Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)
Part V. The Part of Tens
IN THIS PART …
Want to know a great stock when you see one? Discover the top ten indicators.
When markets are down, this part helps you enact some profitable strategies and tactics.
Stocks are not the only game in town (and they shouldn’t be); find some great investments to diversify with.
Chapter 22. Ten Indicators of a Great Stock
IN THIS CHAPTER
Taking note of a company’s profits, sales, and liabilities
Looking for bargain stock prices and growing dividends
Paying attention to politics and megatrends
In a book like this, the goal would be good to identify the Holy Grail of stock investing … the stock … the kind of stock that, if stocks were people, then Apple, General Electric, Proctor & Gamble, and Microsoft would be peasants compared to this king. Yeah, that’s the kind of stock that would be the Grand Pooh-Bah of your portfolio! Well, hold your horses.
That stock is likely in heaven’s stock market right now, and you have to be firmly planted on terra firma. If you have a stock that has all the following features, back up the truck and get as much as you can (and let me know so that I can do the same!).
Seriously, I doubt that you’ll find a stock with all ten hallmarks described in this chapter, but a stock with even half of them is a super-solid choice. Get a stock with as many hallmarks as possible and you likely have a winner.
The Company Has Rising Profits
The very essence of a successful company is its ability to make a profit. In fact, profit is the single most important financial element of a company. I can even make the case that profit is the single most important element of a successful economy. Without profit, a company goes out of business. If a business closes its doors, private jobs vanish. In turn, taxes don’t get paid. This means that the government can’t function and pay its workers and those who are dependent on public assistance. Sorry for veering away from the company’s main hallmark, but understanding the importance of profit is vital.
Profit is what is left after expenses are deducted from sales. When a company manages its expenses well, profits will grow. For info on the numbers measuring a company’s success, look at Chapters 6 and 11 as well as Appendix B.
The Company Has Rising Sales
Looking at the total sales of a company is referred to as analyzing the top-line numbers. Of course, that’s because when you’re looking at net income (gross sales minus total expenses), you’re looking at the bottom line.
A company (or analysts) can play games with many numbers on an income statement; there are a dozen different ways to look at earnings. Earnings are the heart and soul of a company, but the top line gives you an unmistakable and clear number to look it. The total sales (or gross sales or gross revenue) number for a company is harder to fudge.
It’s easy for an investor — especially a novice investor — to look at sales for a company for a particular year and see whether it’s doing better or worse than in the prior year. Reviewing three years of sales gives you a good overall gauge of the company’s success.
Granted, some years are bad for everyone, so don’t expect a company’s sales to go up every year like a rocket. Sometimes success is relative; a company with sales down 5 percent is doing fine if every other company in that industry has sales down much more.
Suffice it to say that when a company’s total sales are rising, that’s a positive sign. The company can overcome other potential issues (such as paying off debt or sudden expenses) much more easily and can pave the way for long-term success.
Check out Appendix B for ways to look at sales and do your own top-line analysis.
The Company Has Low Liabilities
All things being equal, I would rather have a company with relatively low debt than one with high debt. Too much debt will kill an otherwise good company. Debt can consume you, and as you read this, debt is consuming many countries across the globe.
Because a company with low debt has borrowing power, it can take advantage of opportunities such as taking over a rival or acquiring a company that offers an added technology to help propel current or future profit growth.
Notice that I didn’t say a company with no debt. Don’t get me wrong — a company with no debt or little in the way of liabilities is a solid company. But in an environment where you can borrow at historically low rates, it pays to take on some debt and use it efficiently. In other words, if a company can borrow at, say, 3 percent and put it to use to yield a profit of 5 percent or more, why not?
Secondly, notice that I’m talking about liabilities. It isn’t always conventional debt that may sink a company. What if that company is simply spending more money than it’s bringing in? Liabilities or “total liabilities” takes into account everything that a company is obligated to pay, whether it’s a long-term bond (long-term debt), paying workers, or the water bill. Current expenses should be more than covered by current income, but you don’t want to accumulate long-term debt, which means a drain on future income.
