Stock-picking strategies

16 June 2014 05:24 am Views - 1894

Screening for value stocks

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:

• Share price should be no more than two-thirds of intrinsic worth.
• Look at companies with P/E ratios at the lowest 10 percent of all equity securities.
• PEG should be less than one.
• Stock price should be no more than tangible book value.
• There should be no more debt than equity (i.e. D/E ratio < 1).
• Current assets should be two times current liabilities.
• Dividend yield should be at least two-thirds of the long-term AAA bond yield.
• Earnings growth should be at least 7 percent per annum compounded over the last 10 years.

Margin of safety

A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective.
This use of a margin of safety works similarly in value investing. It’s simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of Rs.30 per share.

But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the Rs.26 per share in their scenario analysis.

The investor may find that at Rs.15 the company is still an attractive investment, or he or she may find that at Rs.24, the company is not attractive enough.

If the stock’s intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.

If a company has displayed good growth over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years

Stock-picking strategy: growth investing

In the late 1990s, when technology companies were flourishing, growth investing techniques yielded unprecedented returns for investors. But before any investor jumps onto the growth investing bandwagon, s/he should realize that this strategy comes with substantial risks and is not for everyone.

Value vs. growth

The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price.

Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies’ intrinsic worth will grow and therefore exceed their current valuations.

As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price.

Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.

No automatic formula

Growth investors are concerned with a company’s future growth potential but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis but these methods must be applied with a company’s particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry’s performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.

Given below are some of the aspects you should ask when considering stocks.

• Strong historical earnings growth

The first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. Below are rough guidelines for the rate of EPS growth an investor should look for in companies of differing sizes, which would indicate their growth
investing potential:

Although companies display this type of EPS growth in at least the last five years, a 10-year period of this growth is even more attractive. The basic idea is that if a company has displayed good growth over the last five- or 10-year period, it is likely to continue doing so in the next five
to 10 years.

• Strong forward earnings growth

The second criterion is a projected five-year growth rate of at least 10-12 percent, although 15 percent or more is ideal. These projections are made by analysts, the company or other credible sources.

The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company’s industry - specifically, what its prospects are and what stage of growth it is at.

• Is the management controlling costs and revenues?

The third guideline focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good but if EPS has not increased proportionately, it’s likely due to a decrease in profit margin.

By comparing a company’s present profit margins to its past margins and its competition’s profit margins, a growth investor is able to gauge fairly accurately whether or not the management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if the company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.

• Can the management operate the business efficiently?

Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company’s present ROE is best compared to the five-year average ROE of the company and the industry.

High annual revenue growth is good but if EPS has not increased proportionately, it’s likely due to a decrease in profit margin

• Can the stock price double in five years?

If a stock cannot realistically double in five years, it’s probably not a growth stock. That’s the general consensus. This may seem like an overly high, unrealistic standard but remember that with a growth rate of 10 percent, a stock’s price would double in seven years. So, the rate growth investors are seeking is 15 percent per annum, which yields a doubling in price in five years.

It’s not too complicated: growth investors are concerned with growth. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology. Even though the stocks might be expensive in the present, growth investors believe that expanding top and bottom lines will ensure an investment pays off in the long run.