There are significant problems associated with most of the above stock selection methods:

A Strong Bias Towards a Particular Stock or Stocks

This is one of the most common reasons why people buy some stocks - stocks that are often household names. People hear the name of a stock mentioned regularly over a period of time, and gain a positive impression of that stock. When they are in a position to purchase a stock, the name of that stock springs to mind.

The term 'blue chip' is often applied to stocks that are considered to be safe, profitable investments. Such stocks are usually household names, the company has usually been in business for a long time, it pays its dividends regularly, its directors are well known, and it is a clear leader in its field.

A list of well-known Australian blue chip stocks would traditionally include BHP, Commonwealth Bank, Telstra, Boral, Pacific Dunlop, and Burns Philp. Some have performed extremely well. Others can best be described as being disasters!

Burns Philp, for example, was a blue chip stock with an excellent background and good returns. It changed its focus from shipping to become a world leader in baking products, and herbs and spices. In January 1991 the price of Burns Philp was $2.16. By January 1994, it had risen to $5.03. By June 1998, however, it had fallen to a low of 3.5 cents! So much for buying and holding blue chip stocks!

The first problem with this method of selection is that it assumes that well-known stocks are good investments. This is not necessarily the case.

The second problem with this approach is that we are examining these stocks in isolation. Even if the stock is a reasonable-to-good investment, and even if our buying rules confirm that it can be purchased, we cannot be sure that we are investing in a stock that has the highest probability of making an excellent run in the near future. In fact, stocks become most popular near the end of a strong run! Furthermore, there could be other stocks that show far greater profit potential.

For this reason we do not start our stock selection process by examining stocks with which we are familiar. Instead, we examine a large pool of stocks with the intent of selecting the stocks that show the greatest potential. (Do not underestimate the importance of this process if your real aim is to make money.)

Remember, the majority of investors gain poor to average returns from the stock market. My aim is to use proven techniques to maximise my return on my investment, and hence I will, at times, be doing different things from the majority. I accept that if I choose to blindly follow the crowd, my performance will be, at best, that of the crowd.

Fundamental Analysis Evidence That a Stock Represents Good Value

Fundamental analysis of stocks, as the sole method of stock selection, is downright dangerous, as undervalued stocks can continue to fall for a long time! To learn more about the many problems of using this approach as your sole method of stock selection, I suggest you read the article 'The Problems With Fundamental Analysis'.

Recommendations, Tips and Rumours

One of the most common reasons for buying a particular stock is that someone we know heard from someone 'in the know' that the stock price is set to rise quite dramatically. The reasons for this rise may include an imminent oil or mineral discovery, a takeover bid, or the launching of a revolutionary new product. Such tips place us under powerful psychological pressure to buy the stock.

Whenever we receive such a tip, the greed element tends to make us view the stock's prospects through rose-coloured glasses, while the ego element also pushes us into buying. After all, all of our friends are buying the stock and we do not want to be the only one to miss out when the stock price soars. The desire to cash in on our secret knowledge, not yet available to the general public, is also a powerful motivating force.

Tips can sometimes be a good source of profits, but always treat them with great suspicion. Remember, people only ever give you a tip when they have bought their shares - thus any buying by you and your friends helps to push up the price of their shares. Do not expect big institutions to make public the names of any stocks that they are accumulating in big numbers at low prices - tips are usually only given by people who stand to gain by the information becoming public, or by empty vessels who like to make the most sound.

When you are given the 'good oil' about a stock that 'can't miss', by all means consider purchasing the stock, but please, first consider the person's motives for giving you the tip, and the person's track record in the past at passing on profitable tips. What is most important is to see whether or not it is safe to buy according to your rules. Your rules should be designed to show you whether a stock has a high probability of making you good profits. If our rules indicate that a stock is not a good buy, you are better off ignoring that tip, advice or rumour, and investing in a stock that has a real chance of making money.