Also, in some industries, the liabilities can take a form that isn’t typically conventional debt or monthly expenses. I read the recent industry report that some very large banks and stock brokerage firms have huge positions in derivatives, which are complicated financial instruments that can easily turn into crushing debt that could sink a bank.
In my research, for example, I found one Wall Street broker that had total derivatives of a whopping $35 trillion, even though its net worth on its balance sheet was only $104 billion. There is actually an agency that tracks these numbers (the Office of the Comptroller of the Currency at www.occ.gov), and you should check it out when you’re considering investing in these types of financial institutions.
The point is that one of the hallmarks of a successful company is to keep liabilities low and manageable. You find a company’s debt in its financial statements (such as the balance sheet). Find out more about debt in Chapter 11.
To discover some good parameters of acceptable debt, look at the company’s financial ratios on debt to assets. Get the scoop about this in Appendix B.
The Stock Is at a Bargain Price
Price and value are two different concepts, and they aren’t interchangeable. A low price isn’t synonymous with getting a bargain. Just as you want the most for your money when you shop, you want to get the most for your money in stock investing.
You can look at the value of a company in several ways, but the first thing I look at is the price-to-earnings ratio (P/E ratio). It attempts to connect the price of the company’s stock to the company’s net profits quoted on a per share basis. For example, if a company has a price of $15 per share and the earnings are $1 per share, then the P/E ratio is 15.
Generally speaking, a P/E ratio of 15 or less is a good value, especially if the other numbers work out positively (for example, profits and sales are rising, as I note earlier in this chapter). When the economy is in the dumps and stock prices are down, P/E ratios of 10 or lower are even better. Conversely, if the economy is booming, then higher P/E ratios are acceptable.
I consider myself a value investor, so P/E ratios in the teens or better (lower) make me comfortable. However, someone else might bristle at that and consider P/E ratios of 25 or even 50 acceptable. Then again, at those levels (or higher), you’re no longer talking about a bargain.
Too many investors see no problem with buying stocks that have no P/E ratio. These stocks may have the P (price of the stock), but they have no E (earnings). If you invest in a company that has losses instead of earnings, then to me you aren’t an investor; you’re a speculator.
Investing in a company that is losing money is making a bet, and more importantly, it isn’t a bargain at all. (However, when you find a company that is losing money, it could be a good shorting opportunity; see Chapter 17 for details.)
A stock may also be a bargain if its market value is at or below its book value (the actual accounting value of net assets for the company). You can find out more about book value in Chapter 11.
Dividends Are Growing
Long-term investing is where the true payoff is for today’s investors. But before you start staring at your calendar and dreaming of future profits, take a look at the company’s current dividend picture.
Dividends are the long-term investor’s best friend. Wouldn’t it be great if after a few years of owning that stock, you received total dividends that actually dwarfed what your original investment was? That’s more common than you know! I’ve calculated the history of accumulated dividends for a given stock, and it doesn’t take as long as you think to get your original investment amount back (counting cumulated dividends). I know some people who bought dividend-paying stocks during a bear market (when stock prices are very low) and got their original investment back after eight to ten years (depending on the stock and its dividend growth, of course).
Dividend growth also carries with it the potential growth of the stock itself. A consistently rising dividend is a positive sign for the stock price. The investing public sees that a growing dividend is a powerful and tangible sign of the company’s current and future financial health.
A company may be able to fudge earnings and other soft or malleable figures, but when a dividend is paid, that’s hard proof that the company is succeeding with its net profit. Given that, just review the long-term stock chart (say five years or longer) of a consistent dividend-paying company, and 99 times out of 100, that stock price is zigzagging upward in a similar pattern.
I discuss dividends and dividend-growing stocks in Chapter 9. For exchange-traded funds (ETFs) that have dividend stocks in their portfolios, see Chapter 9. Lastly, check out resources on dividend investing strategies in Appendix A.
The Market Is Growing
In this context, when I say that the market is growing, I mean the market of consumers for a given product. If more and more people are buying widgets (remember those?) and the sales of widgets keep growing, that bodes well for companies that sell (or service) widgets.
