of the Fittest
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.
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.
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.
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
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.
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.
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.
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.
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.
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.
rule out high-debt firms using the debt to equity ratio figure found in
the Balance Sheet section.
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.
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
the “Percent Held by Institutions” in the Share Statistics section.
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.
the Cash From Operations figure in the Cash Flow Statement section.
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.
compare the recent share price to the stock’s moving averages to avoid
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.
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.
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.