Question: What is the Cabot philosophy?

Answer: I really liked this question and have been toying with how to answer it for a few weeks. I think it could have several different answers, so I’m not sure if I’m picking the “right” one, but to me, the Cabot investment philosophy is our growth investing rules that we’ve fine-tuned over the last 40 years and that are employed by our flagship newsletter, Cabot Market Letter (and our other growth newsletters). So I’m going to take a piece of education information from our website, written by the Cabot Market Letter Editor Michael Cintolo himself, because I couldn’t say it better myself:

1. Invest in Fast-Growing Companies

You’ll usually find them in today’s fast-growing industries, where revolutionary new technologies and services are being created. As you study the stocks in these growth industries, you should favor lesser-known stocks that have yet to reach the point of peak perception. Frequently these will be smaller stocks, where growth potential is greater!

2. Buy Stocks with Strong RP Lines

Relative performance (RP) studies-which chart how well stocks are performing against the broad market-are a superb way to identify successful companies and to avoid problem companies. You should buy stocks that are consistently outperforming the market. This is a good indication that they are under accumulation, week after week, month after month, and that the companies are succeeding. The best investing tips come from the performance of the stocks themselves. So ignore hot tips!

3. Use Market Timing to Guide Your Investing

Be cautious when the broad market is against you and aggressive when it’s with you. Don’t underestimate the power of the market to move stocks, both up and down. When Cabot’s market timing indicators are signaling a bull market, don’t delay. The trend is up, so stocks will be going up! Buy your favorite stocks and hang on as long as the ride is profitable.

4. Once You’ve Invested in a Stock, Be Patient

Recognize that time is your friend. Frequently stocks don’t go up as fast as you might want them to. But if you can develop a persistent and tolerant attitude coupled with plenty of patience, you’ll have a great advantage. We call this STAYING POWER! (The need for patience does not apply to losses. Read Rule 6.)

5. Diversify Your Portfolio

For the Cabot Market Letter’s Model Portfolio, 12 stocks provide plenty of diversification. Smaller investors can do well with as few as five stocks, but you should never have all your eggs in one basket.

6. Cut Losses Short

This is the key to ensuring that you retain enough capital to stay in the game. No matter how hard you try, you are going to select stocks that go against you as soon as you buy them. Get rid of these stocks quickly! Never let your loss of your original money invested exceed 20% in a bull market or 15% in a bear market, based on the closing price of the stock. This is a most important rule, and yet we repeatedly hear from new subscribers who ignore it, hold on and suffer far greater losses. They learn the value of this rule the hard way.

7. Sell a Winning Stock When it Loses its Positive Momentum

This is a clear indication that other investors are selling too. And a lot of them know more than you do. So don’t wait for the company to tell you about the bad news. Sell first and read the bad news later. You can usually tolerate RP line corrections of as long as eight weeks but seldom more than 13 weeks before concluding that the stock’s momentum has turned negative. When these limits are exceeded, sell the stock without regret.

8. Let Your Profits Run

The power of compound growth can swell your account dramatically-if you are patient. Long-term investments make more money than short-term investments. So learn to develop staying power. Let your profits run and run and run. This is how big money is made in the market. Not by taking 10% and 20% profits but by thinking big-in terms of 100%, 200% and larger profits.

9. As Time Passes, Buy More Shares of Your Best-Performing Stocks

Add a modest number of shares to your winners from time to time, trying to do this during corrections in the stock, not after the stock has posted a major run-up. Called “averaging up,” this is a great way to reinforce your investments in your best stocks.

10. Be An Optimist

In our nearly four decades of publishing the Cabot Market Letter, we’ve seen many ups and downs for both the market and our country. But after every tough event our dynamic country and economy have eventually rebounded. So no matter how bleak the situation, always stay optimistic because our country and stock market will give you some dazzling opportunities!

If growth investing isn’t your thing, Cabot does offer nine other newsletters that cover a wide range of investment strategies, from value investing to Green investing and emerging markets investing to small-cap stocks.

It’s hard for most investors to do nothing because, let’s face it, in life, success is usually defined as the ability to get things done.  If you’re a salesperson, you go out and sell stuff.  If you’re a teacher, you teach people.  It’s not often you find a profession where the right move is to do nothing.

Moreover, just think of the ways people involved in the stock market are described—investors (you invest) and traders (you trade).  Nobody describes themselves as “somebody who occasionally buys stock and sometimes does not.”  Doesn’t quite have that catchy ring, does it?

