FIVE PROVEN TOOLS TO HELP POLISH YOUR STOCK-PICKING SKILLS FOR 2018
Each of these tips can make you better prepared, Peter Hodson writes.
One of the questions we get regularly from our customers at 5i Research is along the lines of, “How do you actually go about picking stocks?” Well, this topic could fill a few book volumes and we only have 800 words of space for this column. But we can give you five methodologies for stock picking that have proven themselves over time. None of these should be used on their own, but each can form the basis for beginning research on a stock idea.
PRICE/EARNINGS RATIO (P/E)
Most investors are familiar with this ratio, comparing the company’s earnings on a pershare basis with its share price. But the ratio varies widely: A P/E could be 150 times for a fast-growing tech company, or six times earnings for a small industrial company. For example, Amazon (AMZN on NASDAQ) trades at a P/E of 278. Exco Technologies (XTC on TSX) trades at 9. P/E ratios will vary based on company growth, balance sheet strength, liquidity and a host of other factors. Some investors will specifically look for low P/ Es (value stocks), whereas others are willing to pay a lot more for growth stocks. Generally, in your portfolio, a mix of each is probably best. No one wants to overpay for a stock, but if you avoid high P/E stocks you may be missing out on some very fast-growing companies. Keep in mind there is (usually) a very valid reason for a stock to have an expensive valuation. You just need to determine if that high valuation is justified, and sustainable.
PRICE-TO-CASH-FLOW RATIOS
Similar to the above, this ratio for stock screening looks instead at cash flow rather than earnings of a company. There are two main reasons for using this ratio instead: First, cash flow is much harder for companies to manipulate than earnings. It measures the actual cash coming into the company, rather than earnings which are typically set by accounting definitions. Two, it is cash that is needed to pay dividends and pay for stock buybacks. Dividend-seeking investors care far more about whether their dividends can be sustained. These income investors don’t really care about earnings as long as the company’s cash flow covers its dividend payments.
PRICE MOMENTUM
Personally, I love momentum as a stock screener. Effectively, having a stock price rise (with strong volume is better) tells you one thing: other investors think it is a great company, and are willing to pay more for it. Having ‘friends’ with money along for the ride is almost always helpful when owning a stock. In addition, as a stock rises a company’s market cap also rises, of course, and a higher market cap can attract a whole new set of investors. This is particularly true for smaller companies as they cross the $100 million market cap barrier. Now, of course, momentum can change, but generally a rising stock tends to keep rising. This is one reason we rarely advise our customers to “sell into strength.” We see stock strength as a sign that everything is good at a company, and others have noticed as well.
BOOK VALUE
Many value investors look at book value, to determine — more or less — the minimum value of the company if it were to be sold. We are OK with this ratio; however, there are drawbacks. For one, many fast-growing companies, particularly in the tech or software sector, do not have much book value at all. A software company is generally just people and computers, with very few hard assets. Thus, a focus only on book value can limit your investment universe dramatically. Second, book value of a company can either be much higher, or much lower, than actual value. For example, a real estate company might be carrying on their accounting books properties at decades-old prices. A sale at market prices would net a huge gain. On the other hand, a company in a declining industry — printing for example — might show a large book value but its assets might not be worth anywhere near what they are carried at.
RETURN ON EQUITY (ROE)
Many investors like ROE as a single number for stock screening. We know some very successful fund managers who base their whole portfolio on ROE. Effectively, ROE shows you how much a company makes from the equity in its business. A recent Bloomberg screen shows companies such as Air Canada (AC on TSX) with a return of equity of 142 per cent last year, and Norbord Inc. (OSB on TSX) at 45 per cent. One of our favourites, Constellation Software (CSU on TSX) is 43 per cent. But a simple screen can also be misleading. Sigma Industries (SSG on TSXV) screens for a ROE of 110 per cent, but the entire company is only $5.6 million market cap, making it a risky stock (still, the stock has risen 243 per cent this year!).
Of course, for stock picking, these points only scratch the surface. They can be a good start, however, when looking at companies for the first time. The key to any ratio is to determine why a ratio is high, or why it is low. There is nothing wrong with paying for an ‘expensive’ company, if its valuation is justified. But there can be great returns also in buying a ‘cheap’ company, if the reasons for its low price can change, or its price is so low it reflects all possible problems.