After decades of analyzing stocks and equal time spent investing for clients, I’m happy to share in plain English what’s involved in this process, what works, and what doesn’t. Keep in mind the reality that successful stock picking is an effort to maintain a good batting average. In baseball, a batting average of 0.30 or better is considered quite good. With stock picking, you have to do better than 0.50, which means you have more winners than losers
No one gets it right all of the time and it’s not even close. Wall Street analysts all have their selected lists and the financial media regularly hawk their 10 Stocks to Buy Now or something similar. Following that road usually is a direct route to disaster so don’t be tempted.
Determining Stock Prices
Let’s begin with the big picture: The stock market goes up and down over time, but the long-term trend is up. When there’s a rally under way, everyone feels like a genius. When the market hits an air pocket, though with few exceptions, almost every issue hits the skids. The key is the awareness that patience will be required and that typically means the better part of a year, if not several.
What takes place in the short run for individual stocks and the market generally is unknowable and is driven primarily by psychology. It is over longer periods that improving fundamentals that push stock prices higher become meaningful. In most cases, stock prices are a reflection of underlying profits. So a company that consistently improves its earnings will see its shares rise over time. Consistency will lead to a richer a valuation (that is, price-earnings multiple) since investors will view that as an indication of reduced risk. Healthcare as well as consumer staples companies typify this type.
When profit growth is accelerating, valuations often rise and vice-versa. Companies whose records are not as smooth may also see their shares rise, but earnings fluctuations along the way will lead to leaner valuations. Good examples are companies in the construction industry.
There are other issues to be concerned with. What if a company’s profits are rising but a substantial portion of those profits are from one-time developments? In that case, the one-time portion needs to be ignored. What matters are normalized profits and not reported profits. What should be ignored is growth in per-share profits that’s attributable to a reduction in outstanding shares. When companies have excess cash, it’s not uncommon for them to buy back stock. That raises earnings per share, but has no impact on net income. It’s essentially bogus
Company balance sheets need to be viewed as well. Although hefty borrowings may help some companies accelerate their momentum, the interest due on this debt will become a negative when overall business conditions deteriorate. Debt works both ways and will generally lead to leaner stock valuations.
Other things that impact stock prices include such things as earnings surprises (better or worse than forecasts), dividend increases (or decreases), mergers and currency shifts (for companies with significant international operations).
So where should you look for stocks? There are a number of websites that offer stock screening. A good starting point is to select companies with above average growth rates, below average valuations (relative to prospective growth) and solid finances. From there, one can refine in numerous ways. With respect to price action, the key caveat is to watch out for companies whose fundamentals appear to be strong while the price action is noticeably weak. Invariably, this means that there’s a flaw in the fundamental evaluation. That’s less likely in the case of stocks that seem to be going nowhere fast. Their time will usually come.
In almost all cases, patience will be the key to success.
Russell Wayne can be contacted at Sound Asset Management Inc.