How To Pick Stocks
It is interesting that with so many financial literature out there, I have yet to come across one that gives you a step-by-step guide on how to select a stock. Most guides provide pointers to selecting stocks but they are never complete. There is a very good explanation for this. It is definitely not because nobody wants to share their secrets to successful stock picking. It is simply because nobody knows the formula. Guru investors such as Peter Lynch, Warren Buffett and Philip Fisher have dropped some hints here and there throughout their careers. Although they picked their stocks very differently, they are all equally successful.
So, I figure why shouldn't I share with you my investment strategy? I have some advantages over the gurus that allow me to be so open. First, I am a nobody. If my strategy doesn't work, I will not get bad press that will ruin my career (which I don't even have to begin with). Second, half the time, I don't even know what I'm talking about. Hence, people will be skeptic when it comes to scrutinizing my strategy. I wish I could be as powerful as Buffett such that when I announce I will buy shares of Anheuser-Busch (NYSE: BUD) the stock immediately jumps 5%. The truth is I don't hold that kind of influence on the market. So disclosing my strategy will not put me at an disadvantage or vice versa.
Picking Stocks The FatBoy Way
So how do I pick stocks, you ask. I use several methods depending on their results. If any of the methods yield a stock worth investigating in detail, I stop. But why do I use several different methods instead of just one? Simple. If I have funds to allocate, I want to look for a good stock to buy anyway I can until I have exhausted all possible options. If that happens, then I would consider putting the funds in the next best investment vehicle available, possibly short-term CDs, money markets, or savings.
Method 1: Screening
Screening for stocks is a very popular method recommended by almost everyone. It's the best way to narrow down the universe of more than 10,000 stocks available to buy. But screening is not as easy as it sounds. True you can find readily available screens anywhere. Yahoo! Finance alone has about 20 built-in screens. So does MSN and many other financial websites. How do you decide which screen to use? Different screens yield very different results. By favoring one over the other you could be missing out on the next Starbucks.
I don't use the built-in screens. I prefer to use a fairly restrictive screen to narrow down the selection. I like the Yahoo! Screener (not the HTML Screener). Playing it safe, I use the following criteria to screen for small, high-growth companies trading at a bargain price:
A healthy company should have lots of greenbacks. Free cash flow, in laymen terms, means moolah left over after expenditures. The more the excess cash the better. But I am excluding those with more than $1 billion free cash flow because I'm looking for small companies with lots of room to grow. We don't want Microsoft (no offense, MM :) ).
Earnings growth past 5 years greater than 15%
I want fast growing companies. I'm willing to accept 15% growth but am really looking for 20% or more. However, I tend to shun away from stocks growing at 100% or more. The problem with these kind of stocks is the growth is very hard to sustain. When growth is hard to sustain, disappointment is usually around the corner.
PEG ratio between 0.10 and 1.10
PEG ratio gives you a good idea about how the market values the stock. A fairly valued stock will have a PEG ratio of 1. In other words, the P/E ratio is equal to the growth rate. Hence, an undervalued stock will have a PEG ratio below 1. A stock with a PEG ratio of 0.76 means if you purchased the stock at the current price you are buying at a 24% discount. Cool, huh? So why not just buy all stocks with PEG ratio below 1? Well, like all other "formulas" in investing, the PEG ratio is not the formula for success. If it was, I'd be rich and won't be sharing this with you. There are many other factors that affect the price of stocks. Investing, as many will agree, is an art not a science.
Current ratio greater than 1.00
This one can really limit your choices. Even the mammoth retailer Wal-Mart (NYSE: WMT) will fail this test. Wal-Mart has a current ratio of 0.8. The current ratio tells you how easily a company can pay off its short term debt. A company with a current ratio greater than 1 means should creditors demand that they pay up immediately, they can still survive. A current ratio less than 1 indicates the company may have trouble with liquidity. So does this mean Wal-Mart is in big trouble? Not really. Wal-Mart is a grocer. Grocery products are cheap and easy to sell. In other words, the inventories can be easily converted into cash should the need arise. Compared to its peers Wal-Mart is in fact very healthy. So, if you feel this criterion is too limiting feel free to remove or adjust it.
Held insiders greater than 20%
Why does this matter? The more shares the management hold, the better. This indicates management's confidence in the company and themselves. It may also be a sign that the stock is flying under the radar. But like everything else in life, too much of anything is just as bad as too little of nothing. Seaboard (AMEX: SEB), which I reviewed recently, is 70% owned by its management. But it's not exactly good news.
The screen I setup above usually yields between 20 - 50 stocks depending on market conditions. If the market is down, you will get more stocks. But researching 50 stocks can be overwhelming. What I do from here on is adjust the criteria to trim down the list to about 20 - 25 stocks. Then, I quickly glance through the financial statements looking for improving balance sheet and other positive indicators, which I will discuss in detail in future. I can afford to be picky as I do the scan since I have quite a few stocks to pick from. I particularly favor strong brand names selling at a bargain. If this method does not yield any stock you like, it's time to look for alternatives.
Method 2: News, Financial Websites or Recommendations by the Pros
Perhaps you came across some website that recommended a stock that you thought worth looking into. The benefit of this method is most of the research is probably already done by a professional. But I never trust professionals. Not that they are always wrong. It's just that some of them may have misaligned interests. There's nothing wrong even if you follow their recommendations. Just make sure you do your own research. The Motley Fool usually have some good recommendations.
Method 3: Coincidence
This one is actually how Peter Lynch found most of his multi-baggers. You will usually be very glad if you could find one that you can buy. The best way to increase the chance of finding one is to notice what you use and encounter daily. Who makes the toothpaste you brush your teeth with? Who sells the razor you shave with? Who provides the gas for your fuel guzzling SUV? You will be surprised at how these little coincidences could very well be your path to a million dollars by 40.
These are the three methods I go by when I pick a stock. The last two are not methods per se. They are just unconventional ways of digging up the hidden gems. I hope you find these methods helpful. If you use some other methods or have suggestions to improve the methods I'm using, please let me know.
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I use almost the same exact screen that you have posted above. I also add dividend yield of 0.5% since most of the best companies pay some of that free cash back to the investor. So far this year it has provided me with a dozen stocks that have been 10+% winners and only two or three losers that I cut after a 8% decline. Best of luck to you!
Thanks, Evans! Good luck to you too. We shall see how my naked portfolio performs.
