Many of my friends and colleagues have seen enough Cramer to understand the stock market from a high level and often get excited about the earnings potential from investing in the stock market. However, I have noticed that this is often problematic for their portfolios because they most often do not understand that the most important criteria for investing in a stock is how much it is worth and how much it costs, period. The "story" behind the stock, the great management team and all the other reasons to invest in the stock matter much less if you pay too much for the stock. For example, I often hear colleagues bragging about the new company they found to invest in and its cool innovations, but I never hear them mention how much the company is worth and how much they paid for it. During my internship at Invesco one of the portfolio managers there drilled into my head that "a good company does not always equal a good stock."
What he meant by this is that a stock's attractiveness is determined by how much you are paying to be an owner of that company because everything has a value. What I mean is over time a company's stock should represent the true value of the company's equity. The value of a company's equity is measured by the equity holders' claim to the value of its future cash flows. However, because the financial markets are not entirely efficient (Wikipedia: Efficient Market Hypothesis), there are times when all of the value of a company's equity is not fully represented by the company's stock (undervalued) or vice versa there are times when the stock price represents more than the value of the company's future cash flows (overvalued). As an investor you want to find those companies which are undervalued and this is the time to buy those stocks (this is the Benjamin Graham or value method of investing). In this post I will explain the criteria I use when I look for my next stock to buy and how I buy stocks like I buy my groceries not like I would buy perfume as Warren Buffett would put it.
A. How do stocks pique my interest? There are basically four methods I currently use in order to find new stocks in which I am interested.
1. I read a bullish article from Barrons Magazine, the Wall Street Journal or another major news source - My main source for investment research is currently Barrons Magazine. With my limited time, I have found the research from Barrons mostly sufficient for my purposes. Barrons has research from both sell-side and buy-side analysts as well as its own writers.
2. I use a stock screener from TD Ameritrade or Barrons - Large institutional investors have in-house stock screeners which they can customize according to their own criteria, but the screeners you can access for free can narrow you stock selections considerably.
3. The media - I see an article in a major media outlet about some event that has caused the stock to drop dramatically. Or I hear about a company with a new innovation that sounds interesting.
B. What do I do once I have found an interesting company? Once I have found a stock in which I am interested, I first run that stock through my proprietary model (see video on right side bar) and if it passes then I proceed to complete a deeper analysis of the stock. My model pulls the company's financial statements over the past four years and runs several financial ratios. It also rates the stock according to Benjamin Graham Warren Buffett and Joseph Piotroski criteria. It then gives the company a weighted score according to these criteria. If the stock scores better than 70 for the Graham and Buffett rating and better than 7 for the Piotroski rating then I will proceed to look into the stock further.
C. The in depth analysis. This part of my analysis first involves the below 7 steps:
1. Run further financial ratios on profitability, growth, valuation and financial health
2. Complete a Discounted Cash Flow analysis - This analysis forecasts the company's future cash flows using growth and profitability rates (use historical averages, Investment rate x RONIC for growth, and/or industry forecasts) and discounts these cash flows back using the company's cost of capital. This gives me an enterprise value. I then subtract debt and add cash which gives me a value of the company's equity. This number divided by diluted shares gives me a warranted stock price. If the current stock price is less than this value then it is undervalued, but remember the numbers used for growth and profitability have a lot of assumptions. Therefore the DCF is by no means the law.
3. Determine whether future growth and profitability assumptions in valuations are realistic
4. Compare the company's financial ratios to the ratios of its peer group average.
5. Research the company's management
6. Research the company's industry, market share and look for competitive advantages
7. Make a buy or sell decision
In my decision making process the ultimate elephant in the room is how much is the stock is worth and how much am I paying for it. Therefore, even though a company may have a great story behind it, the value of that story may already be calculated into the price of the stock. The stock price could also have more growth assumed in the company's value than what is realistic even with a great story behind it. This is why it is so important to calculate the value of the company's equity because over time the company's stock will revert to the true value of the company's equity. And if you pay too much for the equity then either the stock price will remain stagnant or it will drop. This does not only happen in the stock market. For example, it happened in the housing market. This is why we should buy stocks like we buy our groceries not like we buy our perfume. We should buy a stock for its value and not simply because it smells nice.
Below are the 10 criteria I use in my model for the Benjamin Graham portion of my ratings:
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I realize that the above criteria are not the law and that there are several other factors an investor must look into. However, I have listed these just as a few criteria someone may use in addition to what he or she currently uses. I also realize that some would say (including Buffett) that sometimes it makes sense to pay a fair value for a stock if it is a company with a durable competitive advantage. Last, I realize that I am not an expert and that I have much to learn, but I am simply sharing my ideas with others out there interested in the stock market. Stay tuned for future posts about my stock selection process. Thanks, Nick Hiatt |
