In my last article (‘Stability in sight for this turbulent small cap’) I wrote about why I believe small-cap stocks offer private investors and retail traders exponential returns when researched judiciously. The advantage of not having institutions and teams of analysts dissecting every cash transaction while using discounted cash flow models to create complex terminal values – and instead having other private investors as your competition – cannot be overstated.
It means you’re up against others who might not have done the work that you have, or might not understand the market as well as you do. Some of them will even be gamblers, punting their money into whatever hot story they hear down the pub. People get what they want out of the market. And that can be capital growth or excitement.
Along with small-cap stocks, one pattern I’ve found to be a useful indicator in trading is the cup and handle pattern. A cup and handle breakout is a bullish chart pattern commonly used in technical analysis to identify potential buy signals for a security. The pattern is formed by a cup-shaped base followed by a smaller handle, hence the name. Often these will be scruffy looking, but to the trained eye they can be seen clearly in a chart.
The cup is formed by a gradual downward trend in the price of the security followed by a gradual upward trend forming a curve, similar to a “U” shape. The handle is a small downward trend in the price, forming a short and relatively narrow price range, usually not exceeding one-third of the depth of the cup.
The breakout occurs when the price of the security breaks above the resistance level established by the handle, indicating a potential continuation of the previous upward trend. The breakout is usually accompanied by high trading volume and is considered a bullish signal for the security. But while this is the textbook pattern, often cup and handle breakouts don’t have high volume and just pass through the resistance on average volume. This doesn’t mean the pattern is invalid, but volume is a key indicator of shares swapping hands and supply and demand, so a breakout on high volume means the stock is rising on high demand.
Traders and investors use the cup and handle pattern as a signal to enter into a long position, setting a stop-loss order below the handle to limit potential losses. I always suggest traders eyeball the pattern and put the stop loss outside of stop loss liquidity, because placing a stop directly below the handle is too obvious. Remember, the market is inherently curious and it always wants to test what levels are trading at various points. But like any other technical analysis tool, the pattern isn’t guaranteed and users should test their own results on the pattern and decide for themselves if it’s working. For me, it seems to be reliable and so I often look for cup and handle patterns appearing.
One stock that has had a textbook cup and handle breakout is Kitwave (KITW). Kitwave is a wholesale business that supports deliveries throughout the UK, and specialises in selling impulse products such as confectionery, soft drinks, snacks, frozen foods, alcohol, tobacco and everyday groceries. It’s a competitor to Booker and other wholesalers and uses a buy-and-build model to acquire smaller businesses that are happy to sell. It typically does this by using cash generated from operations (and not by constantly issuing shares).
It may not sound the most exciting business model, but the business is performing strongly and earlier this week announced that it expects full-year figures (for the 12 months to 31 October 2023) to be slightly ahead of expectations. The forecast for the company’s 2023 post-tax profit is £18.2m, putting the company currently on a PE of just above 10.
Looking at Chart 1, we can see the stock listed in the peak pandemic cashout era for IPOs, and while the price came off during 2022, it made a new high in September 2022 only to fall again.
That high was tested in December (forming the cup) and the handle was formed in during January 2023. We can then see a breakout on heavy volume and the stock rallying sharply. This was the ideal entry point into the stock, but we may yet be offered another potential breakout or even a cup and handle breakout.
Moving across to Chart 2, we can see the price has pulled back and rallied sharply. I’ve drawn a line at the recent high of 290p, and this is where I’d be tempted to take a trading position.
The trend in the stock is clearly up, and all the moving averages are pointing upwards. Another added benefit is that the volume has been higher on up days, which shows signs of continued demand driving the price higher. The reasonable valuation and the fact that the business is performing strongly all give me confidence that this is a potential trend to ride.
