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Experts tell us that investment success requires a disciplined approach
for finding, researching, and analyzing potential investments.
This article describes one such approach, and the ensuing chapters fill
in the details. It’s based on sound principles that are practiced by market-
beating money managers. It’s certainly not the only way, and it may
not be the best way. But it’s a place to start, and following it will make
you a better investor. After you’ve mastered these strategies, you can
modify them to suit your needs.
The process involves finding investment candidates, weeding
out the obvious misfits, researching and analyzing the survivors, picking
the best candidates, and equally important, applying a clear-cut set of
selling rules.
Finding Candidates
Finding stocks to analyze can be as easy as going to your hair salon,
talking to your neighbors, picking up a magazine, surfing the Internet,
or turning on the TV. You’ll find no shortage of tips, and you’ll
welcome them once you’ve gained confidence in your analysis skills,
because you’ll be able to weed out the bad ideas quickly.
As your experience grows, you’ll get a feel for what discriminates
strong candidates, and you’ll find yourself increasingly taking advantage
of screening to uncover investment ideas.
Screening is a
technique for scanning the entire market for stocks meeting your criteria.
It’s a powerful tool, but to use it effectively, you have to first understand
how to identify the best candidates.
Treat all names you get, whether from your own screens, friends,
TV gurus, or even Warren Buffett, as tips to analyze using the techniques
you are about to learn.
Analyzing Stocks
Remember COSC: Concentrate On the Strongest Candidates
Our analysis techniques follow a survival-of-the-fittest approach,
where you’re constantly weeding out the weakest contenders.
These techniques work best if you start with a large group of candidates,
say 10 to 20, instead of just a few. Researching stocks takes time and effort,
so eliminate weak contenders as soon as you discover them. That
way you can concentrate your research on the strongest candidates. Be
ruthless. There is no point in wasting time researching stupid ideas.
Quick Prequalify
Use the quick prequalify test to identify the obvious misfits. These
may be stocks that would be bad news for any investor. Perhaps they’re
firms with businesses based more on hype than reality with little or no
sales or earnings. Or they could be stocks that simply don’t fit your investing
style, e.g., maybe they’re value stocks, and you’re a growth investor.
Use the quick prequalify test to check:
1. Company and industry overview.
Find out something
about the company’s business and its industry. It may be
in a business or market sector that you favor or that you
want to avoid. For instance, the home building industry
usually prospers when interest rates drop and suffers in a
rising interest rate environment. So your take on the
future direction of interest rates would influence how you
view homebuilders.
2. Market capitalization.
Market capitalization defines a
company’s total value (share price multiplied by number
of shares). The biggest firms are designated large-caps,
and progressively smaller firms are termed mid-caps,
small-caps, and micro-caps.
There is no good or bad market capitalization, but each
size has its own pluses and minuses in terms of potential
risks and rewards. Generally, larger companies are considered
safer, and smaller firms offer more growth potential.
However, even these generalities vary with current
market conditions.
You may decide that a particular company size range best
suits your needs or, conversely, that you’re open to all
possibilities. Whatever you conclude, eliminate candidates
in this step that don’t fit your requirements.
3. Valuation ratios.
Valuation ratios such as price to earnings
(P/E) or price to sales (P/S) define how market participants
view your candidate’s earnings growth prospects.
High valuations reflect in-favor stocks, that is, those seen
having strong growth prospects, and thus appeal to growth
investors. Conversely, value players look for stocks with
low valuation ratios, indicating that most market players
(growth investors) view them as losers.
Any given candidate will fit into either the growth or
value categories, but not both. The valuation ratios give
you a quick read as to whether you have a value or growth
candidate on your hands.
4. Trading volume.
Trading volume is the average number
of shares traded daily. Low trading volume stocks spell
trouble because they’re subject to price manipulation and
mutual funds can’t buy them. Here’s where you’ll toss
these bad ideas.
5. Float.
Corporate insiders such as key executives and
board members are restricted as to when and how often
they can buy and sell their company’s shares. So insiderowned
shares are not considered available for trading.
The float is the number of outstanding shares not owned
by insiders, and thus available for daily trading.