Remember, brokers were heavily recommending stocks such as Qintex, Bond Corp., Bell Resources and Adsteam in the booming 1980s. A broker's recommendation is not a licence to print money. If you had purchased any of these stocks while they were rising, and had followed proven rules, you would have exited these stocks with a good profit. Today these former glamour stocks all have one thing in common - they are all worthless!

You should also be aware that not all people who tip stocks are honest. Some establish what appears to be an excellent record of tipping stocks. They do this by tipping stocks that have few stocks on issue and do not trade often. Buyers following their recommendations force the price upwards, making their tips look like strokes of genius! Unfortunately for the unsuspecting public, the tipster sells the stock while the public is still buying, making an excellent trading profit. The price then collapses.

New Industries

A highly profitable method of stock selection is to monitor the price of stocks in new, up-and-coming industries. A study of the best performing stocks of the last two hundred years will show that some of the best performers were stocks in new industries - industries that usually developed from technological breakthroughs.

Examples of some key new industries, from the 1800s to present, include companies building canals, steamship companies, railways, cars, airplanes, computers, and the Internet. Traders and investors, who were astute enough to accumulate strong stocks in these industries and to sell them at an appropriate time, have made huge fortunes.

Redundant Information

Human beings feel more comfortable when they are part of a group, and have gained the full approval of the people around them. It is with sadness that I recall friends who cannot make an investment decision without having to ask at least a dozen other people if each one, in turn, agrees with the investment decision. The problem with this approach is that, should they be fortunate enough to ever get so many people to agree, and should the investment be a reasonable one, by the time they get the final person's concurrence, the chances are that they will have missed most of the move. Gann was aware of this problem in 1923:

When the average trader comes to Wall Street he is looking for information. He asks the bootblack "What do you think of the market?" He also inquires of the waiter in hotels, the office boy, his broker, friends and strangers around the broker's office. I am conservative when I say that the average floating trader asks the opinion of 10 to 12 people every day, most of whom are all guessers and know no more about the market than he does.

(Truth of the Stock Tape, page 47.)

Market Phase

Some investors look to buy blue chips early in a bull market. This makes sense, as the blue chips, or so-called 'quality' stocks, are usually the first to be accumulated after a market has made a major bottom.

When the trend is established as being clearly 'up', 'second-line' stocks often become the strongest group, followed by the so-called 'penny dreadful' speculative stocks. Penny dreadful stocks often have their fastest run late in a bull market, however you should remember that such stocks fall faster than they rise, when the market finally turns!

Takeovers

Takeover candidates can be a source of quick profits if you exercise caution. You will make the most money from takeovers when you are in a strong bull market, which is, fortunately, the time when most takeovers occur.

New Issues

New issues can also generate quick profits, but again you must be selective. Your chances are increased when the shares are difficult to obtain. Your daily newspaper will usually give an accurate indication of whether or not members of the public will be able to obtain shares easily. Be extra cautious if your broker offers you an unlimited number of shares in a new issue, particularly if you have found it difficult to get shares in new issues through that same broker before. If the market is flooded with shares in the stock, the chances of a large initial profit are very small.

A Rights Issue

Rights issues occur when a company offers additional shares to existing shareholders in a fixed proportion to their existing holding. For example, if a one for two rights issue were made, and you owned 1,000 shares, you would receive 500 additional shares if you took up your entitlement. The shares issued in a rights issue are priced below the current market price to make them attractive to shareholders.

A Bonus Issue

A bonus issue is when a company offers additional shares to existing shareholders, in a fixed proportion to their existing stockholding, at no cost.

Stocks Added to the All Ordinaries Index

Many funds are required to replicate the All Ordinaries Index by purchasing the stocks in the Index, in their correct proportions. Other funds are required to purchase stocks from the pool that makes up a particular index. The effect of these requirements is that when a stock is added, or restored, to the All Ordinaries Index, many funds are required to purchase its shares. This buying pressure results in an increase in the stock's price. This is one reason for Telstra's strong price soon after it was listed.

