Skip to main content

Sound Advice: September 30, 2020

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®

Comments

Popular posts from this blog

Sound Advice: January 3, 2025

2025 Market Forecasts: Stupidity Taken To An Extreme   If you know anything about stock market performance, you can only gag at the nonsense “esteemed forecasters” are now putting forth about the prospective path of stocks in the year ahead.   Our cousins in the UK would call this rubbish.   I would not be as kind. Leading the Ship of Fools is the forecast from the Chief Investment Strategist at Oppenheimer who is looking for a year-end 2025 level for the Standard & Poor’s Index of 7,100, a whopping 21% increase from the most recent standing.   Indeed, most of these folks are looking for double-digit gains.   Only two expect stocks to weaken. In the last 30 years, the market has risen by more than 20% only 15 times.   The exceptional span during that time was 1996-1999, which accounted for four of those jumps.   What followed in 2000 through 2002 was the polar opposite: 2000:      -9.1% 2001:     -11.9% ...

Sound Advice: January 15, 2025

Why investors shouldn't pay attention to Wall Street forecasts   Investors shouldn't pay attention to Wall Street forecasts for several compelling reasons: Poor accuracy Wall Street forecasts have a terrible track record of accuracy. Studies show that their predictions are often no better than random chance, with accuracy rates as low as 47%   Some prominent analysts even perform worse, with accuracy ratings as low as 35% Consistent overestimation Analysts consistently overestimate earnings growth, predicting 10-12%                 annual growth when the reality is closer to 6%.   This overoptimism can                 lead investors to make overly aggressive bets in the market. Inability to predict unpredictable events The stock market is influenced by numerous unpredictable factors, including geopolitical events, technological changes, and company-specific news.   Anal...

Sound Advice: July 16, 2025

Fixed annuities are poor investments Fixed annuities are often criticized as poor investments for several reasons, despite their reputation for providing stable, predictable income.  Here are the key drawbacks and concerns:   High Fees and Commissions Internal Fees:  Fixed annuities can carry a range of fees, including administrative charges, mortality expense risk fees, and rider fees. These can add up to 2%–4% per year, significantly eroding returns over time. Commissions:  Sales agents and financial advisors often receive high commissions for selling annuities—sometimes as much as 5%–8% of the invested amount. This creates a financial incentive for advisers to recommend them, even when they may not be the best fit for the client. Comparison to Other Investments:  Mutual funds and ETFs typically have much lower fees and commissions, making them more cost-effective for long-term growth. Limited Growth a...