Acceptable float values depend on your investing style.
Large firms typically have floats running from a few hundred
million shares into the billions. However some
investors seek out firms with much smaller floats, typically
below 25 million shares. Since the float represents
the supply of shares available for trading, these small
floats mean that the share price could take off like a
rocket if the company hits the news and the demand for
shares overwhelms the available supply.
6. Cash flow.
Where reported earnings reflect myriad
accounting decisions, cash flow is the amount of cash that
actually flowed into, or out of, a company’s bank
accounts as a result of its operations. Consequently, cash
flow is the best measure of profits.
Except for the fastest growers, viable growth candidates
should be reporting positive cash flow. Here’s where
growth investors should eliminate cash burners from consideration.
On the other hand, viable value candidates
may very well be reporting negative cash flow resulting
from the problems that caused their fall from grace.
7. Historical sales and earnings growth.
Whether you’re
seeking out-of-favor value prospects or hot growth can-
didates, your best prospects are firms with a long history
of solid long-term sales and earnings growth. In this
step, you’ll dispose of stocks that don’t meet this basic
requirement.
8. Check the buzz.
There’s no point wasting time researching
a stock if the company’s main product has just been
rendered obsolete by the competition. At this point, get
up to speed on the buzz surrounding your candidate. Negative
buzz is bad news for growth stocks, and you should
disqualify such growth candidates. It’s a different story
for value prospects, however. The negative buzz is part
and parcel of the market’s disenchantment with the stock,
and is contributing to making it a value candidate.
You will eliminate many of your bad ideas during the quick
prequalify check, most in less than five minutes once you get the hang
of it. Take your survivors on to the detailed analysis.
Detailed Analysis
The COSC process consists of 11 steps, each using a corresponding
analysis tool. For instance, Step 7 involves analyzing a candidate’s
financial health, and employs Tool #7, Financial Strength
Analysis. The analysis tool describe step-by-step procedures
for performing each analysis, while “COSC Growth” and “COSC Value”
describe how to apply the results to each investing style.
Obviously, you’ll need to be familiar with the appropriate analysis
tool to perform the corresponding analysis step.
Eliminate a candidate when it fails any step. For example, don’t
carry a candidate to Step 2 if it failed Step 1.
Step 1: Analyzing Analysts’ Data
Market analysts are employed by brokerages and other firms to
evaluate and rate publicly traded corporations. Start your detailed analysis by reviewing market analysts’ buy/sell recommendations and earnings
and revenue forecasts to determine the level of market enthusiasm
for your candidate. The best value candidates are the ones that analysts
don’t like. Conversely, growth investors need to see some, but not too
much, enthusiasm for their candidates. The Sentiment Index
is a useful gauge of analysts’ enthusiasm.
Analysts’ earnings growth forecasts are another measure of a
stock’s suitability as a growth or value candidate. Strong forecast earnings
growth disqualifies value candidates but identifies strong growth
prospects.
Step 2: Valuation
Would you buy a stock if you knew that the company would
have to grow its earnings 75 percent every year merely to justify its current
stock price? In this section, you’ll determine the earnings growth
implied by your candidate’s current stock price. This will help you
gauge whether there’s sufficient upside stock price potential to justify
further research.
Step 3: Establishing Target Prices
Many value investors use target prices to establish buy and sell
points for otherwise-qualified stocks. For instance, a stock may be an attractive
candidate, but its current stock price is too high to provide the
needed margin of safety. So the value investor will wait for the stock to
come down to the preestablished target price before buying. It isn’t
bought if it doesn’t reach the buy target. Once purchased, the stock is
sold when it reaches its predetermined sell target price.
Although setting buy and sell targets is a linchpin of the value
strategy, growth investors would benefit by following the same procedure.
Doing that would have helped investors avoid many of the disasters
that marked 2000 and 2001. Tool #3, “Setting Target Prices,” makes
it easy.
