Billionaire investor Warren Buffett looks for value when he buys stocks. Peter Lynch, the investment guru who once headed Fidelity’s giant Magellan stock fund, seeks companies with strong growth prospects. Both have been wildly successful, showing that stock-picking success can be achieved from different angles. Indeed, there is no one right way to pick stocks.
And many investors choose not to bother with the process at all, investing in them instead through mutual funds.
However, knowing the basics of stock picking is a fundamental skill that serious investors need to have.
One relatively basic method, used in variations by many professionals, is to combine the growth and value strategies prescribed by Buffett and Lynch. Look for steadily growing companies that are selling at reasonable prices, says Judy Vale, a portfolio manager at Neuberger & Berman in New York.
Vale, who manages a small-company mutual fund called Genesis, says exciting and volatile markets warrant a dull approach to investing--an approach that involves asking a lot of questions about the company’s fundamental business, then doing a little mathematical analysis.
So far, it’s worked nicely for her. Genesis, during Vale’s 21 months as its head, has handily beat the performance of the small-cap market as a whole. While that market--as measured by the Russell 2,000 small-company index--rose 39.6%, Vale’s fund climbed 49.4%.
So how can you find good stocks?
While there are no hard and fast rules, many professional investors screen companies based on a number of factors, including growth in sales and earnings, cash flow and net profits compared with total assets--better known as return on assets.
These figures are important because the future value of a company’s shares is likely to hinge on its ability to grow and prosper. Growth in sales and earnings is a mathematical reading of demand for a company’s products and services. Meanwhile, a company that’s earning a substantial amount on assets--Vale’s standard requires more than a 1% return on assets for a financial services concern and more than 8% for nonfinancial businesses--has proved it knows how to deploy its resources in effective ways.
What Vale looks for in terms of cash flow is whether the company is generating more cash from operations than it’s spending. That tells her if the company is earning enough on its business to finance future growth without resorting to borrowing or issuing more stock--either of which can prove detrimental to existing shareholders, she says.
Finally, she also tries to determine whether the company has a product or provides a service that’s unique and difficult to copy. If it does, it’s likely the company will remain a market leader for a longer period.
If the company makes it through that gantlet, its stock is analyzed to determine whether the price is cheap or dear.
Often that analysis hinges on the price-to-earnings ratio, which is a measure of how the company’s stock price compares to its per-share earnings. A company that earns $2 per share annually and sells for $20, for example, would have a P/E ratio of 10. This company’s stock price is equivalent to 10 times its annual earnings per share.
What investors must keep in mind when looking at the ratio is that every company has a normal P/E range. When the company’s stock price breaks out of that range, it’s time to ask why. If the company’s stock price is higher than normal compared with earnings, it can be an indication that its stock price is too high. Or it can indicate that the company is primed for unusually fast growth.
Likewise, when a company’s P/E is low, it can mean either that bad times are setting in or that the company’s stock price is a bargain.
Where do you find this average price-to-earnings range and a professional reading on the question of whether the stock is overpriced or cheap? There are numerous sources, but one of the most valuable--and easy to find--is the Value Line Investment Survey.
Value Line publishes detailed analyses of about 1,700 publicly traded stocks and ranks them for “timeliness” and volatility, says Stephen Sanborn, research director at Value Line Publishing Inc. in New York. These rankings are updated each week and are available in most major public libraries. (Many institutional investors also subscribe to Value Line, but the subscription cost--$570 annually--is high for a small investor.)
Stocks that receive 1 and 2 timeliness rankings are those that Value Line thinks will end up on the top of the heap over the next six to 12 months.
Value Line reports also give a history of the company’s P/E and rate its cash flow and growth. The reports don’t replace getting an annual report directly from the company you’re considering, but they can certainly help investors narrow the search.
The one caution to narrowing your stock choices based on Value Line’s timeliness rankings that Sanborn notes: Sometimes the top-ranked companies are clustered in just a few industries. If you aim to diversify properly--a requisite for anyone who wants to reduce his or her risks--you have to keep an eye on the industry groups you’re choosing and make sure you choose stocks in many different industries.
Once you’ve chosen a stable of stocks to buy, all you need to do is keep an eye on your selections to make sure you didn’t select poorly.
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