10 tips for top stock picks

Morningstar | 06 Aug 2012

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The following article is part of an ongoing educational series. The previous article can be found here.

 

By this stage of our ongoing investor education series, you may be starting to wonder where all the great stock ideas - or even the good ones - really come from.

How did the earliest investors know to research a CSL Limited (CSL) in the early 1990s, let alone invest in it?

After all, the Australian Securities Exchange (ASX) offers a menu of over 2000 companies, many of which will be unfamiliar to you.

From your ASX shopping list, you'll select just a handful of stocks to start with and probably never more than a dozen or so.

Some may multiply their earnings tenfold in the next couple of years, while others may merely fold. And you can't possibly cover them all.

Add you could spend your life researching also-rans, while everyone around you appears to be riding winners. Then, even when you do strike oil, how will you know it's the best deal around?

Let's kill that last idea straight away.

You won't ever know if you're taking the best opportunity and, even in hindsight, the answer won't always be clear.

If you could pick the best investments every time, you'd be gracing the cover of Fortune magazine and swapping racing tips with the Sultan of Brunei.

When you find a great company at a good price or a good company at a great price, forget what else might be out there - you can buy the others later!

If you really have uncovered a good one, you'll usually be fairly rewarded over time.

But if you're tempted to chase every shooting star, you'll gain first-hand experience of an old stockmarket saying: "Stocks that shoot higher have further to fall."

Actually, as far as I know it's not an old stockmarket saying. But it should be.

Great companies take some finding

It's generally a better plan to look for great companies than soaring stocks, but great companies take some finding if you want to pay a fair price.

The sources of sharemarket information discussed previously in our series - the media, the internet, your broker, research reports and so on - will be a big help, but other investors get this information too.

So, if you want to get in on the ground floor of some of the market's biggest successes, you would be wise to employ one of your real competitive advantages - your eyes and ears.

Most investors still don't employ these precious assets for investment purposes because they see the stockmarket as a virtual reality, where bits of paper become more and less valuable depending on the fickle tide of opinion.

But the stockmarket is not some fancy digital scoreboard. It's there in your savings account at Westpac (WBC), in your phone service from Telstra (TLS), or in your clothing from David Jones (DJS).

Legendary US investor Warren Buffett explains his approach to the market this way: "We try to find businesses that we feel really good about owning. What a company's stock sells for today, tomorrow, next week or next year doesn't matter. What counts is how the company does over a five or 10-year period."

You didn't need a 30-page broker research report to know the lettuce leaves were becoming much fresher, much faster, in Woolworths (WOW) than in Coles supermarkets during the early 1990s.

Or that it was next to impossible to find a parking spot within a day's walk of your local Woolies, such was its popularity. All it took was a weekly shopping trip and a taste for greens.

Similarly, there was no need for an official bulletin a few years later to find that Coles had done some serious catching up.

Any shopper, frustrated driver, or Coles checkout operator could have told you this well before it came through in the financial reports.

On that same shopping trip, you might also have noticed that the Blackmores (BKL) range of healthcare products and vitamins was expanding down aisle nine in a big way.

This "reality-based" approach forces you, of course, to think of your stocks not as lottery tickets but as real companies, producing goods and services that people use.

And for the vast majority of long-term investors, this is by far the most profitable way to think.

If you take nothing else from our investor education series, remember this: stocks don't make detergents, build bridges, mine iron ore, or lay fibre-optic cable.

Companies do.

And when you're buying shares, you're buying a stake in a real-live company, a share of all the activities it undertakes to make a dollar and, critically, to grow that dollar into $1.15 next year, $1.35 the year after and so on.

While mainstream retailers, manufacturers and service companies are all visible targets, there's no reason not to apply the "street-smart" approach to other areas in which you may have special knowledge.

If you work in specific areas of the pharmaceutical or medical industries, for example, you may have had the edge in picking the roaring success that Cochlear (COH) would become in the late 1990s.

 

Limitations of street-smart investment

The "street-smart" approach has a lot to recommend it, although don't be tempted to use it as anything more than a way to generate your own stock ideas before prices have factored in all the good news.

It also tends to work best with smaller companies that have springboard growth potential from one or two products that account for a big chunk of profits.

Bigger, well-established players usually require solid performance across a range of significant divisions to grow their earnings reliably. And, even then, they're less likely to provide the multiple of gains that smaller, more dynamic companies may deliver.

