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Resistance Turning to Support?

sp-resistance5

Our chart is getting interesting! You can see that after a couple of days of the market trading between the two support/resistance lines, we broke out and closed above the former all-time high yesterday. The index added to the move today, which brings us to the Rule of Three.

For long-timer readers of the blog, you are familiar with Mark’s Rule of Three – its states that when either support or resistance is broken, the price much remain above or below the broken resistance or support level for either three days or three percentage points to change resistance into support or vice versa. Today is day two of closing above the former resistance line.

We executed several purchase trades today as part of our rebalance effort – we focused on the issues that were not overbought as those are set to pull back a bit and we will buy those at that time.

You might ask yourself how we tell if a company we want to own is at a point where the price is statistically likely to fall. Lets look at the chart below and I can give you a better idea of what I am talking about:

itw

This is our standard company view chart of Illinois Tool Works (ITW). ITW is a manufacturer of a range of industrial products & equipment. Its segments are: Industrial Packaging; Power Systems & Electronics; Transportation; Construction Products; Food Equipment; Polymers & Fluids; & Decorative Surfaces. It is one of my favorite companies based upon its diverse group of businesses, shareholder friendly policies, and key operating ratios like a Return on Equity in excess of 16%, Return on Invested Capital in excess of 21%, Free Cash Flow Yield in excess of corporate bond yields, and an annualized Book Value Growth Rate in excess of 22%.

From the graph above, you can see that I’ve added two purple circles to two short-term momentum indicators I follow. These two have readings that say the price has moved up to levels that are not sustainable and that either the price has to come down or it has to move sideways until some time passes and investor enthusiasm returns.

As far as investor enthusiasm goes, I’ve drawn two downward sloping blue lines. The one on the index itself shows you this company is having trouble moving back to its previous high – and in fact it is making a series of lower price highs. The one further down is a graph of the money flowing into or out of this company’s stock. In this case, since the line is downward sloping, money is flowing out of the stock. Both downward sloping lines show you that investor enthusiasm is waning here in the near-term at the same time that the momentum indicators show the company is set to fall back in price.

As a buyer, this is what you want to see – the likelihood that we will be able to pick up shares of this high-quality industrial with strong operating ratios at a price lower than currently trading.

If you are already an owner of these shares (like some of our client portfolios that already own shares in this company) – and given the operating ratios you are likely a long-term investor in this company – you can deal with a short-term pullback in price from an all-time high as it is a quality company and will ultimately move higher again. It also gives you a chance to add to your position if you want to increase your allocation to a quality industrial with shareholder friendly operating policies.

We go through this process for every company we purchase. Each one goes through our formal Equity Review, we calculate how much potential upside to price there is, what the various key ratios say about the company, how it compares to other companies in its industry and economic sector, and how it has performed over time. Below is the Equity Review I performed on ITW today, just so you get a feel for our methodology:

Double Click on Any Image to See a Larger Version

itw-p1

This is page one, and the highlights of this page include: our Investment Thesis for owning this company; our estimate of near-term upside potential of a 26.50% return (from today’s price, higher if we buy it lower in a few days); those key ratios I mentioned; and other pieces of data that go into the decision process.

itw-p2

This is page two of our analysis, and it focuses on what independent third parties think about the company along with some detailed momentum data. Additionally, in the yellow box in the center, you get our proprietary Earnings Growth Rank and Financial Strength Rank. These two ranking methods are based upon the research from my Masters’ Thesis from the mid-80’s and have served us very well over the years in helping to point to strong companies with an opportunity of providing above market returns.

Both of these ranks are based upon a comparative analysis of several key ratios that rank a database of 6,000 companies from 1 (lowest) to 100 (highest) on a bell curve. From my perspective, when you have both ranks above 80, you have a company that has strongly positive financial/operating characteristics – it is operating well above the level of most other companies and it is doing it in a fiscally prudent and responsible manner.

itw-p3

This is page three of the analysis, and it gives you the comparative operating ratios for ITW, its industry, and its economic sector. You can see that from a valuation standpoint, at a quick glance, the pink indicates it is a bit expensive at the moment (another reason we’d like to buy it a bit lower in price) but that from an operating perspective (see the Financial Strength, Profitability, and Management Effectiveness sections) the green shows it is going gangbusters. For me, this confirms the results of the two ranks detailed above and adds to my confidence level in this company.

itw-p4

This is page four and it provides a 10-year visual history of the stock price, tangible book value, and free cash flow. For me, it helps me keep in perspective how the company has done over time.

There are additional pages to the analysis, but you are likely getting tired of reading this post so I’d like to close it with this thought: buying a company at the right time and price is just as important as selling it at the right time and price.

No one will ever get it right 100% of the time, but I believe our analytical methodology that combines the fundamental analysis required to ensure (to the greatest extent possible) we own the right companies along with the technical analysis to ensure (to the greatest extent possible) we buy and sell them at the right times is key to our clients wealth management objectives. No need to try to be a hero in investing and take undue risks – sound analysis and decision making is the key to long-term success.

Have a great weekend, stay warm and dry with the expected snow we have forecast, and feel free to subscribe to the blog so that you don’t miss any of our updates.


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Mark