Gil Morales and Dr. Christian Kacher — Part I

No one has had a more massive impact on the careers of so many of this era’s most outstanding growth-stock pickers than Bill O’Neil, chairman of institutional research firm William O’Neil + Co., and founder of Investor’s Business Daily. Players with names like Moses, Ryan, Kuhn, Cooper, Morales, Kacher, and Freestone are but a few on the long list of traders that have rolled up eye-popping results using the combination of fundamental and technical concepts outlined by O’Neil in his seminal book “How to Make Money in Stocks.” O’Neil’s taken things a step further by writing another book, “24 Essential Lessons for Investment Success,” slated for McGraw-Hill publication in late December. This new book will be available at href=”https://www.amazon.com/exec/obidos/redirect-home/tradehardcom”>amazon.com before year-end.

In TradeHard.com’s continuing series of interviews with traders, I sat down with Gil Morales, head of institutional services at William O’Neil + Co., and Dr. Christian Kacher, portfolio manager at William O’Neil + Co. Both have increased the accounts that they’ve managed from between 350% and 440% this year.

Conducted Dec. 7, 1999, the following represents the first of a two-part series of interviews with Morales and Kacher.

Kevin N. Marder: Let’s start with the burning question on a lot of traders’ minds: Does the monstrous runup in the Nasdaq (up 38.6% from Oct. 18 through Dec. 9 on an intraday basis) look like a climax top of intermediate-term proportions?

Gil Morales: Based on our study of historical precedent in the market, you had a follow-through day on Oct. 28, where all of the indexes were up 1% on expanding volume over the previous day. It was a very powerful follow-through day, which was qualitatively and quantitatively different from the prior three that had failed during the summer. So now we’re about six weeks out (from the follow-through day). And (based on) our precedence analysis of market moves from a follow-through day, we rarely see a market top in five to six weeks. But we’re playing percentages here, and we believe that with the power we saw moving out (off the Oct. 18 low) and the emergence of a lot of newer companies in a new entrepreneurial cycle, it’s confirming a new bull move in the market. I think you’re seeing it pretty blatantly in the averages. I also don’t have a problem with the lagging action in the S&P and the Dow. The rotation into technology stocks is occurring in all corners of the institutional investment world. I see university endowment funds, which are several billion dollars to tens of billions of dollars in size, and a lot of pension funds. I look at a lot of these portfolios and I see a lot of old-line industrial companies. This indicates that these investors are out of step with what’s going on today. They need to be rotating out of these old-line companies and into the technology area, which is central to the economy and where everything is really happening in the market. So what they’re doing is reevaluating their holdings. In some cases I’ve seen them farm them out to technology-oriented money managers in an attempt to get these portfolios of theirs to perform again and in step with what’s going on in the economy. I think the action in the indexes confirms this type of activity. A lot of people are saying, “Wow, I’m missing the boat. I’d better get on the stick and unload these garbagey companies and get in with some of the high-tech leaders.”

Marder: Chris, what would be one or two of the things you’d be looking for that would first give some sort of indication that the market is putting in some sort of intermediate-term top?

Dr. Christian Kacher: When we get these nice long trends, and we’re seeing a lot of these tech stocks go up dramatically, often the last day of the run is accompanied by huge climax buying, where a lot of stocks go through the roof. A lot of the leaders like ^EXDS^, ^VRSN^, or ^QCOM^, will run up huge. This is what happened on the April 14 top of this year. That was the day when companies like NetBank, AOL, Schwab, and all of those leading names went up huge that last final day…and then we went into this correction. So we do look for that. There’s no way to tell how long the correction is going to be, but that is an indication that you do have some sort of correction on the way.

Morales: It’s pretty much like an across-the-board ebullience. You look at all of the leading names and they’ll all be running all at the same time. Right now, you’re seeing some names run, like today you saw Yahoo! up and yesterday you saw Verisign up 30.

Marder: Does the Yahoo! action of yesterday and today look like some sort of climactic run?

Morales: Not at all. Not to us. For the simple reason that a climax run, by our definition, and by the way we’ve studied it, occurs after a stock has had at least a 50% to 100% move. So if you look at Yahoo!, this stock is really only four days out of a nice base, a cup-and-handle. That’s actually a sign of power, more than anything. So this probably indicates this stock is going higher from here.

Kacher: Also, in addition to the percentage move, in this market some stocks will move 100% to 200% in a few weeks. What we look at is a timeframe. When a stock breaks out of a base and if it runs for six or seven weeks and it’s gone up 150%, that doesn’t mean it’s topped. Usually, a stock will make its final topping action three months to four months down the line after the breakout if it’s going to top at all.

Marder: You two guys have hit the ball out of the park about as well as anybody in the entire U.S. stock market in 1999. Can you touch on the basics of what you look for in your trading strategy?