Step 4: Industry Analysis
Companies are more likely to achieve success and make money
for their shareholders if they’re selling into fast-growing market sectors
than if they’re mired in a slow growth or stagnant industry. You’ll analyze
your candidate’s industry growth prospects and other factors that
affect industry player’s success prospects in this step. Pinpointing attractive
industries is all for naught if you pick the wrong companies.
Thus, your analysis will also include identifying the strongest players in
each industry.
Step 5: Business Plan Analysis
Microsoft is one of the world’s more profitable companies,
while Gateway Computer struggles. The difference is in the business
models. In this step, you’ll determine if your candidate is more like a
Microsoft or a Gateway.
Step 6: Assess Management Quality
Many money managers consider gauging management quality
an important part of the analysis process. You don’t have time to visit
candidate’s plants and schmooze with key executives, and you don’t
have to. You can evaluate management quality from the comfort of your
own home by reviewing the resumes of key executives and directors,
measuring the firm’s accounting quality, and completing other easily accomplished
checks.
Step 7: Financial Strength Analysis
You lose big if one of your holdings files bankruptcy. But a firm
doesn’t have to go bankrupt to ruin your day. Just the rumors that it
might are enough to sink its stock price. Market analysts typically don’t
bother to check a firm’s financial strength before recommending a
stock. That’s why so many advised buying Enron, Kmart, Global Crossing,
and other recent bankruptcies just months before they failed.
You don’t have to be a victim. You can measure any public corporation’s
financial health using the strategies described in this section.
Step 8: Profitability & Growth Analysis
In the end, stock prices follow earnings. In this step you’ll analyze
sales and profitability trends to determine whether your candidate’s
earnings are more likely heading up or heading down. You’ll also find
out if your candidate is really profitable, or just gives the appearance of
making money.
Step 9: Detecting Red Flags
It’s a disaster when you learn that your stock just dropped 40
percent because it reported disappointing earnings, or management cut
future growth forecasts. These disasters usually don’t come without
warning. In this step, you’ll check for red flags signaling future disappointments
before they sink the stock price.
Step 10: Ownership Considerations
Despite the advantages of the Internet, mutual funds and other
institutional investors have access to better information about stocks
than individual investors. Therefore, analyzing institutional ownership
data can help you decide whether you’re on the right track.
Insiders are directors, key officers, and large investors. Naturally,
you’d like to see that key officers own their company’s stock, but too
much insider ownership signals danger.
This is where you’ll sort out institutional and insider ownership
data to determine if it’s favorable or unfavorable.
Step 11: Price Charts
Believe it or not, occasionally knowledgeable insiders withhold
important information that would affect your investment decision until
they’ve had a chance to act by dumping or loading up on the stock. In
these instances, the stock’s price action is your only clue that something
is going on.
That’s why it’s important to check a stock’s price chart before
buying. In this step, you’ll ascertain whether the stock chart is signaling
that it’s okay to buy.
Analysis Scorecards
You’ll find separate scorecards in Appendix B for the growth
and value analysis strategies. Make copies and fill out the appropriate
scorecard when you analyze a stock. You’ll be amazed how just filling
out the scorecard will improve your analysis.
When to Sell
For me, selling a stock is often more difficult than buying it. If
I’ve made money, I enjoyed the experience and I don’t want to leave the
party when there’s still money to be made. It’s even harder to sell if I’m
behind. The game isn’t over as long as I hold onto the stock, and there’s
always hope that it will go back up. But once sold, the loss goes on my
permanent record.
It’s easy to delay selling by saying “Let’s wait and see what it
does tomorrow.” All too often putting off selling turns profits into losses
and turns small losses into bigger losses.
Establishing a strict sell discipline is an effective antidote for seller’s
procrastination.
In many instances, a condition triggering a sell signal for a
growth investor wouldn’t provoke the same response from a value investor.
For example, a significant reduction in earnings forecasts usually
triggers an automatic sell for growth investors, but wouldn’t faze a value
player. Conversely, a strong uptrending price chart often tells a value investor
that it’s time to sell, but the same event would signal to a growth
type that the party is just beginning.
However certain events such as deteriorating fundamentals, significant
earnings restatements, and announcements of large acquisitions
warn all players that it’s time to sell. | 
Disclaimer
