1. The Analysis Process

Experts tell us that investment success requires a disciplined approach to finding, researching, and analyzing potential investments. This chapter describes one such approach, and the ensuing chapters fill in the details. It’s based on sound principles that are practiced by market-beating money managers. It’s certainly not the only way, and it may not be the best way. But it’s a place to start, and following it will make you a better investor. After you’ve mastered these strategies, you can modify them to suit your needs.

The process involves identifying potential candidates, weeding out the obvious misfits, researching and analyzing the survivors, picking the best prospects, and, equally important, applying a clear-cut set of selling rules.

Identifying Potential Candidates

Finding stocks to analyze can be as easy as visiting the gym, talking to your neighbors, picking up a magazine, surfing the Internet, or turning on the TV. You’ll find no shortage of tips. You’ll welcome all such advice once you’ve gained confidence in your analysis skills, because you’ll be able to weed out bad ideas quickly.

As your experience grows, you’ll get a feel for how to identify strong candidates. You’ll find yourself increasingly taking advantage of screening to uncover investment ideas. Screening is a technique for scanning the entire market for stocks meeting your requirements. It’s a powerful tool, but to use it effectively, first you have to understand how to identify the best candidates. That will come with time. In the meantime, I’ve provided a few sample screens in Chapter 3 to get you started.

Treat all names you get, whether from your own screens, friends, TV gurus, or even Warren Buffett, as tips to analyze using the techniques you are about to learn.

Concentrate on the Strongest Candidates

Our analysis techniques utilize a survival-of-the-fittest strategy, which entails weeding out the weakest candidates at every step of the analysis. This strategy works best if you start with a large group of stocks—say, 10 to 20—instead of just a few. Researching stocks takes time and effort. Eliminating weak contenders as soon as you discover them enables you to focus your research on the strongest candidates. Be ruthless. There is no point in wasting time researching stupid ideas.

Quick Prequalify

Use the quick prequalify test to rule out the obvious misfits. These may be stocks that would be bad news for any investor. Perhaps they’re firms with businesses based more on hype than reality, with little or no sales or earnings. Or they could be stocks that simply don’t fit your investing style. For instance, perhaps they’re worthwhile value candidates, but you’re a growth investor.

Here’s what’s included in the quick prequalify tests:

• Company and industry overview: Learn about the company’s business and industry. It may be in a market sector that you favor or one that you want to avoid. For instance, some pundits say that demand for crude oil will exceed supply for the foreseeable future, driving up all energy prices. Others disagree. So your take on that topic would influence how you view deepwater drilling companies and energy stocks in general.

• Market capitalization defines a company’s market value. It’s how much you’d have to pay to buy all the shares. The biggest firms are designated large-caps, and progressively smaller firms are termed mid-caps, small-caps, and micro-caps.

There is no good or bad market capitalization, but each size has its own potential risks and rewards. Generally, larger companies are safer investments, but smaller firms offer more growth potential. That said, even these generalities vary with market conditions.

You may decide that a particular company size range best suits your needs or, conversely, that you’re open to all possibilities. Whatever you decide, in this step, rule out the candidates that don’t fit your requirements.

• Valuation ratios such as price to earnings (P/E) or price to sales (P/S) tell you how market participants view a stock. High valuations reflect in-favor stocks with strong growth expectations. Thus, they appeal to growth investors. Conversely, value players look for stocks with low valuation ratios, indicating that most market players (growth investors) view them as losers.

Any given candidate will fit into either the growth or value category, but not both. The valuation ratios give you a quick read as to whether you have a value or growth candidate on your hands.

• Trading volume is the average number of shares traded daily. Low-trading-volume stocks are a bad idea because they’re subject to price manipulation. Further, mutual funds and other big players can’t buy them. Here’s where you’ll toss these bad ideas.

• Float: Corporate insiders such as key executives and board members are restricted as to when and how often they can buy and sell their company’s shares. So, insider-owned shares are considered unavailable for trading. The float is the number of outstanding shares that insiders don’t own, and thus are available for daily trading.

Acceptable float values depend on your investing style. Large firms typically have floats running from a few hundred million shares into the billions. However, investors looking for stocks with maximum growth potential often seek out stocks with much smaller floats, typically below 25 million shares. With relatively few shares available, small float stocks could take off like a rocket when the company reports good news and the demand for shares overwhelms the available supply.

• Cash flow: While reported earnings reflect myriad accounting decisions, cash flow is the cash that actually flows into, or out of, a company’s bank accounts from its operations. Because it’s based on actual bank balances, cash flow is the best measure of profits.

Except for the fastest growers, viable growth candidates should be reporting positive cash flow, meaning that cash is flowing in, not out. Thus, this is the step where growth investors would rule out cash burners. On the other hand, value investors would take a longer view and overlook negative cash flow triggered by short-term problems.

• Historical sales and earnings growth: Whether you’re seeking out-of-favor value prospects or hot growth candidates, your best prospects are firms with a long history of solid sales and earnings growth. In this step, you’ll dispose of stocks that flunk this basic requirement.

• Check the buzz: There’s no point wasting time researching a stock if its main product has just been rendered obsolete by the competition. This is where you catch up on the buzz surrounding your candidate. If you’re looking for growth stocks, negative buzz is bad news and disqualifies them. For value prospects, negative buzz reflects the market’s disenchantment with the stock, thus making it a better value candidate.

You will eliminate many of your bad ideas during this quick prequalify check. Once you get the hang of it, you’ll be able to run each stock through this test in less than five minutes. Take your survivors on to the detailed analysis.

