posted 08-04-2003 04:17 AM         

Guide to picking stocks - parts 4 to 6

Part 4: Growth Investing

Chances are you've already heard about the strategy of growth investing. Like many core strategies around today, it was pioneered a long time ago. With growth investing, investors in the 1990s enjoyed unheard-of returns. Before, however, you jump on the bandwagon, realize this strategy isn't for everyone: it comes with substantial risks.

- Background
Growth investing is buying stock in companies that tend to grow substantially faster than others. In most cases, this involves buying young companies with high potential. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Over the past 5-10 years, technology companies have taken the title of growth stocks. Because this strategy has proven viable over a long period of time, growth investing has many followers. On the other hand, as we already mentioned, growth stock investing also involves special great risks, and therefore may not be suitable for all investors.

- What do we look at?
For the most part growth investing involves looking at a company's earnings. The EPS tells investors how much profit is being made for each share in the company. There are many examples of companies with astounding growth in sales but with a widening loss in earnings. Revenue growth of 40% annually is very good, but if EPS has gone down, the increase in revenue is more or less useless. Profit growth of, say, 30% is also great, but if the outstanding shares of the company doubles because of secondary issues, the EPS growth is only 15%.

- Pay close attention to EPS figures
As mentioned above, the EPS of a firm is the main determinant of a company's growth. EPS growth, however, can sometimes be tricky to determine, and figuring out whether the growth is average or above average can also be difficult.

Against what do we compare the growth number? 15% may seem like a pretty decent rate, especially since the firms in the S&P 500 have an average EPS growth of around 13%; however, looking at the main averages can be misleading. For example, a 20% growth rate can be thought of as "negative" if the industry is growing at 30%. It is also important to look at the company's industry. The oil and gas industry, for instance, depends heavily on the price of oil. In the year 2000 the price of oil nearly tripled, and, as a result, energy companies showed earnings growth of 250%. Clearly, it is useless comparing the oil industry to a traditional industry that grows at a steady 10-12% rate.

It is important to remember that some of today's leading growth companies will inevitably be tomorrow's laggards. Some of these laggards will renew themselves and return to the fast growth, but others will fade and become average performers. On the other hand, there are a few companies that have been remarkably successful in maintaining their earnings momentum year in and year out.

- Things to Remember:
1. Growth stocks are risky, and fluctuations in their stock prices will probably be more volatile than the market as a whole.

2. Most growth stocks have higher than average P/E ratios.

3. Fast growing companies need their capital to finance their expansion. Most re-invest a high portion or all of their earnings back into their own businesses, so don't expect any dividends.

Part 5: Momentum Investing

Momentum investing is a relatively new strategy that has taken the markets by storm. Momentum investors are the ones that move fast, have little patience for under-performing stocks, and more importantly, have yet to prove that their method works over the long term.

- Background
Momentum investors buy stocks which have accelerating numbers such as surging share price, rising earnings, or bulging revenues. At the first sign of a dip they usually sell. A momentum investor normally buys a stock after its rise has begun and sells out just after it begins to falter. Most are indifferent to positions. That is, they will go long or short on a stock, but everything they do depends on the stock's momentum.

- Cockroach Theory
The momentum strategy centers around the cockroach theory, which states that bad (and good) news tends to be released in bunches, just as cockroaches tend to travel in large groups. Momentum investors, believing that one item of bad corporate news is rarely an isolated event, buy hot stocks on the way up, and bail out on the first hint of bad news.

- Earnings Growth
Similar to growth investing, momentum investing seeks the company that is improving at a faster rate than the market. Momentum investors also seek-out average companies that are becoming good, and good companies that are becoming great. It is in this transition of improvement, which can be a result of anything from an earnings surprise to a drastic change in business strategy or scope, that the momentum investor makes his or her money.

There are four major factors that can be used to detect a company with momentum:
1. Earnings Growth - when a company’s earnings are accelerating faster than before.
2. Upside Earnings Surprises - when a company delivers better earnings performance than analysts had predicted.
3. Analyst Upgrades - when an analyst or brokerage revises a company's forecasts to be higher.
4. Overall Strength - when a company’s stock price is increasing faster than the overall stock market.

- Risks
Like with all strategies that try to make big money in a small amount of time, there are substantial risks. The danger for momentum investors is that they are hoping that there are people more foolish than themselves. Basically, momentum are going along for the ride with these fools, but getting out before them. The momentum strategy sows the seeds of its own collapse: attractive prospects of a company bring in buyers, but then the price moves higher until finally the stock price becomes so horribly overpriced that it collapses. Sounds quite similar to the "Dot-com crash" of 2000.

Things to Remember:

1. This strategy is short-term and very risky! It is recommended
only for those with ample experience.

2. Most momentum stocks have higher than average P/E ratios because they are expected to grow at a faster rate.

3. Your "sell discipline" should be as strong as your "buy discipline." Be indifferent to a stock.

4. Control your risk. Momentum investing isn't about buying stocks that are being driven up by speculative hype. Always insist that companies meet positive fundamental change criteria.

Part 6: Income Investing

- Dividend Yield
Simply investing in companies with the highest dividends is not the premise of this strategy. More important is the dividend yield, calculated by dividing the annual dividends per share by the share price. For example, if a company share price is $100 and a dividend of $6 per share is paid, the result is a 6% dividend yield. The average dividend yield for companies in the S&P 500 is 2-3%.

Income investors demand a much higher yield than 2-3%. Most are looking for a minimum 5-6% yield, which on a $1 million investment would produce an income (before taxes) of $50,000-$60,000. And forget those tech stocks; virtually none of them pay dividends. One astonishing fact is that the return of mutual funds specializing in dividend-paying stocks has been 15%-16% per year over the past 5 years.

- Dividends Are Not Everything
Never invest solely on the basis of dividends. Keep in mind that high dividends don't necessarily mean a good company. Dividends are paid out of a company's net income. Therefore, the higher the dividends, the lower the retained earnings for the company. Problems arise when a company is
paying out large amounts of their income to shareholders when that income would have been better spent re-investing it within the company.

- Other Options
Investing in dividend paying stocks is not the only way to become an income investor. Other alternatives are "A-rated" corporate bonds, many of which are currently averaging 6-8% coupon yields, and municipal bonds, many of which offer 3-5% tax free returns.

- Risks
Like every stock-picking strategy we have discussed in this eight-part series, income investing involves risks. When you buy common shares, there’s a chance that the value of your original investment could drop.

For stocks, unlike bonds, dividend distribution and the levels of pay-outs are not guaranteed. Should the firm run into financial hardship, or if there is a great investment opportunity which requires significant cash outlay, you could end up without your dividend.

One last warning: income from dividends is taxed at the same rate as that of your wages, whereas capital gains from a rise in stock price are taxed at 20-50% (depending on the country).

- Things to Remember:

1. Income investors can use a combination of stocks, bonds, and preferred shares.
2. It is important to look at the company's fundamentals. Don't just look at dividend yields.
3. "Income" from dividends and bonds are taxed at a higher rate than the gains from price appreciation.
4. Like every stock-picking strategy, it isn't always perfect, so always maintain a well diversified portfolio.

Back to parts 1-3