It's a lot harder for a company like BHP Billiton (BHP) to double in size than it is for a company like Flight Centre (FLT).

 

Getting your priorities straight

If you're already thinking a shortage of investment ideas will be the least of your problems, you're probably right.

Few serious investors lack ideas. In fact, many are so keen to take early positions in potential successes they neglect to carefully assess fundamental company information.

This is dangerous stuff.

If you're a genuine long-term investor, you probably won't lose too seriously if you hold off for a few weeks, or even months, while you get your facts straight.

But while fools may sometimes rush in, you should not analyse each potential profit-maker to the point of paralysis.

Look too long and too hard and you're bound to find reasons, real or imagined, not to invest. Procrastination is the enemy of opportunity.

What is far more likely than any drought of ideas is being confronted by such a flood of possibilities that, given the worsening global shortage of time, you need a brutally efficient way to sift through them.

 

A 10-point stock screening checklist

Before you worry too much about price-to-earnings ratios (P/Es), payout ratios and the myriad other financial indicators, there are some more fundamental questions to answer.

Using a checklist like the one below will help you to weed out the time-wasters quick smart, and determine whether it's worth taking your investigations to the next stage.

There's nothing definitive about this checklist. Simply use it as a starting point and add or subtract from it to find answers to the questions you want to ask.

1. Where did the stock idea come from?

This one's a no-brainer. Some sources you trust, others you don't. Let experience be your guide as to which you look at first.

2. What do you know about the company?

You don't have to know anything to start with, of course, but it certainly speeds things up. If you've heard good reports from all kinds of people, that's usually a warning sign.

Can the stock possibly live up to such high expectations? If your analysis shows it probably can, then great. If it probably can't, you've almost certainly avoided a big loser.

3. Is it a growth stock, income stock, cyclical stock, or none of the above?

As we discussed previously in our series, some companies reinvest their earnings to fund growth. Others pay higher dividends, often because there are few growth opportunities to fund.

Both stocks have a place in your portfolio. But if it's income you need, it's an income stock you want.

The usual suspects - your broker, share tables and so on - will answer this question for you, and you might as well check out the P/E and dividend cover while you're at it.

If there's no growth, no income and none on the way, go back to number one.

4. Do I have a clue about the industry?

You don't need to be a geologist to invest in a mining stock, but you should at least have a rudimentary understanding of the markets the company operates in, the commodities price cycle, the competition, the industry outlook, and the sector's history.

Similarly, if you're looking at a technology stock, where the key to analysis may be picking technologies that will survive the industry's evolution, it's certainly going to help if you talk the talk and have a grasp of the key issues.

5. Does the company make a profit? If so why? If not, why not?

Not surprisingly, given our focus thus far on the one thing that matters most, the biggest losses are often made on companies that never turned a decent profit.

At the height of the technology stock boom, and immediately prior to the 35 per cent plunge in the tech-heavy Nasdaq index in April/May 2000, the vast majority of listed internet-related companies in the US weren't making a dollar. In fact, between them they were losing billions.

There are sometimes good reasons to buy companies that don't make a dollar, but there are often better reasons not to.

This question basically tells you whether the stock represents a real company that makes money by doing understandable things or a "concept stock" with perhaps loads of potential, but unproven earning power.

When speculative or "blue-sky" stocks make it big, they can really make it BIG.

While they do have a place in most portfolios, make sure it's a small place in yours, and be prepared to lose your dough if you get it wrong.

6. Is the profit (or profit potential) growing?

"Growing profits make growing share prices," should be your mantra by now.

A lot of other things make growing share prices as well of course, such as optimists, speculators, growing yields and takeover merchants.

But show me a company that has consistently grown its earnings at a steady clip and more often than not I'll show you a company that's grown its share price over time as well.

Again, you can get the data to answer this question from the usual sources.

On occasions where the rule does not hold and growing profits produce falling or stable share prices, it's usually because market expectations have run so far ahead of what any company could hope to achieve that, even though the company may have done quite well, its share price has disappointed.

It may also be because the market sees a "shock" around the next corner.

7. Can I explain how the company makes its money?

If the company makes money, you need to know how - but keep your thinking fairly simple at this stage (remember, we only want to know whether to shortlist the stock for now).