Yet the lesson I’ve learned many times (too many times, unfortunately) is that the more you trade, the worse you’re likely to do.  I don’t mean, necessarily, that a swing trader will make less than a long-term investor.  What I mean is that, if you normally make 10 trades in a month, and then kick that up to 25, your results are likely to decline markedly.

Really, so much of garnering above-average investing results comes from not losing money.  Part of that, to be sure, is to cut all losses short.  But part of it involves avoiding the “churn periods”—those times when you seem to be buying and selling, buying and selling, buying and selling, but not making any real progress, often taking a bunch of small losses each time.  The end result:  Poor performance and larger drawdowns.

Usually, this churn comes about because an investor fears missing an upmove; he or she sees a good-looking stock with an attractive story, and thus buys the stock even though its chart or the market isn’t quite right.  Or, in the current environment, that investor might get sucked into buying a bunch of stocks every time the market stages a solid up day … only to be forced to sell a week or two later when the downtrend reasserts itself.

Here is a vital point:  Having studied my monthly results for my own trading, I can tell you that it’s usually just a couple of months each year that “make” my year.  In other words, in a decent year, there are usually two or maybe three months that I really make good money, while the rest are either right around breakeven, or have small losses.

Thus, while most people think that doing nothing is an investment sin, I actually think the opposite:  If I could eliminate or cut back on my trading during those “bad” months, I could boost my results in a big way!  This is actually one of the hardest lessons for me to implement, partly because it’s my job to sit in front of my computer.

Nevertheless, I’ve been working hard to trade less—forcing myself to wait for the proverbial fastball down the middle of the plate—which has helped me avoid more serious losses during challenging market environments like we’ve been in since early May.  I think it’s a good lesson for everyone; more trading is not always better … in fact, it’s usually worse!

The first mistake is that some investors try to become jacks of all trades … and end up being masters of none.  What I mean is that novices will focus on way too many indicators and time frames.  First they look at the RSI Index and the Slow Stochastic.  Then they add on the MACD.  Then add on 5 different moving averages (including exponential and simple moving averages).  Then they add on Bollinger Bands.  Yikes!

This is just way too much information, most of which will be too short-term and too contradictory.  You should approach reading charts like you should approach learning to golf–you don’t go out and hit every club two or three times.  No, you focus on a couple of irons (or maybe your driver) and try to develop some consistency with them.  Then you work on some other clubs.  In other words, it’s a step-by-step process.

With charts, I can tell you that, to this day, I only have four things I look at regularly–price, volume, two moving averages (25-day and 50-day simple) and relative performance lines (how a stock is doing compared to the market).  That’s it.  Now, I’m not saying my way is THE right way to look at charts, but I just want to show that it’s usually better to have less on your chart.  So keep it simple, especially in the beginning.

Another mistake to avoid is that you should never assume that charts are going to do something they can’t–predict the future with certainty.  Realize the chart is simply a current look at a stock (or sector’s or market’s) current supply and demand situation, not a crystal ball.  Yes, examining charts can help put the odds in your favor, but there are no sure things in the market, and a chart’s picture can change quickly.

In total, chart reading is a skill you need to learn if you’re going to be a successful growth stock investor over the long haul, and keeping things simple, and realizing what charts can do (put the odds in your favor) and can’t do (predict to the day what will happen) will help you get off to a good start in your education.

To these investors, it’s all about being early–after all, if the market has bottomed, it’s better to buy on the first or second day up than the eighth or ninth day up, right?  In this limited example, yes; obviously, having identified the low, you’re better off buying as close to the low as possible.

The only problem is, correctly identifying the low point is nearly impossible to do in real time.  If we’re talking about the general market, for every sustainable, multi-month low, there are dozens of days that are false lows, after which the market keeps on slipping.  In other words, the only way to get in at the very bottom is to bottom fish during a downtrend … but if you do that, you’re going to be wrong many times before you finally catch a low.  And the end result will be lost money!

Thus, the first lesson of “don’t be early” is to always wait for confirmation of a new uptrend (or downtrend, for that matter).  Market timing is not about being the first to get in at the bottom or out at the top; it’s about correctly identifying the trend and riding it as long as it persists.  Yes, that means you’ll never buy at the bottom or sell at the top.  But it also means you won’t die a death of a thousand cuts (by continually trying to pick the bottom) or ever miss out on a major move in either direction.

