iBooyah.com: The art of analyzing stocks
As most would agree, selecting the right stocks is largely a combination of timing and analysis. The analysis allows us to better understand the company’s business and their potential for growth. However, that’s simply not enough. What separates great analysts from the mediocre is the ability to predict the future surprises with some success. If you can consistently do that, you will find yourself on easy street.
Understanding the fundamentals of companies is what provides us the courage to buy when others are selling. For example, when Wall St. was bearish on Microsoft (MSFT), we bought it knowing the fundamentals were strong and the fact MSFT has a monopoly over the Operating Systems was a huge selling point. So far we are up 30 percent on MSFT.
Using ratios, graphs and other tools, we attempt to gauge how companies will perform. Some of us do this better than others and is able to quickly identify the undervalued stocks. Timing is also crucial when picking stocks. Knowing when to buy is extremely important and will largely determine the rate of return. Moreover, knowing when to sell is just as important. To be successful, investors and traders must be discipline without any biases. It is these biases that sometimes keep us from selling when we should and hold to losers too long. In finance, we call this “Behavioral Finance”.
Stocks are broken into the following groups:
We hear a lot about growth companies. However, a growth company does not mean it is a growth stock. Growth companies are those that above-average increases in sales and earnings. Growth stocks have higher rates of return than other stocks in the market. If investors recognize a growth company and discount the future earnings stream properly, the current market price of the growth company's stock will reflect its future earnings stream. Thus, if you bought the stock at the correct market price, you will receive a rate of return consistent with the risk of the stock.
A growth stock is a stock with a higher rate of return than other stocks in the market with similar characteristics. The stock achieves this superior return because at some point in time the market undervalued it compared to other stocks. Google (GOOG) is a prime example of a growth stock. In comparison to its competitor such as MSFT and YHOO, GOOG is trading at a very high multiple as the market their growth will outperform the overall market.
Defensive companies are those whose future earnings are likely to withstand an economic downturn. They have relatively low business risk and not excessive financial risk. For example, Procter & Gamble (PG), Wal-Mart (WMT) and Safeway (SWY) are considered defensive stocks. In a bad economy, these are the types of companies the market will gravitate towards.
A cyclical company's sales and earnings will be heavily influenced by the aggregate business activity. Such a company will do very well during economic expansion and very poorly during economic contractions. Caterpillar (CAT) would fit into this category.
A speculative company is one whose assets involve great risk, but also has a probability of great gain. A speculative stock is a stock that is overpriced. There is a high probability that when the market adjusts it to its true value, there will be low or negative returns. Consequently, there is a low probability of normal or high rates of return. Companies such as Baidu (BIDU) fit this description as the stock is highly speculative. If BIDU does well, the rate of return will be great as the Chinese market is huge.
When analyzing companies, it is very important to understand that a high quality company is NOT necessarily one that represents a good investment. In other words, the quality of the company does not always mean the stock will perform. For example, GE is a great company, but GE’s their stock performance has typically below major indexes. Lastly, picking stocks is inherent with estimating the expected return for a stock. This process starts with estimating future stock prices. Future values are derived by predicting the stock's earning multiplier and its expected earnings - i.e., next year's expected net income is the product of next year's profit margin estimate and next years' sales estimates. If the estimated value is greater than the current market price, buy the stock.