Detailed Analysis

Part II of this book, containing Chapters 4 through 14, describes 11 different stock analysis tools that can be applied to both the value and growth investing styles. Chapter 16 describes how to apply these tools to analyze value candidates. Chapter 17 does the same thing for growth candidates.

The value and growth analysis strategies both consist of 11 steps, each step using the corresponding analysis tool. For instance, Step 7 involves analyzing a candidate’s financial health and employs Tool #7, Analyze Financial Fitness.

You’ll get the best results by familiarizing yourself with each of the 11 tools described in Part II before attempting to analyze value and/or growth candidates.

Eliminate a candidate as soon as it fails any step. For example, don’t carry a candidate to Step 2 if it fails Step 1.

Step 1: Analyze Analysts’ Data

Brokerages and other firms employ stock analysts to evaluate and rate stocks. Start your detailed analysis by reviewing analysts’ buy/sell recommendations and earnings and revenue forecasts to determine the market’s enthusiasm for your candidate. The best value candidates are stocks that analysts don’t like. Conversely, growth investors need to see some, but not too much, enthusiasm for their candidates. The Sentiment Index, described in Chapter 4, is a useful tool for gauging analysts’ enthusiasm.

Analysts’ earnings growth forecasts are another measure of a stock’s suitability as a growth or value candidate. Strong forecast earnings growth disqualifies value candidates but identifies good growth prospects.

Step 2: Valuation

Valuation is an important issue for both growth and value investors, but for different reasons. If you’re looking for growth, checking valuation tells you whether you’ve arrived too late at the party. For value candidates, valuation analysis tells you whether the upside potential justifies the risk.

Step 3: Establish Target Prices

Value investors typically set target prices to establish buy and sell points for qualified stocks. For instance, a stock may appear to be an attractive candidate, but a target price analysis might find that its current share price is too high to offer the needed risk/reward ratio. If so, the value investor might wait for the stock to come down in price before buying. It isn’t bought if it doesn’t reach the required buy price. Once purchased, the stock is sold when it reaches its calculated sell price range.

Although setting buy and sell targets is a linchpin of the value strategy, growth investors could benefit by going through the same analysis. Tool #3, Establish Target Prices, makes it easy.

Step 4: Industry Analysis

For growth investors, companies operating in fast-growing market sectors make the best candidates. By contrast, value investors find the best prospects in slower-growing markets. In this step, you analyze your candidate’s industry growth prospects and related factors. If you’re looking for growth candidates, picking an attractive industry is all for naught if you pick the wrong player. Consequently, the industry analysis also describes how to pick the strongest player in an industry.

Step 5: Business Plan Analysis

Wal-Mart dominates the retail industry, while former champ Kmart has fallen by the wayside. The difference is in the business models. In this step, you determine if your candidate is more like a Wal-Mart or a Kmart.

Step 6: Evaluate Management Quality

Many money managers consider gauging management quality an important part of the analysis process. You don’t have time to visit candidates’ plants and schmooze with key executives, and you don’t have to. You can evaluate management quality from the comfort of your own home by reviewing the relevant experience of key executives and directors, measuring the firm’s accounting quality, and completing other easily accomplished checks.

Step 7: Analyze Financial Fitness

You lose big if one of your stocks files for bankruptcy. But it doesn’t have to go bankrupt to ruin your day. Just the rumors that it might are enough to sink its share price. Stock analysts typically don’t check a firm’s financial strength before advising buying. That’s why so many advised buying Fannie Mae, Freddie Mac, Lehman Brothers, and other recent bankruptcies just months before they failed.

You don’t have to be a victim. You can measure any public corporation’s financial health using the strategies described in this step.

Step 8: Profitability and Growth Analysis

In the long run, stock prices follow earnings. In this step, you analyze sales and profitability trends to determine whether your stock’s earnings are more likely to head up or down from here. You also find out if your candidate is really profitable or just gives the appearance of making money.

Step 9: Detect Red Flags

You lose big when your stock reports disappointing results or management cuts growth forecasts. Those disasters usually don’t come without warning, however. In this step, you check for red flags signaling future disappointments so that you can act ahead of the news.

Step 10: Ownership Considerations

It may not be fair, but it’s a fact of life that mutual funds and other institutional buyers have access to better information than individual investors. Thus, it makes sense to see what the big players think of your stock before you buy.

Insiders are directors, key officers, and large investors. While it’s good when key officers and directors hold big positions in the company, too much insider ownership signals danger.

This is where you sort out institutional and insider ownership data to determine if it’s favorable or unfavorable.

Step 11: Price Charts

It’s against the law, but sometimes investors who are privy to market-moving news about a company’s prospects act on that information before the news gets out. When that happens, the stock’s price action might be your first clue that something is going on.

In this step, you learn how to find out whether the stock chart is signaling that it’s okay to buy.

Analysis Scorecards

Chapter 18 includes separate scorecards for growth and value analysis candidates. Make copies and fill out the appropriate scorecard when you analyze a stock. You’ll be amazed how just filling out a scorecard will improve your results.

When to Sell

For many, determining when to sell is more difficult than deciding what to buy. When things go wrong, it’s easy to procrastinate on selling while you wait to see if your stock moves back up tomorrow.

Establishing a strict sell discipline is an effective antidote for seller’s procrastination. However, in many instances, a condition triggering a sell signal for growth stocks wouldn’t apply to value stocks. For example, a cut in earnings forecasts triggers an automatic sell for growth investors, but it wouldn’t faze a value player. Conversely, a strong price chart would be good news for growth investors but might trigger a value stock sell signal.

Both the value and growth analysis chapters include sell rules specific to each style with no wiggle room.

Summary

Following an organized approach to finding, researching, buying, and selling stocks will make you a better investor. Now that you know where we’re heading, read on to get started.