Harry Domash's Winning Investing


Survival of the Fittest

Survival of the fittest, the law of nature that says, “Only the strongest survive,” is a principal that investors should apply to qualifying stock candidates. Here’s why. 

Many investors research one stock at a time, typically after they’ve heard it recommended by a TV guru, or by someone at the gym. There’s nothing wrong with using tips as a resource, but if you only look at one stock, chances are you’ll find a reason to like it.

Consider what happens if instead of a single stock, you start your analysis with a bunch of candidates; say 15 or 20. Doing that gives you the luxury of weeding out the weakest stocks as you do your research.

I’m going to outline a quick six-step strategy for narrowing down a list of 15 or 20 stocks to a handful of strong candidates. Coming up with 15 to 20 stocks is easy using Web screening programs. I’ve described many useful screens in past columns and will feature new screening ideas in the future.

You can find the information necessary to perform my quick analysis on many financial sites. I’ll demonstrate using Yahoo. Get a price quote on the Yahoo Finance homepage (finance.yahoo.com) and then select Profile (left-menu). Eliminate a stock as soon as it flunks one test. 

Yahoo’s Profile report describes a firm’s main business. Disqualify any stock that’s in an industry that you want to avoid. For instance, disqualify airline stocks if you think energy prices are headed higher because higher fuel costs reduce airline earnings. Similarly, rule out homebuilders if you think we’re nearing the end of a housing bubble.

Everything we need for the remaining checks can be found on Yahoo’s Key Statistics report. We’ll start with the PEG ratio listed in the Valuation Measures section.

Don’t Overpay
You add unnecessary risk when you overpay for a stock. The price/earnings ratio or P/E (recent price divided by 12-month’s earnings) is the most popular valuation measure. But you can’t rely on P/E alone, you have to consider the expected earnings growth.

Opinions vary, but I consider stocks fairly valued when the P/E is about 50 percent higher than the expected annual earnings growth rate. By that standard, a stock expected to grow earnings around 20 percent annually would be fairly valued if it traded at a 30 P/E.

You don’t have to do the math because Yahoo’s PEG ratio compares a stocks P/E to its expected current fiscal year’s earnings growth. A PEG of 2 means that the P/E is twice the expected growth rate. Using my definition, a 1.5 PEG identifies a fairly valued stock, and higher is overvalued. Since my definition is arbitrary, allow a little leeway. Rule out stocks with PEGs above 2.

One caveat, some industries, such as homebuilders, habitually trade at unusually low PEGs. You can see the PEGs for up to three of your stock’s direct competitors on Yahoo’s Competitors report. For industries such as homebuilders, disqualify stocks trading at PEGs more than 50 percent above other companies in the same business.

Next, we’ll rule out high-debt firms using the debt to equity ratio figure found in the Balance Sheet section.

Avoid High Debt
Firm’s that carry high debt create two problems for most investors. First, if rates continue to rise, these firms’ will have to pay out more interest, cutting into earnings. Second, you’ll have to analyze financial statements to make sure that each firm has sufficient cash flow to service its debt. For my money, it’s easier to finesse the problem by avoiding high debt stocks.

The total debt to equity ratio compares a firm’s total of short- and long-term debt to shareholders equity (book value). Consider firms with total D/E ratios below 0.4 as low-debt and disqualify stocks with ratios above 0.4.

Next, check the “Percent Held by Institutions” in the Share Statistics section.

Institutional Ownership
Institutions are mutual funds, pension plans, and other large investors. Institutional ownership is the percentage of a firm’s outstanding shares that are owned by these big players. Institutions typically own at least 40 percent of the shares of worthwhile stocks. Avoid stocks that these in-the-know players are shunning. Disqualify stocks with less than 40 percent institutional ownership.

Next, check the Cash From Operations figure in the Cash Flow Statement section.

Count the Cash
Operating cash flow is the cash that flowed into or out of a firm’s bank accounts during the past four quarters, and is a more reliable profit measure than reported earnings. Don’t worry about the amount, but stick with companies where the cash is flowing in, not out. Avoid cash burners by disqualifying stocks with negative operating cash flow.

Finally, compare the recent share price to the stock’s moving averages to avoid weak stocks.

Avoid Weak Stocks   
Sometimes insiders know about impending bad news that hasn’t yet been made public. In those cases, a falling  (downtrending) share price may be your only clue that something is amiss. You don’t have to be a charting expert to make this call. Yahoo lists a stock’s 50-day and 200-day moving averages in the Stock Price History section, and its latest share price at the top of its Key Statistics report.

I don’t have room to explain the whys and wherefores here, but stocks trading below either moving average are in downtrends. Disqualify stocks trading below their 50-day or 200-day moving averages.

These six quick tests will eliminate many bad stock ideas. But the survivors still require in-depth research. The more you know about your stocks, the better your results.
published 5/29/05


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