Supernova Stocks User Guide
Table of Contents: Supernova Stocks
What’s the Market User Guide
Doing? . . . . . . . . . . . . . 2
upernova Stocks is unlike many other newsletters that are written by
financial reporters with little or no real world investing expertise. On
The Fundamentals and the contrary, Supernova is written by professional money managers
Valuation . . . . . . . . . . . 2 that actively manage investors’ money, while also writing for Supernova
Finding the Business
In fact, the stock selection process used here at Supernova is how these sea-
Driver. . . . . . . . . . . . . . 3 soned pros generate ideas in their investment business, where they have mil-
lions of dollars at stake. Their process, developed over years of experience,
And Finally, the has proven to be successful in getting in early on stock market winners.
Technicals . . . . . . . . . . 3
I’ll let Supernova Stocks Editor-in-Chief Charles Norton explain in his own
words below the process by which he and Managing Editor Allen Gillespie
How to Buy: Average identify stocks that have supernova potential. First, though, let me take a
Up, Not Down . . . . . . . 4 minute to explain what you can expect from us at Supernova Stocks. You’ll
get three Special Reports in addition to this one, which we hope you’ll
You Own It, Now enjoy and profit from. Check back often as we’ll add new Special Reports
What? . . . . . . . . . . . . . . 4 throughout the year.
The editors of Supernova Stocks, Charles and Allen, both of whom are CFA
Investment Policy & charterholders, are constantly doing research to uncover the next big stock
Trading Restrictions . 5 market winner. Twice a month, subscribers to Supernova Stocks will
receive a new issue with two of their freshest ideas.
Sometimes the stock they discuss may be a timely buy, and other times it
may be a stock worth watching as a possible future investment. Each com-
pany write-up will detail, at length, the company’s fundamentals, the busi-
ness driver, and the stock’s technical condition. Twice a month, you’ll hear
from these two proven money-makers exactly why they think these stocks
could generate huge gains for your portfolio. Not only that, but you’ll learn
all about their stock selection process, valuable lessons you can apply to
your own investing.
In each issue you’ll also get an update on some of the companies followed
by Supernova Stocks. Better-than-expected earnings reports? Insider buy-
ing or a new product launch? You’ll find all this news and more in this sec-
su per no va tion of the newsletter.
1: The explosion of a very large star in Finally, the model portfolio will show all of the stocks that Charles and
which the star may reach a maximum Allen have recommended buying, and each stock’s return since their pur-
intrinsic luminosity one billion times that
of the sun chase.
2: One that explodes into prominence or We hope you enjoy our work at Supernova Stocks, and we hope our stock
opportunity picks help you achieve investing success!
— Ian Wyatt, Publisher
By Charles L. Norton, CFA
and Allen R. Gillespie, CFA
Supernova stocks share common traits: they’ve gener- lesser extent, the Dow - to generate a big-picture opin-
ated large and sometimes accelerating sales and earn- ion of the market’s trend. At the beginning of each
ings growth and are expected to have continued growth issue of Supernova Stocks, we’ll briefly discuss our
in future periods; they are leaders in a leading industry market view.
group; they are under-owned but beginning to attract
institutional attention; and there is a fundamental That’s not to say that there aren’t stocks that go up in
change in their business that serves as a catalyst to bear markets. It just means that the truly spectacular
continue (or increase) growth. moves - the 500% to 1000% gains and more - generally
come during bull markets. But we’re of the belief that
In his classic book about Jesse Livermore, there is always something working. Our job is to identi-
Reminiscences of a Stock Operator, Edwin Lefevre fy what’s working and share it with you.