I’m writing about this topic because of its implications for buying individual stocks … something that is very timely given the current market environment.

A few years ago, I was trying to buy early like most investors.  Now, I was never trying to pick a bottom, but if the market had a few good days (including a good gain on a volume thrust within a few days of a low) I would usually put on a couple of small positions and see how they did.  I would do this even if our own intermediate-term trend indicator, the Cabot Tides, was still negative.

Now, realize that these volume thrusts tend to work pretty well at identifying a low, and they tend to come a week or even two before the Cabot Tides give a bullish signal.  Thus, you’d think my results would be enhanced by buying a couple of stocks at this earlier stage, right?

Wrong!  I went back and studied my trades, and here’s what I found:  There were numerous stocks I bought on the volume thrust that turned out NOT to be leaders.  They looked good initially, but eventually, they petered out and lagged the market

Also, even among the stocks I bought that WERE leaders of the new advance, most didn’t make immediate upward progress.  There were a few exceptions, but the vast majority bobbed and weaved for a while before kicking into gear.  Finally, of course, there were those times when the Tides never did turn positive, so most everything I bought turned out to be a small loss

All in all, the study showed that, on balance, buying before the Cabot Tides turned bullish wasn’t helping my results … in fact, it was slightly hurting them!  Waiting for the Tides to turn positive–it usually takes two or three weeks after a significant low point–allows you to a) home in on the true leaders of the advance, and b) take out a little extra insurance that the rally is the real McCoy.

What about today, you ask?  Well, even though I’ve been highlighting a couple dozen potential leaders to subscribers, I’ve mostly been cooling my heels, waiting patiently for the Tides to give a green light.  For the most part, that has once again been the right move–while some leaders have lifted off in recent days, few have really made big moves (especially after Monday’s reversal lower) and some have pulled back into their bases.  If we get a Tides buy signal in the days ahead (we’re close), my guess is that there will be plenty of good opportunities to make money.

The Cabot Tides appear in our flagship newsletter, Cabot Market Letter, which I’m the editor of. Subscribe today to get the Cabot Tides latest reading, along with that of our other two market timing indicators and recommendations for the market’s top growth stocks.

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In my opinion, it’s saying that the downward market phase that began six weeks ago with worries about Greece, and that accelerated as the BP oil spill worsened, is over.  The bad news has done its job, raising the level of fear in the market while correcting numerous overbought situations.

Hardest hit were some of the indexes.

But the market’s internal strength remains intact, as illustrated by the reading of Cabot’s Two-Second Indicator.  And the action of numerous leading stocks is extremely encouraging.

One of my favorites is Isilon Systems (ISLN), a Seattle company that’s growing fast by providing Network Attached Storage (NAS) to a wide variety of industries that need to store increasing amounts of data while enabling easy and fast access.

Isilon powers the research activities of the world’s foremost cancer research facility.

Isilon provides delivery services for many of the world’s leading entertainment and media companies.

Isilon supports huge galleries of images and other user-generated content for numerous consumer web sites.

And Isilon gives major manufacturers the ability to consolidate vast amounts of complex CAD into shared pools of knowledge, giving engineers immediate shared access to critical data.

In short, as the world’s store of data grows, the needs for services like Isilon’s grow along with it.

And the results are now becoming apparent in the company’s bottom line.  Isilon was founded in 2001 and came public in 2006, and it’s grown revenues every year.  In the past twelve months, it’s brought in $136 million in revenue.  But the company was a regular money-loser until recently, more intent on growing than on making a profit.

Now that’s changed, as economies of scale are truly kicking in.

In fact, Isilon has just posted two consecutive quarters of positive earnings.  Revenues are now growing at an accelerating rate (46% in the first quarter), and the profit margin is expanding (7.5% in the first quarter.)

Finally, the stock’s chart reveals strong support by investors who are learning about this young company’s potential.  Since gapping up to 14 after the release of a terrific first quarter report in late April, the stock has spent two months digesting that gain.  In the depths of the market correction, it had pulled back to its 50-day moving average at 12.

But buyers stepped in, and last week the stock soared on the heaviest volume in weeks, right back up to 14 and more, where it’s primed to break out to new highs.

ISLN was featured in Cabot Top Ten Report back on May 17, when it was trading at 12, so subscribers who followed the advice of editor Mike Cintolo have a nice profit today.

If you’re not a subscriber, perhaps you should be.  To get started with a trial subscription (backed by our money-back guarantee) click here.