Eight Criteria to Use When Picking a Stock

Yesterday, we examined whether a simple market timing strategy can actually work over the long-term. Market timers, such as Sy Harding, frequently shun those who attempt to pick individual stocks to beat the market. Harding used the performance of Warren Buffett ("the greatest investor in the world") last year to declare that it is nearly impossible to win at the stock-picking game. Certainly, Buffett's performance was not the prettiest thing in the world as he had some missed calls such as paying a premium for COP, but who doesn't have a missed called every once in a while?

[begin tangent] While Buffett's performance of his BRK.A shares were down about 32% (compared to -39% for the S&P 500) last year, to suggest that Buffet's lifelong record of stock picking has been anything less than remarkable is ridiculous. In the long-term game that is investing, if you had invested with Buffett at the onset in 1965, your $10,000 would be worth $51 million today! Investing in the S&P would have left you with a nice chunk of change to the tune of $500,000, but that's just ONE percent of $51 million. In addition, due to these stellar results, investors were willing to pay a premium for BRK.A. As with any company, its stock price isn't solely determined by the performance of investments and its bottom-line profit. As we all know, there is a lot more that goes into determining the price. In fact, in Berkshire's annual report (all investors should read these every year as they provide keen insight from the master himself in a clear, concise fashion), Buffett cited something around a 10% loss in his investments - far from the 32% decrease in the stock price. On CNBC's Fast Money last night, Dennis Gartman (who previously said that Buffett was an idiot), stated that Buffett made some "terrible mistakes" last year, which lead to "inexcusable losses." While he took back his idiot remark, he didn't shy away from his criticism of Buffett. Well, in my opinion, Gartman is an idiot. He historically has been critical of all passive buy-and-hold investors. Buffett isn't a trader like Gartman likes; he's an investor. There is a distinct difference and a future blog post will elaborate on this more fully.[/end tangent]

As stated yesterday, those that purchase individual equities typically insist that market timing is a futile affair and leads to poorer returns. Personally, while I think for the vast majority of individuals it makes the most sense to use all their funds to dollar cost average into low-cost index funds over time, I do think that those with the time, inclination, and interest can augment their core holdings (i.e. index funds) with individual stock picks in an attempt to modestly outperform the market.

Here are eight criteria I use when choosing a stock:

  1. Bullish sector - Sectors go into and out of favor based on natural transitions as well as the current economic climate. Oftentimes, these changes are cyclical and predictable or fairly obvious based on economic indicators. Other times, however, it can be difficult to ascertain which sectors are poised to pop. Additionally, yesterday's hot sectors can quickly turn cold, and certain sectors are more volatile and risky (e.g. technology) than others (e.g. consumer staples). All of these factors should be taken into account. You can consult Standard & Poor's or Ned Davis Research for detailed analysis of their weighting recommendations, if so desired. A stock price is not only affected by a company's own fundamentals and earnings reports, but that of its peers in the same industry. Right now, for example, both agencies both recommend overweighting the IT sector. This would be a good place to start looking for a stock. 
  2.  Low P/E relative to its competitors - Looking for value is a staple tactic of any long-term approached investor. Traditionally, value picks have fared better over the long-term than growth stocks. Growth can provide a boost and should certainly be considered an important part of any well-balanced and diversified portfolio, but value is something that cannot be beat. P/E, or the Price to Earnings ratio, is the "real" cost of a stock and should be used to determine if a stock is cheap or expensive - the absolute value is fairly irrelevant. Companies with expected high growth usually charge a premium and exhibit a higher earnings multiple. Let's compare two similar companies: Edwards Lifesciences (EW) and Becton, Dickinson and Co. (BDX). Both are in the Health Care Equipment Industry (not something I necessarily recommend at this juncture, but I'm using it for illustrative purposes only). EW's actual price is 65.15, while BDX is at 68.6. So, BDX is slight more expensive, right? Wrong. EW's P/E is at 22.54, while BDX is at 14.84. So BDX is actually about 34% cheaper; quite a discount. Thus, all else being equal, I'd always buy BDX. 
  3. High growth and low PEG ratio - While a low PE typically indicates low growth, there are some diamonds in the rough out there and stock prices don't always perfectly reflect the numbers. It's our job as individual investors to seek out these deals, and then pull the trigger. I like to look at the 5-year projected earnings growth. Combining the last two criteria, one can just look at the PEG ratio of a stock. The lower the PEG, the more the stock is undervalued. Using EW and BDX as above, BDX has a PEG of 1.2, while EW is at 1.5 - yet another reason to choose BDX over EW. This is just a logical extension of the fact that BDX has a much lower P/E. EW's projected growth would have to much larger to make up for it. 
  4. Reasonable dividend yield - While traders could care less about dividends, I believe the vast majority of people should go into the mindset of being an investor. It has been shown time and time again, that high quality dividend-paying stocks are largely responsible for the average 10.3% rise in equities since the 1920s. It provides protection against the downside, and it is nice getting a check every once in a while, especially considering that the yields on many stocks are currently higher than anything you'd get in a savings account or CD. It's important to note that some sectors traditionally do not have high yields (e.g. tech, banks), while others have more precedence (e.g. consumer staples, REITs). Also, it may be a concerted effort on the part of management to not pay dividends so they are able to dedicate those assets for future growth and to help investors avoid paying taxes on that cash. Warren Buffett's Berkshire Hathaway (BRK.B), for example, uses this rationale and does not pay dividends. I would not automatically avoid such a company, but I still do think that it makes sense to have a stream of dividend income and seek out such companies. I reinvest my dividends in tax-deferred accounts, while I prefer to have the dividends automatically put in my savings account (or money market) for taxable accounts due to accounting. Check out http://www.dividendinvestor.com/ for information on how reliable a particular company has been at paying and raising its dividends. Current stocks with high yields right now (that I believe are "safe;" too high of a yield is a red flag) that look attractive in my mind include BMY, VZ, and JNJ. 
  5. Normal debt-to-equity - I don't like investing in companies with exorbitantly high debt-to-equity ratios. While financing its growth with debt can be a positive, having too much debt is a red flag in my mind and I like to stay away. On the other hand, a company that plays too conservatively may be missing out on growth opportunities. "Normal" depends on the particular industry - so you'll have to research it. 
  6. Positive Industry Specific Metrics - Nearly every industry has key metrics that illustrate how a company is being managed and performing. Looking at these particulars can help investors gleam insight into a stock price even moreso than the generic valuation measures. For example, in the restaurant business, sales per restaurant is a key statistic. You need to do some research to discover what metric is particularly foreboding for future success and how companies are judged relative to their peers. A good site to check out for such information as well as how a particular stock compares to its competitors is wikinvest.com. Search for a stock, click data central, and there you will see an Industry Metrics section. 
  7. Low Price to Book, Low Price to Sales, High Return on Assets, and High Return on Equity - These are all valuation metrics helpful in determining if a company is undervalued. The Price to Book (P/B) is simply the share price divided by the book value per share. This varies widely based on industry, so again, it's best to compare it to its peers. For example, a company that is dependent on services will have a higher P/B than an industrial that requires far more assets. P/B certainly shouldn't be looked at in a vacuum as a low number could indicate a variety of problems such as poor earnings projections or negative investor sentiment. Price to Sales is calculated by dividing the share price by the revenue per share. A stock with a low price to sales when compared to its peers is seen as undervalued, but also can signal other issues, so it's careful to seek out if any such negatives exist. Return on Assets (ROA) is the net income divided by assets (or sometimes net income plus interest divided by average assets). It measures how efficiently a company utilizes its assets to generate earnings. This should be compared to its previous ROA as well as its competitors current ROA. Return on Equity (ROE) is net income divided by shareholder equity and measures how effectively a firm profits from funds raised by shareholders. All else being equal, a higher ROE is better. 
  8. High Operating Margin / Net Profit Margin - Operating Margin is simply operating profit divided by net sales. It gives an idea of how much money a company makes for each sales dollar it earns. For example, a company that has an operating margin of 20% earns 20 cents for every dollar of sales. A higher margin allows a company to more easily pay fixed costs such as debt interest and signals healthy cash flow. Similarly, net profit margin is net income divided by net sales. It's how much money a company gets to keep for each dollar of sales and is used in tandem with operating margin. These metrics can signal the forward progress of a company. If you simply looked at net income and saw that it increased year-over-year, that certainly would be a positive. But if the company also reported decreasing margins, that is a negative. Conversely, a company that had stagnant income but increased margins would be seen as a buy assuming growth going forward seems likely.
                While I certainly consider other factors when picking a stock, these eight places are a good place to start. I also recommend using a limit order when purchasing shares (never buy at the market price) and if you want to manage risk, sometimes it makes sense to place a stop loss order at a certain percentage below based on normal fluctuation. Consulting the beta of a stock or look at http://www.askstockguru.com to get a reasonable percentage to risk and where to place to stop loss order.

                Also, it's important to remain diversified and keep with your target asset allocation. So while I tend to choose stocks in bullish sectors, I never stray too far from the sector allocation of the S&P 500 since my core holdings include index funds. Each stock you own requires significant time and research, so if you don't have the time or interest, there is certainly nothing wrong with investing in an index fund. In fact, I recommend that for the vast majority of individuals and believe index funds should be the foundation of all portfolios. By following these criteria, one can reasonably hope to modestly outperform the market (although there are no guarantees) while making it interesting (yes, I find stock picking entertaining and fun as well as a potential to make money). So, why don't expertly managed active mutual funds routinely outperform index funds you ask? Fees. 60%-70% of actively managed funds lag the market average because of fees. This analysis is for another post. But managing your portfolio yourself, you
                can avoid these fees and make sound investment choices.
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