By Russell Wayne, CFP®
Although many people are content to confine their investing to funds—both open-end mutual and exchange-traded—there are many others intent on working their way through the mountain of publicly available information to zero in on investments that may be worth adding to their portfolios. There's more than enough out there to form sensible conclusions about what's of interest and what's not. The bigger problem is putting the pieces together to determine the merit of the issues being evaluated.
Here are some tips for determining what information is most useful when it comes to selecting stocks.
Ignoring the Media When Selecting Stocks
Before getting into the weeds, it would be good idea to underscore the importance of paying no attention to the media bombardment about hot stocks to buy today. Whether it's the "10 Stocks You Must Have In Your Portfolio" or "Stocks To Hold Forever," please turn a deaf ear. Headlines such as these are utter and complete nonsense. That's equally true of the daily dose of pious platitudes voiced by the seers on financial stations such as CNBC and The Bloomberg Network. (For more from this author, see: Avoid Hot Stock Tips and Focus on Fundamentals.)
One more thing: There is no inside information. Years ago, when I got my first inkling about becoming a securities analyst, I thought (as did many others) that Wall Street professionals had special access to information about the companies they were following. Although it seems entirely possible that was the case a long time ago, it most definitely has not been true for many years. You, the investor, can get the same information that the pros get.
Company Earnings Trend Is Most Important
Over time, what's most important for stock prices is the trend of company earnings. Consistently rising earnings suggests there will be more of the same in the future and that, in turn, builds investor confidence and leads to higher valuation rates. When the earnings growth rate is accelerating, the valuation rate will usually expand, and vice-versa. Then there's the matter of turnaround situations. The typical story with turnarounds is after years of disappointing results, a company is about to embark upon a significant growth phase, often due to an important new product or perhaps new management. The story may sound good, but most turnarounds don't actually turn around.
It's generally more worthwhile to focus on companies with a proven record of earnings per share over time, which is available on many financial websites. What to look for? An above-average annual growth rate. Also, make sure to look for the coefficient variance of the estimates—the measure of confidence Wall Street analysts have in their estimates. A coefficient variance below 4.00 suggests there's some agreement among analysts about a company’s prospective progress. But as the number gets higher, it's a good bet they really have no idea of what's ahead. What if earnings are going down this year, but likely to rebound next year? You should probably pass. (For related reading, see: How to Decode a Company's Earnings Reports.)
Consider Company Finances
In addition to prospects for earnings, it's important to look at company finances. The key measure here is free cash flow. That's what's left of a company's net income after it's taken care of all of its obligations and capital outlays. A steady stream of free cash flow tells you all you need to know. If funds are left over every year, it is quite reasonable to believe the balance sheet is improving, even if it has been a bit shaky in the past.
Strength of Shares
Assuming these two pieces of the fundamental equation are pointing in the right direction, one should take a look at the relative strength of the company's shares. If the price action is nothing special, that's fine. But if the price is heading south while the fundamentals appear to be strengthening, it's often an indication that something's fishy. A simple measure here is the relative strength index, which is found on many financial websites. A good rule of thumb is for the index to be 40 or higher before you invest. (For related reading, see: Overbought or Oversold? Use the Relative Strength Index to Find Out.)
A naïve investor might think a good approach to picking stocks would be to select those whose target prices suggest the greatest price appreciation from the current level. Target prices are calculated by projecting a company's earnings stream several years out and applying a valuation rate. It may be possible to make a reasonable projection of earnings, but coming up with a reasonable valuation rate (a.k.a. price-earnings multiple) is a fool's errand. Why? Because these efforts are typically based on the range of valuations that has prevailed over the last five or 10 years, or more. The problem is this average obscures the changes that have taken place over the period. It includes years when growth accelerated or slowed down. It also includes strong and weak markets. So what valuation number works? The answer is: "Who knows?" This is why target prices are not helpful.
High Dividend Yields
What about the growing perception among investors that high dividend yields are good? The rule of thumb here is a diversified portfolio of high dividend yield stocks will probably deliver above average returns, but the median return of the stocks in the group will be nothing special. If that's the case, why would the group return be above average? Because a few of the stocks will do surprisingly well, despite generally negative expectations, and that will raise the group's net considerably.
With high dividend yield stocks, however, it is essential to take a closer look at the underpinnings of the dividend. Stock dividend yields in the area of 3% to 4% today are often associated with mature companies that have moderate growth rates and limited need to reinvest for expansion. It's a good sign when dividends are increased regularly, but it's a bad sign when dividends are flat and the yield is increasing. That's often a warning that the earnings coverage of dividends is thin (i.e., most of what's earned is being paid out to shareholders), which could signal the possibility of a dividend cut ahead. When dividends are cut, stock prices drop. (For more from this author, see: The High Dividend Stock Strategy: Pros and Cons.)
Then there's the matter of price momentum. Which works well, until things turn in the other direction. Betting on strong price action alone is a loser's game. Don't play it. What if we just pick the stocks with the highest ratings from Wall Street analysts? After all, these guys are generally paid big salaries, which suggests their analysis is worth something. The reality is otherwise. There's been a fair amount of literature on the subject and the usual conclusion is analyst recommendations are of little value.
The bottom line is there's a significant correlation between improving fundamentals and improving stock prices, but that's over extended periods of time, typically several years. For shorter periods, changes in investor psychology, which are unpredictable, are what moves the needle. Be sure you are using the right publicly available information when you decide to select stocks for your portfolio.
(For more from this author, see: 5 Factors to Consider Before Picking Stocks.)
This article was originally published on Investopedia.