Electronic Trading: Conclusion

If you are a long-term investor, you can take this tutorial with a grain of salt. At least now you have some insight into how electronic systems give direct access to the market. We hope this has enlightened your outlook and helped you achieve a greater understanding of how the execution of stock orders is done. For those who are looking to become a trader, this is the tip of the iceberg and we'd advise you to do a lot more research in this area before jumping in.

Let's recap what we have learned:

•The NYSE is an auction market and uses specialists to trade securities.
•The Nasdaq is an OTC market where trading is facilitated through market makers.
•Each stock listed on the NYSE is allocated to a specialist who matches up buyers and sellers, provides liquidity and finds the fair price at the beginning of each trading day.
•A market maker provides continuous bid and offer prices within a prescribed percentage spread for shares in which they are designated to make a market.
•SuperDOT system is an electronic system used to place orders for stocks on the NYSE.
•ECNs network major brokerages and traders, so that they can trade between themselves without involving a middleman.
•SOES is an automatic order execution for individual traders with orders less than or equal to 1,000 shares.
•There are three levels on the Nasdaq that vary on the amount of information and access they provide to investors.

Electronic Trading: Small Order Execution System (SOES)

The lack of liquidity after the 1987 market crash lead the Nasdaq to implement a mandatory system to provide automatic order execution for individual traders with orders less than or equal to 1,000 shares. (For stocks with low volume, it may be less than 200 shares). Market makers must accept small order execution system (SOES) orders and so this provides excellent liquidity for smaller investors and traders.

There are several restrictions for those who are using SOES, rather than a traditional ECN, to place their orders.

1) Trades may not be in excess of 1,000 shares for a particular stock.

2) SOES doesn't not allow trades in stocks that are trading at prices greater than $250 per share.

3) Once a trader places an order through SOES, he or she must wait at least five minutes to place a trade through SOES on the same stock.

4) Short selling through SOES must comply with SEC rules and be on a zero plus tick basis only.

5) Institutions and brokers are not allowed to place orders for their own accounts through SOES, but they can for a client's account.

6) Market makers must honor their advertised bid/ask prices to SOES orders, provided that they are for the amount that the market maker is looking for.

Initially, when SOES was mandatory, it was met with heavy pessimism from Nasdaq member firms because it forced them to execute all SOES trades that met the market maker's advertised price. There were significant limitations implemented to prevent day traders from exploiting the system and taking advantage of old prices quoted by market makers.

SOES has revamped the trading market for individual investors. It has given small investors and traders the opportunity to compete on a level playing field for access to orders and execution.

Electronic Trading: Electronic Communications Networks (ECNs)

An electronic communication network (ECN) is an electronic system that attempts to facilitate (for market makers) or eliminate (for individual investors) third party orders entered by a client's brokerage to be executed in whole or in part. ECNs network major brokerages and traders so that they can trade between themselves without having to go through a middleman. The advantage of an ECN is that it displays orders in real time, whereas on the NYSE, most investors are limited to only viewing the best bid and ask prices. (For related reading, see Direct Access Trading Systems and Introduction To Level II Quotes.)

There are several variations of ECNs in the market, each of which are slightly different. Here are some of the more popular ones and a summary of their basic characteristics:

Instinet
Instinet was the first ever ECN, founded in 1969. It was originally a way for brokerages to display bid and ask prices for practically every stock in North America and abroad and was first used by institutions to transact with each other. Today it also includes a select group of smaller brokerages. Instinet is used to execute a large proportion of orders on Nasdaq and is primarily entered by market makers. Because of this exclusive access many of the large block orders on Nasdaq stocks are traded through Instinet. More recently, Instinet has tried to level the playing field by lowering access fees and allowing individual investors and small firms to access its orders.

SelectNet
This electronic system is primarily used for trading between market makers. SelectNet is known as a negotiable system, which means that market makers may or may not execute your order immediately, as on other ECNs, although they are required to execute immediately if the order is at the advertised price and it appears on the market maker's screen. SelectNet is popular among traders because orders can be preferenced, which allows a trader to isolate and trade with a particular market maker. This is advantageous because traders can target market makers who are active in the stock he/she wants to trade. This way the trader will get immediate attention, which usually results in a faster execution.

There are a few networks that are used to facilitate trading on Nasdaq stocks. One, the small order execution system (SOES), we will discuss next, but there are also other ECNs offered by Bloomberg, Terra Nova and others.

