I thought I should capture some economic indicators that can help you make an informed decision when buying stock. These indicators and theory can be found in many places but it’s easier if they are in the same place, eh?! None of these indicators are an ultimate factor but each gives you a picture of a company – the more positive findings, the better the investment. These are the ones I used but each investment school thinks some others are more important. It might be so but one needs to walk before running.
Indicators to identify a bargain stock
- P/E (Price/Earnings) Ratio – I discussed it before. A good investment has a lower/much lower P/E than its competitors/sector/industry. It shows how quickly, keeping up the earnings the same, the stock will be paid off from these earnings. A company with a P/E of 30 but with a 80% annual growth for the last 3 years most probably is a much better investment than one with a P/E of 25 but with 20% annual growth. Rule of thumb is that one should be very cautious with companies with P/E over 30-40 (they might still be a very good investment but please check carefully)
- Price-to-book Ratio – How much the company is valuated on the market compared with the declared assets. A Price-to-book below 1 seems like a real bargain (in theory, if the company would be liquidated, you would get more money than if you were to sell your share on the stock market)… but be wary! Corroborate with all the other aspects, with its competitors/industry to find out WHY it is so undervalued. Below 2 should be still be fine.
- Price-to-sales Ratio – Share price divided by revenues per share. It is useful when evaluating how quickly the company is growing and how fast it is growing its sales/revenues. Smaller is better – useful when comparing companies in the same sector. A company might be growing very fast, becoming quickly competitive, yet it did not attract yet the attention of the analysts, investors.
Financial Strenght (debt evaluation)
- Quick Ratio – this is a quick look at the cash flow, the power of the company to cover its short-term debts with the money it generates. Above 2 is a sign of financial strength.
- Debt-to-Equity Ratio – Total liabilities divided by equity of the shareholders. A high ratio here means the company is financing its growth by borrowing and that the growth would not be sustainable in time. (Sort of a person taking 10K from a line of credit and then bragging “I have 10K all the time in my chequing account”). It should be checked within the industry range. Capital intensive industries might have such a ratio as high as 2, while others have a normal range of below 0.5. Should be looking for those below 0.5.
- Dividend Payout Ratio – This is the yield (money paid out) vs earnings per share. When we chose a company for the reason it pays dividends, we want to make sure they will continue to pay those dividends. Remember – dividends can be suspended at any time. Beside the length of time the company has a solid dividend paying record. Each recommends a different threshold – some people recommend a ratio of below 50%, others like it to be a little big bigger (70-80%), because it means the management is committed to having performance of the company high. In any case, any dividend payout ratio over 80-90% is a red flag. There are companies paying over 100% but, in long term, that is not sustainable (they pay more than they earn). Mind you – some investments – like REITs – are forced, by law, to distribute more than 90% of their income to investors, so it is ok in those cases to have a payout ratio of (let’s say) 95%.
Earnings-per-share, Sales, Dividend Growth Rates – all these, when compared to the competition/industry average, show how fast the company is growing. A company with traditionally not so good indicators – which makes it stay below the analysts’ radar – but with low debt and big growth in the late 1-2 years – might allow you to be an early investor in a success story.
Beta – discussed before. It is an indicator of price change. Not so important in economic terms but important for your risk-tolerance. The higher the Beta, the more the price of the shares fluctuates. If you are easily unnerved, avoid anything above 1.
There are many other indicators for the solidity of a company. Some are composite indicators I.e. GER Analysis is another composite indicator which combines some of these indicators and some others: P/E, Debt-to-Equity, Return-to-Equity, Price-to-Earnings-vs-Growth, Growth rates, Earnings-per-share, Revenues to provide a composite number 0 (weak) – 100 (strong).
I thought I shouldn’t close this cycle without giving you basic tips. In the end, keep in mind that only YOU have to judge and understand what makes sense for you. I know, I know, it’s difficult: you have to take responsibility of your life and your decisions and who is ready to do this?!
The simplest thing are mutual funds. As you most probably know, mutual funds are a collection of stocks, meant to spread the risk over a number of companies of either the same profile, or in the same country, region etc. There isn’t much to evaluate:
- what sector/country/type of business you believe will grow. There are technology mutual funds, health, energy, emerging markets… endless possibilities.
- what type of fund you select – large or small: large funds have stability should problems show up but the downside is that they tend to have issues liquidating assets not performing. Think about it: selling 3% of 10 billion dollars, means selling 300 mil $ worth of stocks and they cannot do that overnight, especially when that asset has hit hard times, or else they might shoot themselves in the foot, dropping the price even lower.
- who manages what. In this area the mutual fund manager is important – experience in finances, experience in that sector etc. Do your homework because it will pay.
