Journal
Headlines by Business Week Magazine.
Headlines by Business Week Magazine.

How to determine when a stock is a Strong Buy.

The following is a brief explanation of how a stock becomes one of our current positions and obtains a rating of Strong Buy. Many investors will suggest that a person is better off trading just a few stocks that they know well rather than have forty of fifty positions which they may not be able to keep up with and may not know as much as they should about each company. We agree, but we also believe that an area of concentration should be determined first and our method is to limit these areas to three or four at a time.

Some investors might pick a sector, such as, energy to concentrate on. Others might pick an industry. We create our own areas. They may or may not be recognized areas, but we usually can target what we are interested in. For example, the recognized industry is Oil Exploration and Production, but we might just call it Oil and we add a few Bio-Diesel companies and some tar sand companies to compare with the regular oil companies. We obtain these areas by watching the performance of the recognized sectors day by day. The sectors that are up on a regular basis and especially those that are up when the market is down get our attention. We then look within those sectors to find what interest us the most. Information on sector performance is readily availiable on almost any financial website. We use Business Week, Bloomberg, Google Finance, and Reuters. First, we want to be where the profit is being made.

Second, we want to be in an area where we will be comfortable. For example, we like Ocean Shipping, which is part of the transportation sector, but we would not choose transportation to concentrate on because we would not want to be worrying about airlines, or trucking stocks. We are not attracted to oil tanker companies, but we do like bulk shipping and container shipping. We define what we want and give it a name, in this case we call it Shipping.

An investor or trader should choose three to four areas to concentrate on and they should be in areas that are of interest. These areas will change but they should not be changed often and without solid reasons.

Once we get our areas of concentration fixed, we then place all of the relevant stocks in a portfolio service and begin the process of finding the common stocks that we want to own for our account and for our client's accounts. These portfolio services are available on most financial websities. We particularly like the one at Morningstar.com.

We are looking for the following:

Current P/E

Foward P/E

Earnings Growth

Debt to Equity

Consensus Estimated Earnings

Price to Book

Return on Assets

Most businessmen will tell you that if they were going to buy a business they would expect a 10% return on the investment. Most business schools teach that to value a business and set a fair price on it; multiply earnings by 10 or use 2 to 3 times book value. We therefore are looking for stocks with less than 10 Forward P/E and less than 3 price/book value. We sort the stocks by Forward P/E and begin the process of comparing all the other values.

First, the Current P/E must be larger than the Forward P/E. The company must be going to make more profit in the next 12 months than it made in the last 12 months.

Second, the earnings growth should be positive.

Third, debt to equity should be in line with other companies in the area. Financial companies will have large Debt/Equitys, but junior mining companies will have almost no debt.

Fourth, the consensus estimated next years earnings should be roughly equivalent to the Forward P/E. Take the estimated earnings and multiply it by 10. This should be larger than the current price.

Fifth, price to book should be less than 3.

The last value is Return on Assets. This is the profit realized for the year divided by total assets. This is sometimes called "the true test of management skill" because management has control of all of the assets, both those bought with shareholder's equity and those bought with borrowed money. At a minimum, more than the current CD rate should be realized. The thinking is that if a company can not make more income than the current CD rate, then there is no reason to run the business at all. Everyone would be better off if the business was closed and all the cash placed into CD's.

We will then sort the portfolio by Foward P/E and beginning at the lowest Foward P/E we look for all of the above values. Remember that our stocks are not from the entire market but only from the three areas of concentration we have defined as the best places to be invested at this time. We eliminate any stocks that do not meet the above criteria. We want to end up with about three stocks in each area. We will read the entire file on all these stocks so that we understand the business and what they are trying to accomplish.

New York