Electronic Trading: SuperDOT

Initially introduced as DOT, the SuperDOT system (Super Designated Order Turnaround System) is an electronic system used to place orders for stocks that are listed, which usually refers to those trading on the New York Stock Exchange (NYSE). Keep in mind that SuperDOT is not to be confused with an electronic communication network (ECN), which we will discuss next.

The SuperDOT order-routing system facilitates the transmission of both market and limit orders directly to the trading post (and specialist) where the particular security is traded. This allows for a more efficient transaction because the order can be delivered directly to the specialist rather than phoned down to a floor trader and done manually. SuperDOT can be used for trades under 100,000 shares with priority given to orders of 2,100 shares or less. More than three-quarters of the orders executed through the NYSE are done through the assistance of the SuperDOT system.

After the order has been executed, the report of the transaction is sent back to the broker through the SuperDOT system. This means faster execution of the order and faster reporting of the trade. While most individual investors cannot have access to SuperDOT directly, there are complimentary systems offered by many brokers that replicate similar order executions provided by SuperDOT.

Originally, the SuperDOT system was designed for small order entry, but increasingly, SuperDOT has played a big role in portfolio or basket trading.

Electronic Trading: The Role of a Market Maker

Market makers compete for customer order flows by displaying buy and sell quotations for a guaranteed number of shares. The difference between the price at which a market maker is willing to buy a security and the price at which the firm is willing to sell it is called the market maker spread. Because each market maker can either buy or sell a stock at any given time, the spread represents the market maker's profit on each trade. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. There can be anywhere from four to 40 (or more) market makers for a particular stock depending on the average daily volume. The market makers play an important role in the secondary market as catalysts, particularly for enhancing stock liquidity and, therefore, for promoting long-term growth in the market.

Market makers must maintain continuous two-sided quotes (bid and ask) within a predefined spread. A market is created when the designated market maker quotes bids and offers over a period of time. They ensure there is a buyer for every sell order and a seller for every buy order at any time.

Once the market maker has entered a price, he or she is obligated to either buy or sell at least 1,000 securities at that advertised price. Once the market maker has either bought or sold these shares, he or she may then "leave the market" and enter a new bid or ask price to make a profit on the previous trade.

For example, let's say that a market maker has entered a sell order for Microsoft (MSFT) and the bid/ask is $65.25/$65.30. The market maker can try to sell shares of MSFT at $65.30. If this is what the market maker chooses to do, he or she can then turn around and enter a bid order to buy shares in MSFT. The market maker can bid higher or lower than the current bid of $65.25. If he or she enters a bid at $65.26 then a new market is created (referred to as making a market) because that bid price is now the best bid. If the market maker attracts a seller at the new bid price of $65.26 then he or she has successfully "made the spread." The market maker sold 1,000 shares at $65.30 and bought these shares back at $65.26. As a result, the market maker made $40 (1,000 shares x $0.04) on the difference between the two transactions. This might not seem like much, but doing this repeatedly with larger order sizes can provide lucrative profits. All day long market makers do this, providing liquidity to individual and institutional investors. The major risk for the market maker is the time lapse between the two transactions; the faster he or she can make the spread the more money the market maker has the potential to make.

However, making money from the differences in bid and ask prices is not the only function of market makers. Their first priority is to provide liquidity to their own firm's clients, for which they will receive a commission. They may also facilitate trading for other brokerage firms, which is very similar to the duties of a specialist.

It should also be noted that market makers are required by law to give customers the best bid or ask price for each market order transaction. This ensures a fair and reasonable two-sided market. If these regulations were not in place, customers' profits would be gouged and share prices would be much more volatile than they already are.

Electronic Trading: The Role of a Specialist

The NYSE facilitates trading through a human being who is known as the specialist. Each stock listed on the NYSE is allocated to a specialist and all the buying and selling of a stock occurs at the location of this person, known as "the trading post." Buyers and sellers represented by a floor trader will meet at the trading post to learn about the best current bid and ask price for a security. These bid and ask offers are called out loud and indicate the current prices to any interested party. A trade will be executed when the bid and ask orders meet. (For more insight, see Why The Bid-Ask Spread Is So Important.)