- performance. Look for a track of performance and check the best and worst years. Especially the worst to see if you can stomach those drops. At the same time, if the average looks good enough and you are not really close to retirement, take a chance because there is no gain without pain. Many mutual funds with high-load boast about their “performance” in years when the market is losing money. i.e. A mutual fund might lose 15% when the industry it’s focused on lost as a whole -23%… yet as somebody was pointing, we can’t eat negative returns. Same mutual funds in years when the industry made 12%, only managed to achieve an 7%…
- Fees. MER (Management Expense Ratio) is the most important because it is ongoing. A mutual fund with 0.7% is a great deal but most, in Canada at least, charge 2.3-3%… It might seem paltry to bargain over 1% yet over years that translates in lots of money. Ofc, as somebody was pointing out there is no point in getting a very low fee fund if it doesn’t perform… yet there seems to be no direct relationship: there are low-MER funds that perform well and high-MER ones that don’t do so well. Other fees that can kill you are the loads: front-load and back-load. Front-load means they take a commission upfront, while backload means they will take some money, less and less as years go by. Usually most of it goes to the financial advisor. Most of the funds have versions that incorporate a 1% for the financial advisor while one can get the same mutual fund without that load or with a much lower load when buying a different series of that mutual fund. I personally believe that in the beginning, index funds are great – very low MER and very few other funds manage to beat them year over year. All you need is to figure out what area of the economy will grow. I have 2 iShares mutual funds – Gold and Asia without Japan – doing quite well.
- Don’t forget to chose DRIP in case they pay dividends (and many do). Year after year, those dividends will start making a difference.
With the stocks the situation becomes more complicated – more work, more risks but at the same time potential for more growth is better. I generally subscribe to a number of newsletters who bring to my attention a number of companies within the larger picture of the industry. It was said that an average company within a stellar industry performs much better than the best company in a sector in recession. What we are trying to achieve is identify a good player in a good/excellent industry. Stay away from top performers posted in your local newspaper – read about them but normally, if they hit the large press these stocks are overpriced. How do you know that a stock is overpriced, how do you know when it’s risky?!
- P/E Ratio – Profit of the last year/Number of shares = Earnings Per Share (EPS). Divide the price of the stock with the EPS and you get P/E Ratio which is a basic indicator of how much is the confidence in that company. Another way to put it, this P/E Ration shows how many years the earnings of that company should stay at least the same to pay for the stock itself – to get your money back. Both Google and Apple, i.e. show a P/E of more than 22, yet they grow a lot each ear… P/E Ratio is only relevant when compared to the industry average but it is something you can take in consideration. Check the growth of the company as it may justify the large P/E Ratio.
- Dividend/Yield – if you, like me, are focusing on dividends (recommended in these uncertain times), this is important. Check for companies with long track of paying dividends, since these are not guaranteed but a long track says something. Yield will change over time as the price of the stock unit increases or drops: it’s the value of the dividend divided over the total cost of the share: i.e. if the company pays 1$ in dividends per year and the stock is currently 10$/share, the yield is 10%. If the share prices becomes 20$, then the yield is only 5%. Focus on companies that increase their dividends over years.
- 52-week price: shows the low-end and the high-end of the stock during the last year. If the company is financially sound (check their financials) and the price is close to the bottom, chances are you will be doing good.
- Beta – index to show how volatile a stock is, or else said how much its price varied in the last year. S&P500 – is given a beta of 1. If the Beta index of the company is below 1, it means it was more stable than the market; if it is over 1 it is more volatile. Normally, you should look for stocks with high-returns with a beta bellow 1. If you can stomach higher risks and the company has a Beta over 1, it might still be a good deal, since higher risks should always mean higher potential return. But by itself it’s not a good indicator because it is only math, not the real situation of the industry which might be in a restructuring period etc. Use it only for short-term planning.
There are more indicators but the best indicator is common sense. It is a fun game but don’t expect to win it every time. If you are not a gambler, then don’t gamble! Make solid investments that need maybe 1-2 re-adjustments per year and keep an eye on them monthly – in normal times even this could be bypassed yet surprises are to be expected in such a roller-coaster ride. Never “play” more than you can afford to lose – maybe a 10% of your portfolio – this means buying and selling on short term, stocks not so reputable. They might be a bargain but then again neighbour’s garbage is an even bigger bargain.
Other rules of thumb which, while well-known, might be news for some of you. These are normal fluctuations:
- “sell in may and go away” – stocks drop over the summer as industrial activity slows down, less interest in the market, people redeeming investments to pay for vacations. Yet, I would recommend to start when everyone else is selling. Yes, they might drop a little bit more yet in September, if you chose good investments, it will pay off and you will rejoice with the timing. Beside this, much timing cannot be done on the investments, unless you are a day trader… in which case, why the hell are you reading this?!
- It’s normal for companies being acquired to have the stock going up and for the ones purchasing to have their stock going down
- Before the dividend date, many investors buy that stock 1-2 weeks, maybe 1 mo, in advance, depending on the rules established (“this will be paid to investors who were on the record at the date X”). Buy outside of those rush periods and you might save a 1-2% or even more. In general, try to avoid the stampedes for a certain stock – for every Apple, there are many obscure but solid investments.
- If your stocks follow the market indexes (NASDAQ, Dow Jones), don’t panic – it’s quite normal. Actually, don’t panic in any circumstance. Keep an eye on the investments and if they have sudden moves – drops or raises check the news to see what caused those moves.
Get Rich! Slow!