Kacher: We use tools like WONDA (William O’Neil Direct Access) to screen out stocks with certain characteristics. We look for stocks that are in leading groups that are near new price highs that have high relative strength that have either a really solid accelerating earnings track record, or a sales track record. A lot of these new companies don’t have earnings and some of them are not going to be earning for maybe another year or so. But their sales are ramping up very nicely, with high triple-digit quarter-over-quarter sales growth. So we look for one or the other.

Marder: What percentage weighting would you put on your fundamental analysis vs. your technical analysis of a particular stock?

Kacher: That’s a great question. The way we approach it is we don’t buy stock just on a technical basis. It’s got to have good solid fundamentals. We want to buy stocks that are going to lead their space. So we look first for those stocks that have the strongest fundamentals. And then from there we look at those stocks that are close to their old highs and are forming sound bases.

Morales: I would add that I ask myself a very simple question whenever I’m going to buy a stock. If it’s got the technical formation and the earnings or sales that we’re looking for, does this company dominate its industry or does it have the potential to dominate its industry? And that requires a little bit of putzing around on their Web site, maybe looking at some other analyst reports, assessing an industry. And right now, that’s quite a challenge because you have a lot of emerging industries, what with e-commerce and all. But I am asking myself that question because we do know that, with the biggest winning stocks, probably the No. 1 characteristic is that they dominate their industry. Cisco, Microsoft, Dell, Home Depot, Wal-Mart, you can go down the line. And that’s really what we’re looking for. You don’t find very many of those. But by asking that question we do position ourselves in the right stocks. And we have the potential to maybe have one or two of these massive winners. Right now, I have made more money in six weeks percentage-wise than I have ever made in any other period in the market since I’ve been in this business in 1991.

Kacher: I would have to say the same thing. It’s been phenomenal.

Morales: The real question for us now is whether we are looking at compressed timeframes. Stocks are going up in six weeks as much as they normally would move up in six to eight to 12 months. We’re wondering if this is a sign of power or a sign that we’re in these compressed timeframes, and maybe we’d better start looking at taking some off the table here. That’s a question we’re grappling with right now. We don’t really have an answer for that. But as long as the trend is our friend, we’re going to stay with it.

Kacher: This is a very exciting time. Actually, it’s the most exciting time I can remember to be in the market because there’s all these new emerging technologies like storage area networking, business-to-business, e-commerce, and fiber optics. We’re trying to figure out what the next big name is going to be in each of these areas and we use a lot of fundamental analysis to figure those things out.

Morales: Just to answer the question of “Who is the next Cisco or Home Depot?” We think that we own a couple of them. We’re not sure yet which ones they are, since you would know it all in hindsight. But at the time that is what we’re trying to do. That really drives the fundamental side of our stock selection.

Marder: Gil, just getting back to the earnings side of things, a lot of these Internet companies have not earned any money yet. Would that turn you away from buying the stock even though the potential is there and it could be the leader in its space?

Morales: Initially, it was very difficult for us to get a handle on the whole Internet thing and to assess it. A lot of the names initially, like Yahoo and AOL, we weren’t putting them on our buy list because they didn’t have earnings. But we had to think about this more from a fundamental aspect. And also, considering that the stock market is really just a big pricing mechanism, you have the cumulative mind of the stock market representing all of these people that are participating, their opinions and their knowledge about where they’re going to put their money. So I see the market as a pricing mechanism. Number one, it recognized that there is definitely a significant economic development going on in the Internet. Then the problem became why some of these had no earnings. But the market sensed or could tell that this was going to be big. And so now, the market being a pricing mechanism, it has to grasp onto some way to price it. And since there were no earnings, the next best thing, as far as we could tell, was topline sales growth. We’ve studied these models now, since we’ve got a lot of recent models of these types of big-winning Internet stocks. We know that the primary characteristic, or the characteristic that’s replaced earnings, is a huge sales ramp-up. So we’re looking now for companies in these spaces that have huge sales ramp-ups. And the market is using the sales growth as a way to gauge these companies and function as a pricing mechanism to put a value on these companies. I also think that the market is trying to assess the overall value of the Internet as a whole. Sometimes what happens is you get some companies that have no earnings and maybe in the long-run they don’t have great potential, but right here, right now, they become representative of a new emerging industry. And so the market grasps onto these companies as well, to try and assess the value and put a price on everything. Our job is to find out what the market’s keying on, and what we’ve discovered is that it is the huge sales ramp-ups. And I mean significant ramp-ups. Not $200,000 this quarter and then $500,000 next quarter, which looks like 150%. We’re looking for $10 million last quarter and now $26 million this quarter. That’s the type of ramp-up we want to see — significant, big sales.

Kacher: It’s interesting because the market does function like a pricing mechanism. You can find these things either looking for high sales rates, high earnings-per-share rates, or even high relative strength. A relative strength of 99 represents the absolute top across the board. Because a stock with a relative strength of 99 probably is running for a reason. You can further investigate it using WONDA.

Morales: You can also use Daily Graphs On-Line, another William O’Neil + Co. product.