The specialist doesn't only match up buyers and sellers. Many specialists are forced to hold an inventory of shares themselves to minimize the imbalance of buy and sell orders. The specialist does this until an equilibrium price is reached, which is when demand and supply are very close. Buying an inventory of stocks is not a common occurrence. In fact, it is estimated that a specialist will be in on only one out of every 10-15 trades.

Another duty that a specialist attends to occurs if a customer's order is priced at a level higher than the lowest ask, or lower than the best bid price (known as a stop order). The specialist will then hold the order and execute it if and when the price of the stock reaches the level specified by the customer. (For related reading, check out Understanding Order Execution and The Basics Of Order Entry.)

A final responsibility of the specialist is to find a fair price for each of the stocks that he or she is responsible for at the beginning of every trading day. This fair price is based on the current supply and demand of the stock. The NYSE opens for trading at 9:30am, but if the specialist can't find a fair price, he or she may delay the opening of trading on a stock until that fair price is found.

It is the specialist's job to act in a way that benefits the public. Because specialists are responsible for keeping the market in equilibrium, they are required to execute all customer orders ahead of their own.

Electronic Trading: The Nasdaq Vs. The NYSE

From a glance, the difference between the New York Stock Exchange (NYSE) and Nasdaq may not be marked. The NYSE lists household names like Coca-Cola, Wal-Mart, Citicorp, and General Electric, whereas the Nasdaq is home to many of the tech giants such as Microsoft, Cisco, Intel, Oracle and Sun Microsystems. Besides the heavy tech weighting, the fundamental difference between the two exchanges is in the way securities are traded.

NYSE

The NYSE is an auction market that uses floor traders to make most of its trades. Each stock on the NYSE has a specialist; this is a person who oversees and facilitates all of the trades for a particular stock. If you wish to buy a stock that trades on the NYSE, your broker will either call your order to a floor broker, or enter it into the DOT system (which we will discuss later on). (For more insight, see Markets Demystified and The Tale Of Two Exchanges: NYSE and Nasdaq.)

Nasdaq

The Nasdaq, on the other hand, is not a physical entity. The Nasdaq might be known for its fancy MarketSite Tower and broadcast studio in Times Square, but very little is done there. The Nasdaq is an over-the-counter (OTC) market and it relies on market makers rather than specialists to facilitate trading and liquidity in stocks. For each stock, there is at least one market maker, (large stocks such as Microsoft have several), whose duties we will discuss later on. (Want to learn more? Read What's the difference between a Nasdaq market maker and a NYSE specialist?)

Rather than being an auction market, the Nasdaq is a communications network between thousands of computers. Instead of brokers calling out orders, market makers place their names on a list of buyers and sellers, which is then distributed by the Nasdaq in a split second to thousands of other computers. If you wish to buy a stock that trades on the Nasdaq, your broker will either call up a market maker with the information of your trade or enter your order into a Nasdaq-sponsored online execution system.

Electronic Trading: Introduction

When it comes to electronic trading, for most individual investors, taking a long-term buy-and-hold approach is probably the best strategy. Most of us simply don't have the time or the expertise to trade for a living. But for some investors, trading can be an extremely lucrative profession.

There have always been professionals who made their living off of trading. It wasn't until recently, however, that technology enabled individuals who weren't working for a brokerage to directly access the markets. This tutorial will delve into the workings of the electronic systems that allow this direct access. We'll also talk about the differences between the New York Stock Exchange (NYSE) and the Nasdaq and learn how market trades are executed, both by market makers and by specialists.

Whether you are an aspiring trader or a seasoned investor looking to find out how it all works, this tutorial explains all the nitty-gritty electronic trading systems in layman's terms. Is electronic trading a new way for you to build you own portfolio?

Stock-Picking Strategies: Conclusion

Let's run through a quick recap of the foundational concepts that we covered in our look at the most well-known stock-picking strategies and techniques:

•Most of the strategies discussed in this tutorial use the tools and techniques of fundamental analysis, whose main objective is to find the worth of a company, or its intrinsic value.
•In quantitative analysis, a company is worth the sum of its discounted cash flows. In other words, it is worth all of its future profits added together.
•Some qualitative factors affecting the value of a company are its management, business model, industry and brand name.
•Value investors, concerned with the present, look for stocks selling at a price that is lower than the estimated worth of the company, as reflected by its fundamentals. Growth investors are concerned with the future, buying companies that may be trading higher than their intrinsic worth but show the potential to grow and one day exceed their current valuations.
•The GARP strategy is a combination of both growth and value: investors concerned with 'growth at a reasonable price' look for companies that are somewhat undervalued given their growth potential.
•Income investors, seeking a steady stream of income from their stocks, look for solid companies that pay a high but sustainable dividend yield.
•CAN SLIM analyzes these factors of companies: current earnings, annual earnings, new changes, supply and demand, leadership in industry, institutional sponsorship, and market direction.
•Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial Average (DJIA) with the highest dividend yield.
•Technical analysis, the polar opposite of fundamental analysis, is not concerned with a stock's intrinsic value, but instead looks at past market activity to determine future price movements.