says, “Nowhere does history indulge in repetitions so
often or uniformly as in Wall Street…The game does Even in bear markets, there are certain industry groups
not change and neither does human nature." Indeed, or global markets that perform well for a period of
when it comes to finding the next big stock market time. We’re equal opportunity investors – regardless of
winners, studying past stars is a great starting point. a company’s size, sector, exchange, or index member-
Evaluating the charts and stories of previous leading ship, if it meets our criteria, we’ll consider it for invest-
stocks, and applying those lessons to today’s market, ment. Eventually, however, even the best performing
can help uncover some true gems. sectors give in to the strong forces of the broad mar-
One concept that we’ve learned from studying the char-
acter of market-leading stocks that is often overlooked It is during this period, usually when the broad market
by many investors is that leading stocks can trend is in a bear phase, that future market leaders start base
higher for long periods of time. As William O’Neil building, preparing for their next launch. Until then,
explains in his classic book, How to Make Money in the sidelines may be the best place to be. Supernova
Stocks, “The hard-to-accept great paradox in the stock Stocks is a long-only newsletter, but that certainly
market is that what seems too high and risky to the doesn’t mean our model portfolio will always be fully
majority usually goes higher and what seems low and invested. In fact, in bear markets we may be in all cash
cheap usually goes lower.” This philosophy means that waiting for a more favorable environment.
we don’t shy away from a stock because it’s “up too
much,” and we don’t bother trying to bottom fish The Fundamentals
among the laggards.
Of course, even using previous leaders as a guide to
picking future winners will not prevent us from Thousands and thousands of stocks trade each day.
selecting a dud every now and then. In fact, I can Our mission is to sift through all the stocks out there in
promise you that we will have our fair share of order to find gold: the select few that could be the next
lemons. However, sound portfolio management rules market winners. Our process begins by using quantita-
are the cornerstone of the Supernova process. tive screens to narrow the field of possible investments
Disciplined risk management is absolutely crucial for to only those companies that meet our stringent funda-
investing success. Realizing when it’s time to sell is mental criteria.
just as important as learning when (and what) to
buy. This criteria include strong quarterly and annual sales
and earnings growth, and the higher the better. Ideally
What’s the we look for accelerating growth over the past three
quarters, although that is not a requirement. Not only
Market Doing? does a company have to exhibit a nice track record of
growing both their top and bottom line, but we also
Because most stocks move in the direction of the mar- like to see expectations that this growth will continue.
ket, many of the biggest winners of all time occurred
during a bull market in the broad market. Therefore, Another thing we look for in this initial process is
we monitor the health of the major stock market strong and improving profitability, as measured by
indices - the S&P 500, the Nasdaq Composite, and to a return on equity and expanding profit margins. After
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all, what good is sales growth if it’s not making its way our research and we will always discuss it in our com-
down to the bottom line? We prefer to see companies pany write-ups. That’s not to say that we only buy
with a solid return on equity and a few consecutive cheap stocks or if we consider a stock to be expensive,
quarters of margin expansion. we won’t buy it. In fact, many stocks that turned into
supernovas seemed expensive before they took off, and
We also focus on the leading industry groups and look we don’t want to miss a potential huge market winner
for the top few companies within these groups. Most regardless of its perceived valuation. But knowing what
stocks move in tandem with the other stocks in their the valuation is helps us judge the amount of risk
industry, and often companies with lagging fundamen- involved. In general, the higher the valuation, the
tals will move higher just because their group is greater the risk.
advancing. These “sympathy” plays are of no interest to
us at Supernova. That is, we are searching for the Finding the
cream of the crop: the most dominant, fundamentally
superior companies in the leading industry groups. Business Driver
Steadily growing institutional sponsorship is another Now that we’ve narrowed the universe of possible
important attribute favored for stocks that we select. investments down to a manageable number, it’s time to
Institutional investors like mutual funds, hedge funds, go through them one by one, trying to uncover the
corporate pension funds, bank trust departments, and driver of each company’s growth. Quantitative screens
university endowments move the market, not the indi- are very useful in quickly filtering through thousands of
vidual investor. It doesn’t take very much buying inter- stocks to find ones that warrant a closer look. But now
est by one or more of the large institutions to drive a it’s time to roll up the sleeves and start digging for the
stock higher. gems, the great fundamental stories. After completing
quantitative screens, the real detective work begins.