Marder: A lot of the great stock performers just really don’t give you much opportunity to enter at the beginning of their big advance. Sometimes they’ll come out of little two-week congestion areas. Given that these are coming out on big volume, is that the kind of situation that you would bend the rules and hop into, or would you stick pretty rigidly to your discipline of buying a stock with a base of at least six weeks?

Kacher: That’s a really good question. You can take Qualcomm in this market cycle or you could take AOL in the last market cycle earlier in 1999. When the market corrects you have all of these market indices going lower and lower, but these really strong stocks resist the tendency to go lower. So what happens is they do correct a little bit, but then they’re also the first to spring back up when the market has a good day. What happens is that they tend to form what we call ascending bases, where the stock seems to want to get dragged down but doesn’t. It resists, and actually goes higher and higher by a little bit during the period that the market’s actually going lower. Now when the market finally turns around and gets that 1% confirmation day, these stocks, with the weight of the market off, just spring right on out of there.

Morales: The ascending base is telling you that they want to go higher. To give you an example of two of them, if you look at the chart patterns of AOL and ^SCH between January 1999 and the end of February 1999, they both made the same type of pattern. Neither made a classic O’Neil base but they made an ascending pattern. It’s almost like you took a base and tilted it up slightly. AOL and Schwab both formed these ascending bases. And when they break out of the top of these ascending bases, we will be buying these stocks, and generally with success. That is a very powerful pattern. The stock is telling you that the weight of the market is trying to hold the stock down, but the stock still wants to keep creeping slightly upward.

Kacher: And Qualcomm did the same thing in the last market cycle.

Morales: All through the four months of the summer when we were weak in June, July, August, and September, it just kept going higher and higher. You can actually see that as it’s ascending all the way up to 220 and then it breaks out at about 230. And that’s a pivot point, actually, and we’re buying the stock there.

Marder: As far as money management goes, if you’re wrong you obviously cut your losses. Do you have any preset percentage limit that you use or do you play each situation a little bit differently depending on how the general market is acting.

Morales: I use a 5% stop loss. I know Bill O’Neil says 7% or 8%, but at this stage of my development of my career, I should be good at picking stocks at the right point. So I should be up right away with a position.

Marder: Right away, meaning the first day?

Morales: Within the first hour or the first couple of days. My stops are generally 5%. I don’t let them get too much further than that…8% percent at the most. But when it’s down 5% I’m looking at just getting rid of it. Chris might do something different.

Kacher: I would say that if a stock is not behaving right, yeah, I generally cut the position within 5%. A lot of my sells are actually 2% or 3% losses. Probably the majority of them are like that. Because we trade size, it’s important not to get stuck in a stock that’s a little thin. So when you’re trying to get out of it, sometimes we’re going to be selling it at an average of 8% to 10% off where we bought it if it’s not working out. We’re pretty quick to see when a stock’s not working out, so we immediately try to sell at that point.

Marder: How do you add to a winner on the way up? Do you double down at a certain point?

Morales: I use a simple rule. Let’s say I have $1 million that I have allocated to this one stock, and it’s a $100 stock. So if the stock breaks out, I put one-half the money in it and I buy 5,000 shares. If it goes up 2% from my buy point, I put in the other $250,000. And then if it goes up another 2% from there, I put in the next $125,000. And then the last bit I kind of use at my discretion, where I want to add to the position. But that’s how I pyramid a position right away and get my full position. If it moves up like that, I’ll be in right away and get my full position. I’ll be in right away and I’ll be in deep. Heavy. That’s how I do it. Now Chris might have a different way.

Kacher: What I do is, when you get to the pivot point and if the volume’s there, I’ll buy one-half of a full position outright on the breakout. Say that very same day the stock closes at the top end of its range, as long as it’s not too extended and ran 10% that day I will buy another one-quarter position at the end of the day. So now I’ve got three-quarters of my full position intact at the end of that first breakout day. Now as a stock runs up, I’m not going to touch it. But what happens often is, after breaking out, these things will come back on lower volume for a few days before running up again. I will go ahead and sometimes add another one-quarter and get my full position that way. Another way to do it is, let’s say the stock came back a little bit, everything looked good, I bought that last quarter, so now I’ve got my full position. If the stock then runs up another 50%, what happens during a one-month market setback is that these stocks will sometimes come back to the 50-day moving average line. If they’re institutional quality, what I find is that a lot of mutual funds that own the stock will come in and support the stock at the 50-day moving average. You can actually use the 50-day as another pyramid point. That’s assuming, though, that you already have a lot of cushion in the stock. If it comes all the way back down to the 50-day, if you’re up appreciably in the stock, then there’s very little risk to you to add to your position at that level.

Marder: So a lot of institutions are really watching that 50-day then.

Kacher: Yes. You can see that with companies like Qualcomm. Every time Qualcomm hits the 50-day it tends to bounce. Sometimes it’ll go below the 50-day, but it’s very quick to bounce above it, usually within a day or two. And ^JDSU^, remarkably, every time it hit the 50 it bounced. It’s also an institutional quality stock.

Marder: It’s been real. Thanks for your time.


Charts courtesy of Omega Research