Stock-Picking Strategies: Technical Analysis

Technical analysis is the polar opposite of fundamental analysis, which is the basis of every method explored so far in this tutorial. Technical analysts, or technicians, select stocks by analyzing statistics generated by past market activity, prices and volumes. Sometimes also known as chartists, technical analysts look at the past charts of prices and different indicators to make inferences about the future movement of a stock's price.

Philosophy of Technical Analysis
In his book, "Charting Made Easy", technical analysis guru John Murphy introduces readers to the study of technical analysis, explaining its basic premises and tools. Here he explains the underlying theories of technical analysis:

"Chart analysis (also called technical analysis) is the study of market action, using price charts, to forecast future price direction. The cornerstone of the technical philosophy is the belief that all factors that influence market price - fundamental information, political events, natural disasters, and psychological factors - are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down."
The most important assumptions that all technical analysis techniques are based upon can be summarized as follows:

Prices already reflect, or discount, relevant information. In other words, markets are efficient.
Prices move in trends.
History repeats itself.
(For a more detailed explanation of this concept, see our Technical Analysis tutorial.)

What Technical Analysts Don't Care About
Pure technical analysts couldn't care less about the elusive intrinsic value of a company or any other factors that preoccupy fundamental analysts, such as management, business models or competition. Technicians are concerned with the trends implied by past data, charts and indicators, and they often make a lot of money trading companies they know almost nothing about.

Is Technical Analysis a Long-Term Strategy?
The answer to the question above is no. Definitely not. Technical analysts are usually very active in their trades, holding positions for short periods in order to capitalize on fluctuations in price, whether up or down. A technical analyst may go short or long on a stock, depending on what direction the data is saying the price will move. (For further reading on active trading and why technical analysis is appropriate for a short-term strategy, see Defining Active Trading.)

If a stock does not perform the way a technician thought it would, he or she wastes little time deciding whether to exit his or her position, using stop-loss orders to mitigate losses. Whereas a value investor must exercise a lot of patience and wait for the market to correct its undervaluation of a company, the technician must possess a great deal of trading agility and know how to get in and out of positions with speed.

Support and Resistance
Among the most important concepts in technical analysis are support and resistance. These are the levels at which technicians expect a stock to start increasing after a decline (support), or to begin decreasing after an increase (resistance). Trades are generally entered around these important levels because they indicate the way in which a stock will bounce. They will enter into a long position if they feel a support level has been hit, or enter into a short position if they feel a resistance level has been struck.

Here is an illustration of where technicians might set support and resistance levels:



Picking Stocks with Technical Analysis
Technicians have a very full toolbox. They literally have hundreds of indicators and chart patterns to use for picking stocks. However, it is important to note that no one indicator or chart pattern is infallible or absolute; the technician must interpret indicators and patterns, and this process is more subjective than formulaic. Let's briefly examine a couple of the most popular chart patterns (of price) that technicians analyze.


Cup and Handle
This is a bullish pattern that looks like a pot with a handle. The stock price is expected to break out at the end of the handle, so by buying here, investors are able to make a lot of money. Another reason for this pattern's popularity is how easy it is to spot. Here is an example of a great cup and handle pattern:



Head and Shoulders
This pattern resembles, well, a head with two shoulders. Technicians usually consider this a bearish pattern. Below is a great example of this particular chart pattern:



Remember, these two examples are mere glimpses into the vast world of technical analysis and its techniques. We couldn't have a complete stock picking tutorial without mentioning technical analysis, but this brief intro barely scratches the surface.
Conclusion
Technical analysis is unlike any other stock-picking strategy - it has its own set of concepts, and it relies on a completely different set of criteria than any strategy employing fundamental analysis. However, regardless of its analytical approach, mastering technical analysis requires discipline and savvy, just like any other strategy.