There is a fine line here, though. Some stocks, like
Microsoft and Cisco, are “over-owned.” That is, so What we are looking for in this stage is the “story": the
many institutional investors own these stocks that catalyst that will likely propel the stock to new highs.
there are not enough potential new buyers around to These growth drivers could include a new product
move the stock to new highs. So we look for a few insti- launch, a new management team that has the experi-
tutional sponsors with steadily growing demand, but ence to take a business to the next level, or a macro
not stocks that are already overowned. We also moni- event that is having a dramatic impact on an entire
tor the track record of the institutional holders that industry, like new legislation or new technology.
already have a position in the stock, because we prefer Whatever the case, it is this catalyst - and our analysis
to be shareholders alongside the better performing of it - that separates a supernova stock from an average
funds that have had previous success in finding emerg- stock.
This is a laborious process that includes going through
Finally, we’ll look at the valuation. There are a lot of piles of annual reports and SEC filings, reading sell
ways to measure a stock’s valuation, and different types side research reports and news stories, listening to con-
of companies lend themselves to different methods of ference calls and management presentations, and
determining value. speaking with other investment managers and analysts.
While it may be arduous, the rewards make it all
Sometimes we’ll look at a stock’s value based on a worthwhile. Even then we’re still not done with the
number of different metrics compared to its historical process.
valuation. Other times, we’ll compare a stock’s current
market value to the theoretical value generated using a And Finally,
discounted cash flow model. Sometimes an earnings
growth rate relative to its price/earnings multiple the Technicals
model (a frequent barometer of “growth at reasonable
price”, or GARP, investors) is better. Finally, compar- After this stage, companies will fall into one of two cat-
ing different valuation metrics relative to a firm’s egories. First, there are the stocks that passed the
industry group peers is another approach we often use. quantitative screen but lack a compelling story. These
Whatever the case, valuation is an important part of warrant no further attention and are pretty much dis-
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By Charles L. Norton, CFA
and Allen R. Gillespie, CFA
carded because, while they passed the screen, there is However, for the purposes of this newsletter, in order
no major fundamental change in the company’s busi- to simplify things when we recommend a stock for the
ness. The other group is comprised of stocks that meet model portfolio, in most cases the full position will be
all of our stringent fundamental criteria and have a taken at once. Sometimes we will start smaller, though,
great catalyst that we think can drive the stock higher. if there is greater risk in the stock.
These stocks go to the final step in the process, an
analysis of the chart - or technical analysis. You Own It,
The stocks that have made it to the final stage are the Now What?
ones that we will be writing about, twice a month. If a
stock is extended because it has already made a large While the decision of what we buy - the uncovering of
advance, then it will go on our watch list and we may the potential supernova stocks - is primarily based on
write about it, but we will not buy it immediately in the the fundamentals, the sell decisions tend to be based
model portfolio. If, on the other hand, a stock has off the technicals. Of course, if the fundamental story
formed a base, or consolidation, and is breaking out of changes, that is also a reason to sell. But in most cases,
that pattern, then we will write about it and buy the by the time that is apparent, it is too late. In our opin-
stock in our model portfolio. ion, technical analysis is the most effective way to spot
a stock that may be topping, and to sell before a com-
What we’re looking for is a base of at least 5 weeks. Once pany’s fundamental slowdown becomes apparent.
a stock emerges from this base on heavy volume, this
indicates an increase in demand that is disrupting the Once we own a stock, we continue to monitor its price
supply/demand equilibrium present during the consoli- and volume action daily. Many times a stock will
dation period. We will look to enter as the stock trades break out, only to pull back to its pivot point, or buy
above the highest point in the base, or the pivot point. point, on light volume. That is acceptable and we
remain patient during these brief pullbacks.
