give a professional take on some valuable general investing tips. Enjoy…
*Three Easy Steps for Picking Stocks*
By Wayne Mulligan
July 1, 2008
Someone just e-mailed me…
How exactly do you go about finding stocks to buy?
And after I read it, I really began to think about how my investing process
works. How do I go about identifying, researching and ultimately buying a
stock?
For many investors the process has evolved so much for them that it's tough
to tell what their exact methodology or framework is anymore. So after
reading that question, I decided to pull out my yellow legal pad and
literally write down my investing methodology…and here it is (the abridged
version):
*1. Stock Screen & Filter*
This part of the process isn't set in stone but it's what I find myself
doing when I'm searching for stocks that aren't on my radar yet. But many
times I'll simply find companies due to overall macro trends that I'm
following (e.g. wireless, China, etc.) and then I'll just skip this first
step.
But in the event that I am looking for new companies, what I'll typically do is use one of the free stock screeners out there (Yahoo! Finance has a great Java app for screening stocks). Here are some of the criteria I'll use:
Market Cap: Depending on which types of stocks I'm looking for (large-cap,
small-cap, etc.) I'll tweak this setting accordingly.
*Return on Equity (ROE):* This is an extremely important metric in
determining the overall health of a business and how competent management
is. Anything above 15% is a healthy ROE number.
*Earnings Yield:* This is a number many people don't look at but it's very
helpful in quickly screening for potential investments. The Earnings Yield
is basically the inverse of the P/E ratio, so it's Earnings divided by
Price. Think about it this way, if you could get a 5% yield on a government bond (a risk free investment), then wouldn't you want more out of a company you're investing in?
I'll typically look for companies with earnings yields north of 6%, but the
higher the better.
*Look Out For Debt:* While I'd ideally like a company with zero long-term
debt, some debt is ok as long as it's not breaking the company's back. So
make sure the company is able to comfortably meet interest payments
(interest coverage ratio) and that long-term debt doesn't make up the
majority of its capital structure.
*2. It's All Business
*After you get your list of stocks, the next step is to filter it down
further but this time you'll need to look a bit deeper than the numbers.
For me, I'll only invest in a stock if I really understand the business
behind it. I'll want to know exactly how the company makes money and what
makes it a better company than its competitors, etc.
So you would never see me invest in a chemical company because I just don't
know enough about the industry to say which company has a real advantage
over another.
So make sure the business you're investing in is one you're familiar with
and understand.
*3. What's It Worth and Is the Price Right?*
OK, so now we're back to the numbers — and here's where it gets tricky…
Let's say we're looking at a stock with a $500 million market cap.
How do we know it's not really worth $100 million?
How do we know it's not worth $5 billion?
The answer is tricky in that there is no single "correct" way to determine
the value of a business. Everybody uses their own metrics and equations.
But what I can tell you is that nobody will ever come up with the exact
value of a company. It's impossible to be right about something as dynamic
as a business. There's just too many different variables and moving parts.
So what is an investor to do?
For this topic I'll default to the kings of value investing: Benjamin Graham and Warren Buffett. To be clear, Graham was the one who came up with the concept I'm about to discuss, but Buffett's success in applying it makes it worth including his name here as well.
And the concept I'm referring to is, "Margin of Safety."
For example, if you think a stock is worth $1 billion, then you should only
buy it when it's trading for $500 million. Meaning, you should require a
Margin of Safety of 50% or more on every investment you make.
This way you eliminate a lot of the uncertainty and the risk involved in
trying to accurately value a company. If you get nothing else out of this
article, then I hope that the concept of Margin of Safety really sticks and
you use it in all of your investing operations.
Here's the process in a nutshell:
First, find a list of companies with strong financial characteristics and
make sure you really study the industry and who else is operating in it.
Finally, figure out what the business is worth and make sure you don't
overpay for it.
I'm obviously oversimplifying here, but I know if you stick to a regimented
system, whether you're buying a large cap tech stock or small cap
alternative energy company, you'll consistently outperform the market.
Throughout all my years of investing I've found that the big money was never made in the buying or the selling. The big money was made in the waiting. - Jesse Livermore
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