For example, "Cochlear makes money by selling implants that help hearing impaired people to hear."
Sounds like a simple business with a big target market - could be worth a look!

One other quick point: note the wording of this question. If you can't clearly explain what a company does, are you sure you really understand it?

8. Will the company be around in three years?

Companies go broke the same way people go broke. If you owe a pile of money on your mortgage and don't earn enough money to pay it off, your debts mount up until one cloudy day the bank pulls the plug.

For stocks, you can take a quick "three-year" test by looking at the ratio of the company's debt to shareholders equity. You'll find all the information you need on the balance sheet in the company's annual report.

If you go through the full calculation, you'll be forced to address a whole raft of issues for different types of company, accounting treatments of various assets and liabilities and so on.

Really, all you want to do at this stage is work out whether the company will be able to keep repaying its debts without any trouble.

Equity ownership, remember, normally involves dividend payments, which can be reduced or even suspended for a period if the company needs time to get back on its feet.

While you obviously don't want this to happen, a company that is making money and has a low debt burden isn't likely to be filing for bankruptcy any time soon.

Debt is a different beast. Interest payments to banks and other lenders can't be reduced or suspended without the real risk of default and liquidation. And excessive debt catches up with everyone eventually.

Most brokers' reports will provide a "gearing" ratio but, to get an initial feel for how the company stacks up, you can compare non-current liabilities (the debt the company will be paying off for years to come) to total shareholders' equity (the owners' stake in the company).

Anything over about 80 per cent warrants further investigation and, generally, the lower the gearing ratio, the stronger the balance sheet - but only up to a point.

Relatively high gearing is no big deal (or, at least, much less of a big deal) if a company has a strong enough underlying cash flow to service/pay off the debt.

For example, if you have a $200,000 mortgage outstanding on a home unit, $5000 cash in the bank, and $100,000 equity in that unit, what is your personal gearing ratio (forgetting whatever else you may have in other assets)?

Your gearing ratio is your net debt ($200,000 - $5,000), divided by your equity in the home unit ($100,000) or 195 per cent.

That shouldn't be a problem if you have a decent regular salary to service/pay off the debt but, if your cash flow is poor and patchy, there's a chance you won't have that unit in three years time.

The important question, then, when it comes to stocks is: how resilient is that cash flow to a downturn in operating conditions?

While you're visiting the company's balance sheet, it will take all of 10 extra seconds to check out how much cash it has stashed away.

If a stock is trading at $4.50 with $2 in cash (net of its liabilities, of course) on the balance sheet for each share on issue, it's a good bet the share price won't go too far south of $2.

One final point about debt and equity: don't get into the habit of thinking "debt bad, equity good". The real trick is the balance between the two.

Debt is often a cheaper way for companies to raise money, so funding an initiative by debt can actually boost the relative rate of return to shareholders.

The main thing to consider is simply whether there's so much debt the company will struggle to pay it off, or be held back significantly by the overhang of interest repayments.

9. Is there a special reason for buying now?

Is there a particular reason why the company is more attractive now than, say, six months ago? If this is the case, obviously you'll want to fast-track it up your list of stocks to investigate.

Also consider whether you're interested in the stock as a trade or as a long-term holding.

Know your mind and know what you expect from each stock you hold.

10. Does the stock suit your financial position?

If you've been following this checklist, you should already know whether the stock promises growth or income.

But you also need to consider at this stage how you're going to pay for it, should you decide to buy. Will you have to sell other investments to buy it? If so what? Does that make sense?

How long can you afford to have money tied up in the stock, and how long do you expect to have money invested in the company to extract the value you want?

You'll need good answers to all of these questions. If you sell a core portfolio position to take a punt on a speculative stock, you'll have made your whole portfolio more risky.

While the chances of strong outperformance may be improved, so are the chances of significant underperformance. There's nothing wrong with doing that, as long as it's a conscious decision and you understand the risks.

Finally, can your portfolio - not just your individual stock holding - cope with the downside if the worst happens?

Assuming you have the basic company information in front of you, this whole test should take about 10 or 15 minutes. And if you get past these sorts of questions, you may be on to something.

You might not be as well, but at least you'll know it's worth taking your analysis to the next stage.

If you can think of any extra questions you'd like to add to your checklist, write them down now.

Coming up next in our ongoing educational series, we'll look at company analysis, as well as how to assess businesses and the industries in which companies operate.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

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