tell us that investment success requires a disciplined approach for
finding, researching, and analyzing potential investments. This chapter
describes one such approach, and the ensuing chapters fill in the details.
Itís based on sound principles that are practiced by market-beating
money managers. Itís certainly not the only way, and it may not
be the best way. But itís a place to start, and following it will make
you a better investor. After youíve
mastered these strategies, you can modify
them to suit your needs.
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
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. Youíll find no shortage of tips, and youíll welcome
them once youíve gained confidence in your analysis skills, because
youíll be able to weed out the bad ideas quickly.
your experience grows, youíll get a feel for what discriminates strong
candidates, and youíll find yourself increasingly taking advantage
of screening to uncover investment
is a technique for scanning the entire market for stocks meeting your
criteria. Itís a powerful
tool, but to use it effectively, you have to first understand how
to identify the best candidates. That will come with time, and in
the meantime, Iíve provided a few sample screens in Chapter 3 to get
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.
Concentrate On the Strongest Candidates
analysis techniques follow a survival-of-the-fittest approach, where
youíre 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.
Use the quick prequalify
test to identify the obvious misfits. These
may be stocks that would be bad news for any investor. Perhaps theyíre
firms with businesses based more on hype than reality with little or
no sales or earnings. Or they could be stocks that simply donít fit your
investing style. For instance, maybe
they are value stocks and youíre a growth
the quick prequalify test to check:
Company and industry overview.
Find out something about
the companyís 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.
Market capitalization defines a companyís 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.
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
may decide that a particular company size range best suits your needs, or
conversely, that youíre open to all possibilities. Whatever you
conclude, eliminate candidates in this step that donít fit your
Valuation ratios such as
price to earnings (P/E) or price to sales (P/S) define how market
participants view your candidateís 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.
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.
Trading volume is the
average number of shares traded daily. Low trading volume stocks spell
trouble because theyíre subject to price manipulation and mutual funds
canít buy them. Hereís where youíll toss these bad ideas.
Corporate insiders such
as key executives and board members are restricted as to when and how
often they can buy and sell their companyís shares. So insider owned
shares are not considered available for trading. The float is the number
of outstanding shares not owned by insiders, and thus available for daily
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.
Where reported earnings
reflect from myriad accounting decisions, cash flow is the amount of cash
that actually flowed into, or out of, a companyís bank accounts as a
result of its operations. Consequently, cash flow is the best measure of
for the fastest growers, viable growth candidates should be reporting
positive cash flow. Hereís 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.
Historical sales and earnings growth.
Whether youíre seeking out-of-favor value prospects or hot growth
candidates your best prospects are firms with a long history of solid
long-term sales and earnings growth. In this step, youíll dispose of
stocks that donít meet this basic requirement.
Check the buzz.
Thereís no point wasting time researching a stock if the companyís
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. Itís a different story for value prospects, however. The
negative buzz is part and parcel of the marketís disenchantment with the
stock, and is contributing to making it a value candidate.
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.
The COSC (concentrate on
the strongest candidates) analysis process is described in Chapter 16 and
Chapter 17. Although describing two very different selection strategies,
both employ the same analysis tools detailed in Part 2.
COSC process consists of 11 steps, each using a corresponding analysis
tool. For instance, Step 7 involves analyzing a candidateís financial
health, and employs Tool #7, Financial Strength Analysis. The analysis
tool chapters 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.
youíll need to be familiar with the appropriate analysis tool to perform
the corresponding analysis step.
a candidate when it fails any step. For example, donít carry a candidate
to Step 2 if it failed Step 1.
1: Analyzing Analystsí Data
Market analysts are
employed by brokerages and other firms to evaluate and rate publicly
traded corporations. Start your detailed analysis by reviewing market
analystsí 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 donít like. Conversely,
growth investors need to see some, but not too much, enthusiasm for their
candidates. The Sentiment Index, described in Chapter 4, is a useful gauge
of analystsí enthusiasm.
earnings growth forecasts are another measure of a stockís suitability
as a growth or value candidate. Strong forecast earnings growth
disqualifies value candidates but identifies strong growth prospects.
