Source: Thomas Nast's "Battle Of Bears And Bulls"
For this portion of the investment guide, I will focus entirely on my process of picking a stock. I am not saying this is the right way, only way, guaranteed way - none of those are true. My strategy has a major flaw: I do not do the phone-based research Peter Lynch advocates for in his books (or anything other than web-based research, really). More than likely that is why my growth isn't bigger. However, I am comfortable with the risks that I have taken, and what little I was able to invest in actual cash for a limited time I made money on. I also understand that the lower growth rate is the payment for being lazy. Keep that in mind.
Note: Anytime I mention stock specific information (price, P/E ratio, etc.) I will always add the date and time afterwards. The stock market changes constantly, so these numbers are only good as an example, not representative of what may be going on when you read this.
1) Pick an index.
The easiest way to start picking stocks is to pick an index. This will give you a list of stocks to look into and make the big wide worlds of stocks look a little smaller. There are a variety of indexes to choose from, the biggest U.S. three being the Dow Jones Industrial Average (DJIA), the NASDAQ, and the S&P 500. Each index has its own requirements that a stock must meet to be listed. For my personal portfolio, I started with the S&P 500.
Oh, another admission: I picked the S&P 500 because the numbers are smaller, so I don't feel like I'm on a constant roller coaster ride when I'm watching the news ticker of the stock prices go by. Remember in the first chapter when I mentioned people invest with their stomachs? Choosing the S&P 500 makes my stomach feel a little less queasy. Follow your stomach so you pick stocks you're more likely to stick with, even in tough times.
2) Find a listing of the companies on the index.
Wikipedia.org is what I used for this. Here's the current (8/21/11 5:19am) Wikipedia listing for the DJIA looks like:
3) Research the stocks on the listing.
Since we're already looking at it, let's go ahead and start by looking at stocks with the DJIA. The first stock is 3M. Yahoo! has some very cool, free tools to research companies with. I went to Yahoo! Finance to start my research. Feel free to use some other research tool (web, magazine, annual reports), but know that the guide may be less helpful to you from here on out. I may go through these later, if people ask for it, but understand that will take some time for me to try out strategies and see the results. If you want to follow along, go ahead and load the website. I'll wait.
Ready?
Near the upper left hand corner you'll notice a little box that says "Get Quotes." From the Wikipedia listing, you'll notice that 3M's stock symbol is MMM. The stock symbol is an easy, quick way to identify a stock as prices are scrolling by your screen. Enter MMM in the Get Quotes field on the Yahoo! Finance site.
What is all that crap?
Information. Most of it I feel pretty safe in ignoring. If you want to pour through the information and you have the time, go for it. I'm lazy by nature, so take this for what it's worth.
The best growth stocks are boring, undervalued, and have good looking balance sheets. "Boring" and "undervalued" are both relative terms, so looking at information on a company's competitors can be a good starting point for finding the gems.
For "boring", you can check the volume statistic. Volume is the number of times stocks are bought and sold. If a company's volume is 6 million, it means 6 million stocks were either bought or sold in that time period (usually reported daily). If more than 50% of the volume were stocks that were bought, then the stock price goes up. If more than 50% of of the volume were stocks that were sold, then the stock price goes down. The more a company is traded, the more well-known the stock tends to be, and the more volatile the price. The reverse is also true.
If you're still on the Yahoo! site, scroll down and click on the "Competitors" link, underneath COMPANY on the left-hand sidebar. 3M's Competitor screen looks like this (8/21/11 5:45am PDT):
3a) Analyzing the P/E ratio
In general, an undervalued stock has a low P/E ratio.
So how do you know if a stock has a low P/E ratio?
My way is to look at the industry average. For 3M's screen, the industry average P/E ratio listed here is 13.50. This means that for every $1 of earnings, the price of the stock is $13.50. Keep in mind that the P/E ratio also represents the number of years it will take for you to earn your money back. On average, it will take a company in 3M's industry 13 1/2 years to make an equal return on your money. See why a low P/E ratio is good? A company with a P/E ratio of 5 would earn back its investment in 5 years. 3M's P/E ratio is 13.05, a little below industry average. This suggests that 3M has pretty much saturated its market, so we might research this stock later if our portfolio needs dividends (to be covered in a separate chapter).
Now what?
Look for a P/E ratio on the screen that's below industry average. Notice that AVY (Avery Dennison Corporation) has a P/E ratio of 9.37, well below the industry average of 13.5. On the surface, this suggests that Avery might be a better growth investment than 3M. Click on the AVY stock symbol on the competitor's chart to go to that company's stock page. Sometimes it's a useful exercise to click to the competitor's chart again, to see who AVY competes with: sometimes there are different stocks listed than are listed on 3M's page. For now, scroll down and click on Balance Sheet, left-hand sidebar, underneath FINANCIALS.
3b) Analyzing the Balance Sheet
The balance sheet is a listing of a company's assets, debts, and stockholder's equity. Let's pull out the important information to analyze to determine if AVY's low P/E ratio is because it's undervalued, or a representation that the company is on shaky financial ground.
To determine if a company is solvent, I need to check the company against a "worst of the worst" case scenario. What would happen if the company lost all sales and all its debts were made due tomorrow? Would the company survive, or would it have to declare bankrupcty?