Stock-Picking Strategies: Dogs of the Dow

The investing strategy which focuses on Dogs of the Dow was popularized by Michael Higgins in his book, "Beating the Dow". The strategy's simplicity is one of its most attractive attributes. The Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial Average (DJIA) with the highest dividend yield. In the Dogs of the Dow strategy, the investor shuffles around his or her portfolio, adjusting it so that it is always equally allocated in each of these 10 stocks.

Typically, such an investor would need to completely rid his or her portfolio of about three to four stocks every year and replace them with different ones. The stocks are usually replaced because their dividend yields have fallen out of the top 10, or occasionally, because they have been removed from the DJIA altogether.

Is it Really that Simple?
Yes, this strategy really is as simple as it sounds. At the end of every year, you reassess the 30 components of the DJIA, determine which ones have the highest dividend yield, and ask your broker to make your portfolio as equally weighted in each of these 10 stocks as possible. Hold onto these 10 stocks for one calendar year, until the following Jan 1, and repeat the process. This is a long-term strategy, requiring a long period to see results. There have been a few years in which the Dow has outperformed the Dogs, so it is the long-term averages that proponents of the strategy rely on.

The Premise
The premise of this investment style is that the Dow laggards, which are temporarily out-of-favor stocks, are still good companies because they are still included in the DJIA; therefore, holding on to them is a smart idea, in theory. Once these companies rebound and the market has revalued them properly (or so you hope), you can sell them and replenish your portfolio with other good companies that are temporarily out of favor. Companies in the Dow have historically been very stable companies that can weather any market decline with their solid balance sheets and strong fundamentals. Furthermore, because there is a committee perpetually tinkering with the DJIA's components, you can rest assured that the DJIA is made up of good, solid companies.

By the Numbers
As mentioned earlier, one of the big attractions of the Dogs of the Dow strategy is its simplicity; the other is its performance. From 1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dows averaged 11%. The performance between 1973 and 1996 was even more impressive, as the Dogs returned 20.3% annually, whereas the Dows averaged 15.8%.

Variations of the Dogs
Because of this strategy's simplicity and its returns, many have tried to alter it in an attempt to refine it, making it both simpler and higher yielding. There is the Dow 5, which includes the five Dogs of the Dow that have the lowest per share price. Then there is the Dow 4, which includes the 4 highest priced stocks of the Dow 5. Finally, there is the Foolish 4, made famous by the Motley Fool, which chooses the same stocks as the Dow 4, but allocates 40% of the portfolio to the lowest priced of these four stocks and 20% to the other three stocks.

These variations of the Dogs of the Dow were all developed using backtesting, or testing strategies on old data. The likelihood of these strategies outperforming the Dogs of the Dow or the DJIA in the future is very uncertain; however, the results of the backtesting are interesting. The table below is based on data from 1973-1996.



Before you go out and start applying one of these strategies, consider this: picking the highest yielding stocks makes some intuitive sense, but picking stocks based strictly on price seems odd. Share price is a fairly relative thing; a company could split its shares but still be worth the same, simply having twice as many shares with half the share price. When it comes to the variations on the Dogs of the Dow, there are many more questions than there are answers.




Dogs Not Fool Proof
As is the case with the other strategies we've looked at, the Dogs of the Dow strategy is not fool-proof. The theory puts a lot of faith in the assumption that the time period from the mid-20th century to the turn of the 21st century will repeat itself over the long run. If this assumption is accurate, the Dogs will provide about a 3% greater return than the Dow, but this is by no means guaranteed.

Conclusion
The Dogs of the Dow is a simple and effective strategy based on the results of the last 50 years. Pick the 10 highest yielding stocks of the 30 Dow stocks, and weigh your portfolio equally among them, adjusting the portfolio annually, and you can expect about a 3% outperformance of the Dow. That is, if history repeats itself.

Stock-Picking Strategies: Growth Investing

In the late 1990s, when technology companies were flourishing, growth investing techniques yielded unprecedented returns for investors. But before any investor jumps onto the growth investing bandwagon, s/he should realize that this strategy comes with substantial risks and is not for everyone.

Value versus Growth
The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.

As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.

No Automatic Formula
Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis, but these methods must be applied with a company's particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry's performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.

