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Sound Advice: September 21, 2022

The Professional Approach To Stock Selection

There are various approaches to stock selection, but the two that predominate are fundamental analysis and technical analysis.  Fundamental analysis is a numbers-based method that evaluates key factors such as income and financial health, including the past, present, and future.  Technical analysis emphasizes movements and formations of stock prices.

Fundamental analysis is based on factors that over time have proved to have a meaningful impact on stock price movements.  The optimal picture of corporate profitability is steady growth, both in the past and, prospectively, in the coming years.  Steady growth is rewarded by higher valuations of underlying earning power than those accorded companies with erratic progress.

When professionals screen (filter) the data of the broad universe of stocks, they look for companies that move ahead every year, regardless of the prevailing economic conditions.  Although high past growth is no guarantee of what’s to come, it does tend to build greater confidence in where things are likely to go in the period ahead.

Growth companies are not the only ones worth considering.  Cyclical companies, those whose results reflect changes in the economy, may be interesting candidates when their stock prices are depressed prior to a time of rebound.  For these, however, timing is critical.

In all cases, an evaluation of financial health is essential.  A simple measure of same is a view of free cash flow.  Companies that earn enough to more than cover their expenses, debt obligations, dividend payments, and the like, are in the best possible shape.  That’s true even if they begin with relatively little in the bank.  The ability to generate excess funds every year makes weak companies strong and strong companies stronger.

Another important part of fundamental analysis is valuation.  Stock prices are generally based on a multiple of underlying profits.  If, for example, a company earns $2.00 a share (e.g., company profits of $2 million divided by one million shares), a fast-growing company’s stock might sell for 20 times $2.00 a share.  That’s a price of $40.  A slower growing company might sell for 10 times earnings, i.e., the price-earnings multiple.

Then there’s technical analysis, a school of bizarre thought that suggests that future pricing can be divined by the range of prices and price patterns of a stock’s history.  There are numerous different shapes and theories considered by those who subscribe to this approach.  Unfortunately, however, there is nothing in the literature of investing that in any way supports the forecasts these folks would have you believe.

Even so, please note: If the fundamental analysis is favorable, but the stock’s price is tumbling, there’s probably something wrong with the fundamental analysis.

N. Russell Wayne, CFPÒ

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