Don't Get Burned By Hot Stocks (and How To Find Good Ones)
Early this past summer, I got a call from a fellow
whose portfolio had lost almost one third in less than two months while the
market was moving steadily higher. When
I asked how this happened, he said he was "investing" in hot tips he
got online.
I came across an even more troubling situation last
year when speaking with the sales assistant of a stockbroker whom I had known
for a long time. The broker was an
amiable gentleman who built a sizable practice based on a carefully cultivated
image. He was a tall man, with a neatly
trimmed gray beard, and always wore gold-framed granny glasses. His semicircular desk held a half dozen large
monitors, each of which had a colorful chart or table prominently displayed.
There was little beyond the image. Although his background in investing was one
step above nonexistent, his "marketing efforts" succeeded in rounding
up hundreds of accounts. Sad to say, he
got an unfortunate diagnosis a couple of years ago and the practice ended up in
the hands of a staff whose prime responsibilities had been answering phones,
scheduling appointments, and keeping files up to date.
When I heard the news from his assistant, I asked how
the accounts were being managed. Her
reply: "We get stock recommendations online." My reaction: shock.
Here's the problem.
There's an enormous amount of information available online, more than
enough to provide the foundation for productive analysis of stocks. The bigger issue, however, is what you do
with the information. If you do nothing
more than regularly loading up on this week's list of "10 Stocks To Buy
Now", best of luck to you. You'll
need it.
If, on the other hand, you look more deeply to uncover
issues with worthwhile potential, the probabilities begin to shift in your
favor. The basics of coming up with
worthwhile additions to your portfolio include an analysis of ongoing profit
trends, current valuation, and balance sheet health.
When appraising profit trends, take a look at earnings
per share for the latest year, estimates for the current year and next year,
and growth projections for the next five years.
The earnings path should be consistently higher and future prospects
should call for continuing gains of 10% or better.
For a stock to be of interest, the valuation needs to
be reasonable. How to figure that?
Calculate the price-earnings multiple (P/E): current price divided by estimated
earnings per share for the current year.
If the earnings estimate is $1.00 per share and the price is 25, the
price-earnings multiple is 25 times.
Let’s take that one step further. If the projected growth rate is 10% a year
and the price-earnings multiple is 25 times, that gives us a price-to-earnings
growth ratio (PEG) of 2.5. A PEG of 2.5
is a rich number, which may hold up if there are no problematic corporate
developments, but should there be bad news, shouts of "Timber!" may
be heard.
Far better to limit holdings to those with PEG ratios
of 2.0 or less. Above that, stocks may
be considered to be priced for perfection.
Perfection is rare, which means the risks are high.
At this point, your list of candidates has probably
been narrowed considerably. Now you need
to find out whether the companies are consistently generating free cash
flow. This is the net income available
each year after outlays for capital expenditures, debt repayments, and
dividends. Companies that can meet all
of their obligations and still have funds left over are moving in the right
direction. That’s true even if they have
so-so balance sheets and considerable debt.
Free cash flow is a key indicator of good financial health.
After having covered these fundamentals, it's
essential to check out the relative strength of the companies' shares. As long as they're at least moving sideways,
there's no problem. Even so, if the
price is plunging while the fundamentals look good, there's usually something
wrong with the appraisal of the fundamentals.
A stock that's going south when the earnings numbers are going north is
something to worry about . . . and avoid.
One more thing: Don't forget to take a close look at
the industry or sector in which the companies are operating. Usually, you will find that the narrowed-down
group is in industries with bright futures, but there will be exceptions that
must be weeded out. And, of course,
there are cyclical companies in an upcycle that appear to be of interest even
though they really are not.
N. Russell
Wayne, CFP®
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