posted 08-04-2003 04:15 AM         

Guide to picking stocks - parts 1 to 3

Overview:
Whether you are a small individual investor, mutual fund manager, day trader, or stock broker you need a strategy to picking stocks. There is no single strategy that works for every investor, and sometimes a combination of different strategies can produce the best results. For this 8 part series we will take an in-depth look at the wide range of strategies that investors use to select stocks, we'll let you decide which is best for you.

Part 1: Qualitative Analysis

- Management
A strong management is the backbone of any successful company. This is not to say that employees are not also important, but it is management that ultimately makes the strategic decisions. One good indicator of management's effectiveness is the length of time the CEO has been serving the company. Secondly, check how the company and stock price has done during the time the CEO has been leading the company. If the company has "restructured," it probably means management has had troubles.

- Industry/Competition
Market share is another important factor. Take for example how Coke and Pepsi dominate the battle in the soft drink industry. Anyone trying to enter this market would face almost unbeatable competition from these firms. By having a huge market share, Coke and Pepsi can take advantage of economies of scale, which makes it difficult for smaller producers to compete.

Barriers against entry into a market are extremely important. Compare, for instance, the restaurant industry to, say, the automobile or pharmaceuticals industry. Anybody can open up a restaurant because the required skill level and capital are very low. The automobile and pharmaceuticals industries have massive barriers to entry: large capital expenditures, exclusive distribution channels, government regulation, patents, etc. The harder it is for competition to enter an industry, the greater the advantage for existing firms.

- Brand Name
When considering to invest into a company, ask yourself, "Does this company have a valuable brand name?" This is a very important competitive advantage that should be considered. Coke is one of the most popular brand names in the world, and the financial value of this is huge. Many estimate that the intangible value of Coke's brand name is billions of dollars. Companies like Proctor and Gamble rely on hundreds of popular brand names such as Tide, Pampers and Head & Shoulders. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the under-performance of another.

Assessing a company from a qualitative standpoint, and determining whether you should invest in it are as important as looking at the sales and earnings. This strategy may be one of the simplest, but it is also one of the most effective ways to evaluate a potential investment.

Part 2: Quantitative Analysis

Quantitative Analysis

As we mentioned earlier, fundamental analysis, which has a very broad scope, includes looking at the general (qualitative) factors of a company. The other component of fundamental analysis, quantitative analysis, considers tangible and measurable factors. This requires crunching and analyzing numbers from the financial statements. If used in conjunction with other methods, quantitative analysis can produce excellent results.

- Background
Quantitative analysis has been around since the beginnings of the stock market. Looking at, among other factors, revenues, earnings, expenses, inventory, and cash flow has been the traditional strategy for picking stocks. If these factors looked good, the company was said to have "good fundamentals." For the most part, this approach is alive and well today.

This strategy, though, has not been without snags. The double and triple digit rise of technology stocks in the late 90s made this field very complicated. Those sticking to the "quant analysis" missed out on tremendous gains because most of the companies had no fundamentals, just good growth prospects.

- Historical Data
Common among almost every investment strategy is the consideration of historical performance. This is particularly true for "quants," who will often look at data that dates back five to ten years to detect any trends in the numbers, and to determine whether the stock seems over/under valued in comparison to its historical performance. Businesses and the economy tend to grow cyclically. With sufficient historical data, quants have the ability to capitalize on these changes. For example, if the economy appears to be entering a recession, quants will, to see if there are any similarities in the fundamentals, look at how the company did the last time the economy entered a recession

- Factors to Consider
While there are hundreds of financial valuation ratios that analysts use, there are a couple factors that have particular importance. The first factor is year-over-year earnings growth. This indicates whether or not a company has been growing at a steady and solid rate for the past few years. The same is true for sales revenues, which are the backbone of earnings growth.

The P/E Ratio has historically been used to determine whether a stock is over or under valued. But this is quickly being taken over by the PEG ratio, which in its formula includes growth, as well as the stock price and earnings. Investors are getting more picky: many have abandoned the P/E ratio not because it is worthless, but because they desire more information about a stock's potential.

Quants set financial valuation limits by which they abide in their trading activities. For example, a quant may only buy stocks that have at least 20% annual earnings growth, a P/E under 20, and a profit margin of at least 30%. Should the stock not meet any one of the numerical requisites, the quant will not buy the stock. If the fundamentals are really bad, a quant will even consider shorting the stock.

- What do these figures tell us?
Looking at the fundamentals of a company is second nature for many investors, but for others these numbers are only trivial. Day traders and momentum traders don't use quantitative analysis because the factors it considers are not likely to affect the stock price over the next couple minutes or hours. Long term investors believe that it is possible to detect long-run inefficiencies in a stock when the fundamentals don't support its price.

By setting numerical limits at which they will buy and sell stocks, quants avoid getting emotionally attached to a stock. The limits are always based on value and growth principles, which are not just a guide, but a strict law to be followed.

Part 3: Value Investing and the Bargain Hunter

Value investing and looking for a bargain is one of the oldest ways to pick stocks. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out the framework for value investing. The concept is similar to shopping for the product that is most reasonably priced for its quality. Unfortunately for value investors, they often take a back seat to emerging trends in the market. As the market moves through boom and bust periods, value stocks come in and out of favor.

- Background
A value company is one that is relatively cheap compared to its earnings and book value. In most cases value stocks tend to outperform during bear markets and are therefore considered a defensive investment. In contrast, a growth company is one whose shares are fairly expensive in relation to its current earnings or assets. Value stocks tend to have a low P/E ratio, and their book value (or tangible assets) is much closer to the stock price. Value investing is founded on looking for companies with a solid history of earnings and sales, so there is little uncertainty about their operations or future performance.

Value investors pay very close attention to the price-to-earnings ratio (P/E ratio). As mentioned, a relatively low P/E ratio indicates that the company is "inexpensive." To decide on stocks they like, value investors will also conduct some fundamental analysis with various other ratios. They will then wait for those stocks to trade at bargain prices.

- When to Buy
Value investors always look to capitalize on bad news and stocks that are shunned by other investors. By examining the fundamentals of a company value, investors decide whether or not the tumble in stock price was "overdone." If the company meets their criteria, the value investor will strike.

- Value, Not Cheap!
The prospects of value investing may sound intriguing, but buying a stock simply because it is cheap is not the right approach. There is a significant difference between an undervalued company and a cheap company. Cheap companies have seen a tumble in their stock price because there is something fundamentally wrong. Unfortunately, all the analysis in the world might not detect the fundamental problem with the company. This is a risk that all value investors take when investing in beaten down companies.

One way to protect yourself is using the PEG Ratio, calculated with a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.

Things to Remember:
1. Value is relative. Manias exist from time to time, whether they be over tulips, gold, or Internet stocks. You usually only get a bargain when something is out of favor.

2. Enormously under valued stocks are usually that way for a reason. Be wary!

3. Avoid investing in a stock that has significant uncertainty. It could go from a value stock to a chapter 11 faster than you think.

4. Value stocks may take some time to prove their worth, sometimes over 15 years! Often you must be patient.

Continue to parts 4-6