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 step, youíll
determine the earnings growth implied by your candidateís current stock
price. This will help you gauge whether thereís sufficient upside stock
price potential to justify further research.
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
pre-established target price before buying. It isnít bought if it doesnít
reach the buy target. Once purchased, the stock is sold when it reaches
its predetermined sell target price.
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.
4: Industry Analysis
Companies are more
likely to achieve success and make money for their shareholders if theyíre
selling into fast-growing market sectors than if theyíre mired in a slow
growth or stagnant industry. Youíll analyze your candidateís industry
growth prospects and other factors that affect industry playerís 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.
5: Business Plan Analysis
Microsoft is one of
the worldís more profitable companies, while Gateway Computer struggles.
The difference is in the business models. In this section, youíll
determine if your candidate is more like a Microsoft or a Gateway.
6: Assess Management Quality
Many money managers
consider gauging management quality an important part of the analysis
process. You donít have time to visit candidateís plants and schmooze
with key executives, and you donít have to. You can evaluate management
quality from the comfort of your own home by reviewing the rťsumťs of
key executives and directors, measuring the firmís accounting quality,
and completing other easily accomplished checks.
7: Financial Strength Analysis
You lose big if one
of your holdings files bankruptcy. But a firm doesnít have to go
bankrupt to ruin your day. Just the rumors that it might are enough to
sink its stock price. Market analysts typically donít bother to check a
firmís financial strength before recommending a stock. Thatís why so
many advised buying Enron, Kmart, Global Crossing, and other recent
bankruptcies just months before they failed.
donít have to be a victim. You can measure any public corporationís
financial health using the strategies described in this section.
8: Profitability & Growth Analysis
In the end, stock
prices follow earnings. In this step youíll analyze sales and
profitability trends to determine whether your candidateís earnings are
more likely heading up, or heading down. Youíll also find out if your
candidate is really profitable, or just gives the appearance of making
9: Detecting Red Flags
Itís 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 donít come without warning. In this step, youíll
check for red flags signaling future disappointments before they sink the
10: Ownership Considerations
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 youíre on the right track.
are directors, key officers, and large investors. Naturally, youíd like
to see that key officers own their companyís stock, but too much insider
ownership signals danger.
is where youíll sort out institutional and insider ownership data to
determine if itís favorable or unfavorable.
11: Price Charts
Believe it or not,
occasionally knowledgeable insiders withhold important information that
would affect your investment decision until theyíve had a chance to act
by dumping or loading up on the stock. In these instances, the stockís
price action is your only clue that something is going on.
why itís important to check a stockís price chart before buying. In
this step, youíll ascertain whether the stock chart is signaling that itís
okay to buy.
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. Youíll be amazed how just filling out the scorecard
will improve your analysis.
For me, selling a stock is often
more difficult than buying it. If Iíve made money, I enjoyed the
experience and I donít want to leave the party when thereís still
money to be made. Itís even harder to sell if Iím behind. The game isnít
over as long as I hold onto the stock, and thereís always hope that it
will go back up. But once sold, the loss goes on my permanent record.
easy to delay selling by saying "Letís wait and see what it does
tomorrow." All too often putting off selling turns profits into
losses and turns small losses into bigger losses.
a strict sell discipline is an effective antidote for sellerís
procrastination. The "COSC Growth" and "COSC Value"
analysis chapters each provide detailed instructions for deciding when to
many instances, a condition triggering a sell signal for a growth investor
wouldnít 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 wouldnít faze a value player. Conversely,
a strong uptrending price chart often tells a value investor that itís
time to sell, but the same event would signal to a growth type that the
party is just beginning.
certain events such as deteriorating fundamentals, significant earnings
restatements, and announcements of large acquisitions warn all players
that itís time to sell.
Following an organized
approach to finding, researching, buying, and selling stocks will make you
a better investor. Now that you know where weíre heading, read on to get