The NAIC
The National Association of Investors Corporation (NAIC) is one of the best known organizations using and teaching the growth investing strategy. It is, as it says on its website, "one big investment club" whose goal is to teach investors how to invest wisely. The NAIC has developed some basic "universal" guidelines for finding possible growth companies - here's a look at some of the questions the NAIC suggests you should ask when considering stocks.

1. Strong Historical Earnings Growth?
According to the NAIC, the first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. Below are rough guidelines for the rate of EPS growth an investor should look for in companies of differing sizes, which would indicate their growth investing potential:




Although the NAIC suggests that companies display this type of EPS growth in at least the last five years, a 10-year period of this growth is even more attractive. The basic idea is that if a company has displayed good growth (as defined by the above chart) over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years.

2. Strong Forward Earnings Growth?
The second criterion set out by the NAIC is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources.

The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company's industry - specifically, what its prospects are and what stage of growth it is at. (See The Stages of Industry Growth.)

3. Is Management Controlling Costs and Revenues?
The third guideline set out by the NAIC focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it's likely due to a decrease in profit margin.

By comparing a company's present profit margins to its past margins and its competition's profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.

4. Can Management Operate the Business Efficiently?
Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.

5. Can the Stock Price Double in Five Years?
If a stock cannot realistically double in five years, it's probably not a growth stock. That's the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock's price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.

An Example
Now that we've outlined the NAIC's basic criteria for evaluating growth stocks, let's demonstrate how these criteria are used to analyze a company, using Microsoft's 2003 figures. For the sake of this demonstration, we'll discuss these numbers as though they were Microsoft's most current figures (that is, "today's figures").

1. Five-Year Earnings Figures


• Five-year average annual sales growth is 15.94%.
• Five-year average annual EPS growth is 10.91%.

Both of these are strong figures. The annual EPS growth is well above the 5% standard the NAIC sets out for firms of Microsoft's size.

2. Strong Projected Earnings Growth


• Five-year projected average annual earnings growth is 11.03%.

The projected growth figures are strong, but not exceptional.

3. Costs and Revenue Control


• Pre-tax margin in most recent fiscal year is 45.80%.
• Five-year average fiscal pre-tax margin is 50.88%.
• Industry's five-year average pre-tax margin is 26.7%.

There are two ways to look at this. The trend is down 5.08% (50.88% - 45.80%) from the five-year average, which is negative. But notice that the industry's average margin is only 26.7%. So even though Microsoft's margins have dropped, they're still a great deal higher than those of its industry.

4. ROE


• Most recent fiscal year-end is ROE 16.40%.
• Five-year average ROE is 19.80%.
• Industry average five-year ROE is 13.60%.

Again, it's a point of concern that the ROE figure is a little lower than the five-year average. However, like Microsoft's profit margin, the ROE is not drastically reduced - it's only down a few points and still well above the industry average.

5. Potential to Double in Five Years


• Stock is projected to appreciate by 254.7%.

The average analyst projections for Microsoft suggest that in five years the stock will not merely double in value, but it'll be worth 254.7% its current value.




Is Microsoft a Growth Stock?
On paper, Microsoft meets many NAIC's criteria for a growth stock. But it also falls short of others. If, for instance, we were to dismiss Microsoft because of its decreased margins and not compare them to the industry's margins, we would be ignoring the industry conditions within which Microsoft functions. On the other hand, when comparing Microsoft to its industry, we must still decide how telling it is that Microsoft has higher-than-average margins. Is Microsoft a good growth stock even though its industry may be maturing and facing declining margins? Can a company of its size find enough new markets to keep expanding?

Clearly there are arguments on both sides and there is no "right" answer. What these criteria do, however, is open up doorways of analysis through which we can dig deeper into a company's condition. Because no single set of criteria is infallible, the growth investor may want to adjust a set of guidelines by adding (or omitting) criteria. So, although we've provided five basic questions, it's important to note that the purpose of the example is to provide a starting point from which you can build your own growth screens.

Conclusion
It's not too complicated: growth investors are concerned with growth. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology. Even though the stocks might be expensive in the present, growth investors believe that expanding top and bottom lines will ensure an investment pays off in the long run.

What's the difference between "top-down" and "bottom-up" investing?

Before we look at the differences between top-down and bottom-up investing, we should make it clear that both of these approaches have the same goal - to ferret out great stocks. Now, let's look at the different strategies used by top-down vs. bottom-up investors to select companies in which to invest.

