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Sound Advice: March 10, 2021

The ABCs of Stock Picking

After decades of analyzing stocks (and funds) and investing for clients, I'm happy to share in plain English what's involved, what works, and what doesn't.  Keep in mind the reality that successful stock picking is an effort to maintain a good batting average. In baseball, a batting average of .300 or better is considered quite good.  With stock picking, you need to do better than .600, which means you have many more winners than losers.

No one gets it right all of the time.  It's not even close.  Wall Street shops all have their recommended lists and the financial media regularly hawk 10 stocks to buy now. Following that road usually is a direct route to disaster.  Don't be tempted.

Let's begin with the big picture: The stock market goes up and down over time, but the long-term trend is up.  When there's a rally under way, everyone feels like a genius.  When the market hits an air pocket, though, with few exceptions almost every issue hits the skids.  The key is the awareness that patience will be required.  That typically means the better part of a year, if not several.

What takes place in the short run for individual stocks and the market generally is unknowable.  This is driven primarily by psychology.  Improving fundamentals that push stock prices higher become meaningful over longer periods.

In most cases, stock prices reflect underlying profits.  A company that consistently increases its earnings will see its shares rise over time.  Consistency will lead to a richer valuation (that is, higher price-earnings multiple) since investors view that as an indication of reduced risk.  Health care as well as consumer staples companies are good examples.

When profit growth is accelerating, valuations often rise.  And vice-versa.

Companies whose records are not as smooth may also see their shares rise, but earnings fluctuations along the way will lead to leaner valuations.  These are often cyclical companies such as those in the construction industry.

There are other issues to be concerned with.  What if profits are rising, but a substantial part of those profits is from one-time developments?  In that case, the nonrecurring portion needs to be ignored.  What matters are normalized profits, not reported profits.

What should also be ignored is growth in per-share profits that's attributable to a reduction in the number of outstanding shares.  When companies have excess cash, it's not uncommon for them to buy back their own stock.  That raises earnings per share, but it has no impact on net income.  It's not an indication of progress.

Company balance sheets need to be viewed as well.  Although hefty borrowings may help some companies accelerate their momentum, the interest due on this debt will become a negative when overall business conditions worsen.  Heavy debt is an indication of weak finances and generally leads to leaner stock valuations.

Other things that impact stock prices include such things as earnings surprises (better or worse than forecasts), dividend increases (or decreases), mergers, and currency shifts (for companies with significant international operations).

Where to look for stocks? There are a number of websites that offer stock screening.  A good starting point is to select companies with above average growth rates, below average valuations (relative to prospective growth), and solid finances.  From there, it’s essential to take a closer look, learn more about the company’s products, services, and industry.

The key caveat is to watch out for companies whose fundamentals appear to be strong while the price action is unusually weak.  Invariably, this is a signal that there's a flaw in the fundamental evaluation.  That's less likely in the case of stocks that seem to be going nowhere fast.  Their time will come.

In almost all cases, patience will be the key to success.

N. Russell Wayne, CFP®


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