliable in the GICS sectors we have today than in the more tightly focussed sector indexes we used to have before the ASX sold out to S&P.

However, over and above this, smaller companies can outperform their sector in some circumstances. They may have a "hot" product. They may have developed problems in their business and fallen out of favour with the market. In these circumstances the market usually drives their price too low. When the management turn the company around, the market may wait to see them put the runs on the board. This is a situation in which a smaller company could outperform its sector as the market notices the recovery and restores its relative rating. Essentially this is what lay behind the approach I used in the article you cited. Of course, if the management \d\r\o\p the ball as they did on one company in particular in that list, it may delay the process for some time.

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