Top-down investing involves analyzing the "big picture". Investors using this approach look at the economy and try to forecast which industry will generate the best returns. These investors then look for individual companies within the chosen industry and add the stock to their portfolios. For example, suppose you believe there will be a drop in interest rates. Using the top-down approach, you might determine that the home-building industry would benefit the most from the macroeconomic changes and then limit your search to the top companies in that industry.

Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Advocates of the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors. What constitutes "good prospects", however, is a matter of opinion. Some investors look for earnings growth while others find companies with low P/E ratios attractive. A bottom-up investor will compare companies based on these fundamentals; as long as the companies are strong, the business cycle or broader industry conditions are of no concern.

What's the difference between a stop and a limit order?

Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you place a stop or limit order, you are telling your broker that you don't want the market price (the current price at which a stock is trading), but that you want the stock price to move in a certain direction before your order is executed.

With a stop order, your trade will be executed only when the security you want to buy or sell reaches a particular price (the stop price). Once the stock has reached this price, a stop order essentially becomes a market order and is filled.

For instance, if you own stock ABC, which currently trades at $20, and you place a stop order to sell it at $15, your order will only be filled once stock ABC drops below $15. Also known as a "stop-loss order", this allows you to limit your losses. However, this type of order can also be used to guarantee profits.

For example, assume that you bought stock XYZ at $10 per share and now the stock is trading at $20 per share. Placing a stop order at $15 will guarantee profits of approximately $5 per share, depending on how quickly the market order can be filled.

Stop orders are particularly advantageous to investors who are unable to monitor their stocks for a period of time, and brokerages may even set these stop orders for no charge.

One disadvantage of the stop order is that the order is not guaranteed to be filled at the preferred price the investor states. Once the stop order has been triggered, it turns into a market order, which is filled at the best possible price. This price may be lower than the price specified by the stop order.

Moreover, investors must be conscientious about where they set a stop order. It may be unfavorable if it is activated by a short-term fluctuation in the stock's price. For example, if stock ABC is relatively volatile and fluctuates by 15% on a weekly basis, a stop loss set at 10% below the current price may result in the order being triggered at an inopportune or premature time.

A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. For instance, if you want to buy stock ABC, which is trading at $12, you can set a limit order for $10. This guarantees that you will pay no more than $10 to buy this stock. Once the stock reaches $10 or less, you will automatically buy a predetermined amount of shares.

On the other hand, if you own stock ABC and it is trading at $12, you could place a limit order to sell it at $15. This guarantees that the stock will be sold at $15 or more.

The primary advantage of a limit order is that it guarantees that the trade will be made at a particular price; however, your brokerage will probably charge a higher a commission for the limit order, and it's possible that your order will not be executed at all if the limit price is not reached.

How to avoid taxes with an IRA

I just learned something AWESOME, maybe you already know this, but I had a question about taxes and trading profits in a Roth IRA.

My question was if you trade stocks in a Roth IRA and do not withdraw the profits but re-invest them are they taxed? Well here is the answer:


One of the most common and 100% IRS-approved ways for the active trader to avoid taxes is to trade within an IRA. Please note, I am not a CPA or Tax Advisor. These are simply a few observations from one trader to another (or would-be trader). Consult directly with your tax advisor prior to taking any action in regards to the following. All the same, this should serve as an introduction into how traders can trade tax free within an IRA structure.

Short term gains which are what are produced by active trading are taxed at your regular tax rate. Long term gains on investments held for one year or more are taxed at 20%. However, if you actively trade within your IRA, not only are ALL taxes deferred, you don't have to report any gains or losses. The reason being there is no tax effect on the gains/losses so the IRS doesn't care what happens.

A Roth IRA is an even better vehicle for active traders to trade within. Profits made within the Roth IRA structure are never required by the IRS to be reported. Besides, gains are never taxed if the rules are followed. Basically, you need to hold the Roth for a minimum of 5 years and be over 59 1/2 to withdrawal 100% tax free.

Many traders believe that one can only trade on the long side within an IRA. This isn't true. Short selling is permitted under certain guidelines. In addition your IRA can be traded on margin to magnify the gains.

The IRS may be the trader's nemesis, but knowledge of the beast will mitigate the harm in a completely legal and ethical manner.

Dave Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.
That is great news, now I know that I can trade in my Roth IRA and not worry about taxes WOOHOO!