Stock Strategies: Choosing A Stock

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Stock Strategies: Choosing A Stock

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Stock Screens

There are literally thousands of stocks available for purchase on the stock market. So how do you go about finding the right ones to buy? Often it is helpful to use a stock screen, a set of criteria that you can quickly compare stocks against to see if they meet your requirements. You should first sit down and come up with a list of your investment objectives; once you have that you should be able to come up with a suitable screen. Your selection criteria for the initial screening should be a few quantifiable measures that you think are the most important for your investing.

Here are a few criteria worth considering (and of course there are many others):

  • Earnings growth
  • Recent earnings surprises
  • Price/earnings ratio
  • Dividends
  • Market cap or size
  • Industry
  • Relative strength

Stock Research

Once you’ve narrowed down the list of stocks that you are interested in, the next step is to research the stocks. There are a ton of great resources available out there for researching stocks, and fortunately, most of them are free. Online research is becoming more and more popular because of its convenience and ease of use. See the JB Oxford stock screener on this website for an effective way to rank sets by the criteria that you select. You should also take a look at the company’s annual report and its financial statements for the following.

From the Income Statement:

  • Earnings growth (earnings acceleration is even better). Does the company have a record of exceeding analysts’ expectations? Earnings are considered by many investors to be the most important single number, the assumption being that earnings pave the way for future dividends.
  • Revenue growth.
  • Stable or increasing margins
  • Stable or increasing R&D; spending as a percentage of sales (specifically for technology companies).
  • Tax abnormalities. For example, taxes below 25% usually mean the company is using tax loss carry-forwards against income, which are only a temporary earnings booster.
  • The number of common shares outstanding. Increases in the number of shares negatively impact earnings per share (issuance of new shares isn’t necessarily bad; the important consideration is why they’re doing it).

From the Cash Flow Statement:

  • Cash flow. Ideally, cash flow should be positive, large, and increasing. In any case, understand why the company’s cash flow is what it is.

From the Balance Sheet:

  • Debt. The debt to equity ratio (long-term debt divided by stockholder’s equity) is the measure typically used. Lower is better, and zero is ideal.
  • Cash (relative to annual sales). Cash is always a good thing, but it’s especially important to companies that sometimes want or need to temporarily go cash flow negative. Remember that when new shares are issued, proceeds from the sale also appear here.
  • Return on equity. This is a measure of net income relative to the stockholder’s equity. Higher is better.
  • Receivables and inventory. They should not be rising much faster than sales are.
  • Current ratio. This is the ratio of current assets (cash, receivables, and inventory) to short-term liabilities. The higher the better.

From the Management’s Discussion and Analysis:

  • What is the outlook for the future; are there any potential threats and uncertainties they expect to encounter?
  • What are the company’s products and/or services? Do you see a continuing need for them? Are the products and/or services things that customers buy once or repeatedly? Do you see competitive offerings that are as good or better?
  • Can the company protect its position? If not, big margins can quickly become small margins. Are there no close substitutes to the products and services they offer? Are there barriers to entry? Do they have copyrights, patents, innovative processes, economies of scale, de facto standards, or anything else that will help them defend their niche? Is the product highly differentiated? How do they compare with their competition?
  • Are they generating significant earnings and revenues from products introduced within the last few years?
  • What’s the outlook for the future, both for the company and for their industry? Do they have lots of new products/services coming? Do they have favorable long-term prospects? Where will they be in ten years? Consider what the analysts and others expect for the future, but also make your own determination. If possible, work out your own revenue and earnings projections. Another technique is to assume that the analysts’ expectations are completely factored into the current price; if you think the outlook is better than they do, the stock could be a bargain.
  • Current dividends. This is more important for portfolios focusing on income rather than capital appreciation, or for investors fearful of a broad market downturn. Growth stock investors are willing to wait patiently for earnings to turn into dividends.
  • How’s the management? What’s the corporate culture? Are they able to attract and keep highly skilled personnel?
  • Insider ownership (more is better, especially by the CEO), and recent insider activity.
  • Do they have a global presence? U.S. companies that operate around the world have outperformed the S&P; 500 handily over the last 5 years, and should continue to do so.
    How is their marketing?
  • Do they have a consistent operating history? Uncertainty is something to be avoided unless you are adequately compensated for it. Change, difficult situations, product shifts, and big mergers all bring with them uncertainty. If a company doesn’t have experience with these things but you see them coming, be careful.
  • Do they have a history of success? Past performance is no guarantee of future results, to paraphrase the mutual fund mantra; but there’s certainly a positive correlation (on Wall Street and in life).
  • Is the stock expensive or cheap? Compare the P/E ratio (or book value, or price to sales ratio, or price to earnings growth, or whatever measures you use), relative to the company’s historical average and relative to the industry. See if discrepancies are justified. Also, do their design, manufacturing, and distribution costs increase or decrease each year?

Perhaps the easiest way to access all of the statements available is through the SEC’s EDGAR database (EDGAR stands for Electronic Data Gathering, Analysis, and Retrieval). The database contains required disclosure documents for public companies and mutual funds, including annual 10K and quarterly 10Q reports, proxy statements for all public companies, and prospectuses and semiannual reports for mutual fund companies. You can access the EDGAR database directly, or there are other sites that re-organize the EDGAR data to make it easier to use.

Choosing a Stock

Once you’ve gathered the facts, you should then perform the analysis. Different investors use different methods for determining what stocks to buy. Most investors prefer fundamental analysis, although there is also a large number who focus on technical analysis. Whatever one you decide to use, here are a few final considerations to keep in mind:

  • Focus on the market cap, not the per-share price. The market cap is the per-share price times the number of shares outstanding. In essence, this is how much you would have to pay to buy the whole company. Every company has a different number of shares outstanding, making per-share price comparisons meaningless. For this reason, a stock that is trading at $100 per share might actually be cheaper than a stock trading at $2 per share. This doesn’t mean that price per share is completely unimportant; some technical analysts believe it can provide clues to where the stock will go next but for fundamental analysis, it’s really not important.
  • There is no perfect stock screen because every investor is looking for something different. Some are looking for growth, others for value, still others for dividend income. The screens you apply should be done with your unique goals in mind.