The first bit of data is the assets (8/21/11 6:14am):
I've pulled out this part of the assets table because the other items are either long-term assets (difficult to liquidate when the business needs immediate cash) or because they don't represent physical items that can produce cash (like the intangible assets).
Add the "Total Current Assets" and "Property Plant and Equipment" line.
Total Current Assets - the number which represents the most liquid of a company's net worth, usually in the form of cash, inventory, and other on-hand assets.
Property Plant and Equipment - While not as liquid as current assets, this number represents the amount of the company's net worth tied up in property, machines, desk furniture, etc. However, keep in mind that this number is usually over-estimated, due to some funky ways of accounting for depreciation and property values.
If necessary, AVY could raise 3.213 billion in cash on a relatively immediate basis. But that doesn't mean anything just yet.
Source: Allfree Logo
What about debts?
I'm so glad you asked. In our doomsday scenario, AVY is sitting on a nice, plump pile of cash. But the big bad creditors are about to come calling. What happens once all the creditors are done taking their part of AVY's pile?
AVY's liabilities look like this:
Now, I'm very mean and protective of my money. You should be too. So we want to make it as hard as possible for the company to survive our doomsday scenario. While long-term assets were ignored, long-term debts are counted. The only number we look at here is Total Liabilities - 3.453 billion.
3.213 billion (Current Assets) - 3.453 billion (Total Liabilities) = -$240,000,000
Source: Business Cartoons
Under what conditions would this still be a good investment?
This is where my strategy is inadequate. Behind every company is a story, a reason for why they are where they are. My personal stock picking strategy ends here; I would move on (and for the purposes of this guide we will). But, an investor who pushes a little further here would probably get better returns than I. This is the place where you could do phone research. Peter Lynch mentions talking to CEOs; I haven't tried it (would you believe I'm nervous?). But it is possible that there is a story behind AVY that would make it a comeback kid and bring great returns. But there is also the risk that AVY won't be able to improve its position, and eventually the company will fold. Knowing the story mitigates that risk.
This is also where non-web-based research can come in handy. If there is a investment magazine out there that has featured an innovative AVY product that might turn the company around, I wouldn't know. I don't subscribe to investment magazines, for the simple fact of lack of money. I suspect the average investor who will be reading my blog doesn't have the money for it either, which is why this focuses so much on web research.
Ugh. I tried to go through the rest of the DJIA listing, but I wasn't finding what I liked. To continue this guide, let's look at one of the stocks I've been following, Cummins (CMI). CMI is the darling of my portfolio right now; even accounting for the latest rollercoaster ride, CMI is up 171% from when I purchased it, and the numbers still look very good.
Here is the same balance sheet information from CMI that we looked at with AVY, but notice the difference in the numbers (8/21/11 7:02a):
6.289B + 2.041B = 8.33 billion Current Assets
8.33B - 5.732B = +2.598 billion dollars
Cummins has a current networth of over $2.5 billion dollars U.S. This means in our doomsday scenario, the company would be able to weather the storm and still end up with money to start over. The property portion of current assets, which I know to be overstated, is only 1/4 of the total current assets, so you could even cut CMI's property values by half and it would still be in the black at the end of the day.
You'd never know about Cummins' great numbers if you only watched the standard TV channels though. To have known about this company before you started research, you likely would have known about diesel engines. But how many people in the industry (even Cummins' own employees) actually take the step to invest in a gem that's sitting right under their noses and fingertips?
I'm a mechanic now, but CMI attracted me long before I knew anything about engines. After talking to people who have more automotive history than I, all of them have stated something along the lines of "Cummins? They make great diesel engines!" Back in part 1 I mentioned that if you like the product, you'll love the company. Nothing like real-world practice to shore up idealized theory.
4) Buy the stock.
Yup, I'm saying it, because I know that there will be people who will work all the way through the guide, go up on their favorite stock trading website, get ready to click that buy button, and go make themselves a cup of coffee. . . and then read the newspaper. . .and then walk the dog. If you're not truly comfortable with investing, walk away and never put a dollar into stocks. But if you done the research, you have better chance at making money on the stock market than those who consider what they do "playing" the market. If six out of ten of your investments make money, you've done better than the majority of fund managers out there.
I bought the stock. Now what?
Watch the stock grow (but not so much you get nervous). Once a year, I go through the process all over again. If any companies in my portfolio fail the requirements, I dig deeper to see if there's a reason the situation has changed. Did they take a big loan to buy equipment to produce a new product? Big debt loads aren't a problem if used to further growth, but debt loads needed to pay the bills suggest a failing company. If the numbers and story suggest the company is going downhill, cut the stock now. You may be on an upswing, but the price will come crashing down once reality sets in.
Any single statistic you look at doesn't necessarily point to a good investment, but when taken together, these little bits of data point to a company that is set to grow steadily and make a solid winner in a portfolio, or warn you about a company that may be experiencing difficulties. However, I hope I have emphasized enough that my strategy has its failings and a slightly lower growth rate than its potential, but I am willing to exchange that for being lazy and slightly more conservative.
Coming soon - Stock Market Investing Part 3 - Picking Growth Stocks For The Slightly-Less Lazy Investor