Older Stocks

Some people feel more comfortable investing in stocks that have been listed on the stock exchange for a long, long time. Just because a stock is a household name does not mean that it is in a strong growth phase. Watch for signs that older stocks are beginning to perform poorly. Older companies often become unresponsive, have high cost structures, and become bureaucratic organisations with complacent management. Their prospects for future growth are therefore severely limited. Similarly, remember that when mining and oil stocks complete their exploration activities, they tend to behave more like industrial stocks than exploration stocks. Their speculative appeal is now considerably less.

Blue Chips

Some people have but one investment rule - they only buy the so-called blue-chip stocks. Regrettably, as mentioned earlier, even the bluest of blue chips will decline when the market declines, and they may take years to recover.

Dividends

Never buy or sell or hold a stock just because a dividend is to be paid, or is not to be paid. Some people will ignore signals to sell a stock purely because it pays good dividends, or because a dividend is due to be paid soon. If a stock is weak, it is usually weak for a good reason. Remember that dividends can be eliminated and stock prices can fall to zero!

Similarly, if a stock is strong, and does not pay a dividend, this does not preclude the possibility of the company paying a dividend later. A reason for its strength could be the likelihood of it generating a good dividend stream in the future. By that time much of the capital appreciation may have occurred!

Dividend Reinvestment Schemes

Some companies give shareholders the option of reinvesting their dividends in order that the shareholders can obtain additional shares instead of receiving regular dividends. This can be advantageous if it is a strong stock that you would purchase in any case.

One well-known Australian blue chip that had a dividend reinvestment scheme is Pacific Dunlop. A prominent financial guru heavily promoted Pacific Dunlop, and its dividend reinvestment scheme, some years ago. If you had purchased the company's shares on 1 February 1994, and had opted for dividend reinvestment, and you had held the shares until 30 April 2001, you would have watched them fall from $5.92 to $1.13, and lost 81 percent of your initial investment and a large proportion of your dividends!

Counter-Cyclical Purchases

The counter-cyclical purchasing of stocks involves the purchasing of stocks which are fundamentally sound, but which are out of favour. Counter-cyclical strategies are particularly effective after major market lows, such as in 1974, 1982, 1987, 1992 and 1994. This technique can be effective, however it still requires the stocks chosen to give legitimate buy signals according to your trading or investment rules.

Shareholder Discounts

Some companies offer shareholders, who own a specified minimum number of shares, discounts. Such companies include the ANZ Banking Group, the Fosters Brewing Group Limited and Pacific Dunlop Limited. In Australia, the list of companies offering shareholder discounts exceeds 20.

Picking the Strongest of Stocks

One of the most profitable stock selection methods is to select stocks that have shown the greatest strength.

As W.D. Gann confirmed:

If you are waiting for an indication to buy stocks, you want to select the strongest stock in certain groups, as the stock which is in the strongest position is naturally the one that will lead in a Bull market and the one in the weakest position will lead in a Bear market.

(Truth of the Stock Tape, page 93.)

This method of stock selection is an important component of the Stockmarket Master Course.

Which Stocks Will Lead the Next Advance?

When a market has had a substantial decline, and has moved from the descent phase into the accumulation phase, the likely leaders of the next major ascent phase will be stocks that have declined by the smallest percentage. The reason these stocks declined so little is because sellers were reluctant to sell the stock, and buyers were more inclined to buy the stock than other stocks, thus supporting its price. This indicates that the stock has underlying strength.

Conclusion

The secret to making large trading and investment profits is to find strongly-trending stocks. Obviously, stocks that move quickly, in a sustained manner, are more profitable and easier to trade than stocks that meander sideways.

One of the biggest advantages of trading and/or investing in the stock market is the large number of stocks one has to choose from. This choice increases the probability of us being able to find strong stocks. This advantage helps to explain why stock market traders and investors are generally more profitable, as a group, than traders of options, warrants and futures.

It is important that all traders and investors use proven stock selection methods. To blindly buy stocks based on hot tips is to gamble.

If you cannot make such decisions yourself, consult your stockbroker. Professional traders and investors respect their broker's opinion, but do their own homework to ensure that the stock they are considering is indeed a stock with a high probability of producing a good return.