The four types of base patterns that we look for are the
cup-and-handle, the double bottom, the flat base, and However, heavy-volume selling pressure is a cause for
the ascending base. All of these various chart forma- concern. This signals to us that institutions are net
tions will be described in greater detail when we write sellers and enough professional selling, or distribu-
about them. tion, can be powerful enough to knock down even a
fundamentally sound company. Rallies in light vol-
How to Buy: Average ume also make us uneasy, as it shows a lack of insti-
tutional interest despite its recent break-out.
Up, Not Down
So excessive distribution or lack of accumulation
One last note on buying stocks. In the real world, would be a cause for concern because both are signs
when we are investing on behalf of our clients, we typi- of weakness and may lead us to sell a stock. If the
cally don’t buy a full-sized position all at one price level fundamental story remains intact, we would keep it
or on one day. We will start with a smaller position and on the watch list, and if it provides a better entry after
see how the stock behaves. If the market confirms our building another base, we can always get back in.
research and the stock begins to move higher, we will
then add to the position and build it up as the stock Another reason we would sell a stock is a technical
continues to increase (but not too far above the pivot failure, like falling out of a base on heavy volume or
point). breaking down out of a bearish chart pattern, which
signals a possible change of trend. Again, we would
If, on the other hand, the stock moves against us and watch the stock and look for a better opportunity to
we end up being wrong, we will frequently cut bait, tak- get back in after the stock forms another base.
ing a loss on a smaller position. We typically won’t
average down - we prefer to build our position as the We may also sell a portion of a position once we are
stock moves higher. up 20% to 30%. Our philosophy is that there’s noth-
ing wrong with taking a little money off the table, but
In your own investing, we would recommend this we’ll only trim the position to lock in some profits,
process, sometimes referred to as “pyramiding.” and keep the remainder invested for the long haul.
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Finally, we may sell if a stock shows signs of a climax
top, which is a huge price move after the stock is Investment Policy &
already extended out of its base. Climax runs often end
in exhaustion and mark the top in a stock after an
explosive move, and we will sell into the overwhelming As full-time money managers, occasionally Allen and I
increase in demand. We will discuss signs of a climax will discuss a stock that we have a position in at our
top, sometimes called a “blow-off” top, in greater detail money management firm, GNI Capital. In addition, the
in future reports. publisher of Supernova, Ian Wyatt, might personally
own a stock that we’re highlighting. Supernova is a full
By far, the most important rule that we follow above all disclosure newsletter: at the end of every company
others is our maximum loss rule. If we ever get down write-up, we will disclose our position in the company.
10% on a stock, we’re out, no questions asked. To us,
this means that we misread something and the market In addition, there are certain periods of time when
is telling us that we are wrong. As William O’Neil has essentially, our hands are tied and no one affiliated
said, “The whole secret to winning big in the stock mar- with Supernova Stocks can trade in the stocks that we
ket is not to be right all the time, but to lose the least are discussing. For the five trading days preceding pub-
amount possible when you’re wrong." lication and the three trading days following, we are
forbidden to buy or sell the stocks in the newsletter.
If there’s one thing we’ve learned over the years, it’s That means if we don’t already own a stock in this peri-
that the market is the ultimate arbiter of right and od, we are unable to buy it and you, as a subscriber,
wrong, and when the market is telling you something, will have a head start on these fresh ideas. If we do
you had better listen. We’re certainly humble enough own it, then we can’t sell it (or buy more) during this
to admit our mistakes and get out if we are down 10%. window.
Then it’s time to go back through the file and look at it
through neutral eyes. Sometimes when you own a stock Supernova’s mission is to identify explosive superstar
it is human nature to only see things in a positive light stock market leaders that have the greatest profit
even though some negatives may be right there in front potential, and we believe that our process gives us an
of you. edge in finding these stocks in their early stages.
Welcome to the Supernova community - we hope you
So 10%, we’re out. Our philosophy is that you can enjoy our service and that it helps improve your per-
always get back in, but having a disciplined sell rule sonal investing results.
means that you are nearly guaranteed never to lose
20%, 30% or more (with the exception of gap down
openings). In some cases, if we can tell we are wrong
before losing 10%, we will just get out and re-evaluate
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