Want To Bag More Winners? Here’s Why Fundamentals Aren’t Everything…

When it comes to investing, you should always stick to the fundamentals. This refrain, or some version of it, is what many new investors are taught.

In our opinion, that’s terrible advice. In fact, it could be costing you money every single day.

How? Let’s take, for example, a metric such as the price-to-earnings (P/E) ratio. It is often cited as a way to measure the fundamental health of a stock. A low P/E ratio is thought to signify stocks that are “cheap” or are trading at an attractive valuation relative to peers.

But the goal of investing and trading is not to own “cheap” stocks. The same goes for “fundamentally healthy” stocks. It’s to make money. That means finding stocks that are likely to appreciate — and quickly.

Fundamentals Aren’t Everything

Now, don’t get it wrong… We are not saying that fundamentals such as P/E ratios (especially when using the forward rather than the traditional trailing variety) are completely irrelevant or should be ignored. We are also not saying that fundamentals such as earnings growth should be cast aside as immaterial.

What we are saying is that these factors only matter if the stock is likely to move higher. Relying solely on such metrics is a “fundamental flaw” many traders make.

In “How to Make Money in Stocks,” Investor’s Business Daily founder William O’Neil writes, “Our ongoing analysis of the most successful stocks from 1880 to the present shows that, contrary to most investors’ beliefs, P/E ratios were not a relevant factor in price movement.”

Here’s a great example of this in action. Amazon (Nasdaq: AMZN) has been a household name for years. But how many individual investors actually owned it during its best days of growth?

Probably less than you’d expect. And one reason for that could be because Amazon has never been “cheap” by practically any normal fundamental standard. Look at the chart below, which shows the stock’s historic rise plotted against its P/E ratio at the time. (When there are no bars, it’s because AMZN didn’t have any earnings to speak of…)

Another Way To Look For Growth

By only looking at fundamentals, many investors ignore what we consider one of the most important metrics for identifying potential winners.

That metric is relative strength (RS).

In a nutshell, relative strength gives us a quick and easy way of determining how a stock performs relative to the rest of the market. The belief is that stocks that have outperformed in the past will continue to do so, while those that have been the weakest will continue to underperform.

In other words, those “cheap” stocks can stay cheap for a long time. Of course, this will not always be the case. But relative strength is one of the few technical indicators proven to work.

Professor Eugene F. Fama of the University of Chicago was awarded the 2013 Nobel Prize in economics. In one of his most well-known studies, he showed that relative strength was one of the most critical factors in a stock’s future price movement.

Separately, James P. O’Shaughnessy, author of “What Works on Wall Street,” calculated that using a relative strength-based system would have beaten the market by an average of 3.65% per year over the past 83 years.

The Takeaway

Some of the world’s top investing minds have looked at the data. They’ve concluded that relative strength is a better way to screen for potential winners. Of course, if you can find stocks with attractive fundamentals and a strong RS ranking, that’s even better.

If you want to make double-digit gains in a relatively short time, relative strength is one of the best tools available to select your trading candidates.

We’ll save the details of RS for another day. But think of RS as a way to quantify momentum. It may sound counterintuitive, but the fact is that stocks that have strong momentum are likely to continue going up. It’s that simple.

The bottom line is that if you are screening for stocks strictly based on traditional metrics like P/E, you should reconsider. You may have missed out on some big winners by solely looking for something “cheap.” This can cause you to miss out on substantial gains.

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