Take a look at demographics and market data and use this information to further filter your investing choices. You could run a great company, but if your fortunes are made when a million folks buy from you, and next year that number shrinks to 800,000, and the year after that it shrinks again, what will happen to your fortunes?
Consider this example: If you have a successful company that is selling something to seniors and the market data tells you that the number of seniors is expanding relentlessly for the foreseeable future, then this rising tide (demographics) will certainly lift that particular boat (your stock). Find out more about market growth using the resources in Appendix A.
The Company Is in a Field with a High Barrier to Entry
If you run a company that offers a product or service that is easy to compete with, building up a strong and viable business will be more difficult for you; you’ll need to do something different and better.
Maybe you have a great technology, or a patented system, or superior marketing prowess, or a way to make what you’re selling both cheaper and faster than your competition. Maybe you have a strong brand that has endured for decades.
A high barrier to entry simply means that companies that compete with you will have a tough time overcoming your advantage. This gives you the power to grow and leave your competition in the dust.
Here’s an example: Coca-Cola (KO) positioned and branded itself for decades as the top soda with a secret recipe for its soda. In spite of imitators and competitors, it’s still dominant today — more than a century after its founding. The company’s soda is still on kitchen tables and in picnic baskets, and its shareholders are still being refreshed with stock splits and dividend increases.
To find resources that can help you learn about the advantages and characteristics of stocks with a high barrier to entry, check out Appendix A.
The Company Has a Low Political Profile
Politics: Just the thought of it makes me wince. Political discussions may be great at cocktail parties and perhaps fun to watch as your relatives go at it, but I think that flying below the political radar is a good thing for companies. Why?
We live in times that are politically sensitive (I don’t think that is a good thing). All too often, politics affects the fortunes of companies and by extension the portfolios of investors. Yes, sometimes politics can favor a company (through back-room deals and such), but politics is a double-edged sword that can ruin a company.
History shows us that companies that are politically targeted either directly or by association (by being in an unpopular industry) can suffer. There was a time that holding tobacco companies in your portfolio was the equivalent of garlic to a vampire.
All things being equal, I would rather hold a stock in a popular industry or a nondescript industry than one that attracts undue (negative) attention.
The Stock Is Optionable
An optionable stock (which has call and put options available on it) means that you have added ways to profit from it (or the ability to minimize potential losses). Options give a stockholder ways to enhance gains or yield added revenue.
Say you do in fact find the perfect stock, and you truly load up and buy as many shares as you can lay your hands on, but you don’t have any more money to buy another batch of shares.
Fortunately, you notice that the stock is optionable and see that you can speculate by buying a call option that allows you to be bullish on 100 shares with a fraction of the cash needed to actually buy 100 shares. As the stock soars, you’re able to take profits by cashing out the call option without having to touch the stock position at all.
Now, with your stock at nosebleed levels, you’re getting a little nervous that this stock is possibly at an unsustainable level, so you decide to buy some put options to protect your unrealized gains from your stock. When your stock does experience a correction, you cash out your put with an enviable gain. With the stock down, you decide to take the proceeds from your put option–realized gains and buy more of the stock at favorable prices.
Options (both the call and the put in this scenario) give you the ability to bank more gains from the same great stock. Find out more about options in my book High-Level Investing For Dummies (published by Wiley).
The Stock Is Benefiting from Favorable Megatrends
A megatrend is a trend that affects an unusually large segment of the marketplace and may have added benefits and/or pitfalls for buyers and sellers of a given set of products and services. A good example of a megatrend is “the aging of America”; the United States has more than 85 million people who are getting ready for retirement as they reach and surpass the age of 65 (although some assume a larger number when they include folks who are over 50). Those companies that provide services and products for senior citizens would have greater opportunities to sell more of what they provide and would then be a good consideration for investors.
When megatrends are with you, you can even have a mediocre stock but end up with extraordinary gains. In fact, even a “bad stock” will rise sharply if it’s swept up in a rally pushed by a powerful megatrend. Of course, a bad stock won’t have staying power (the stock will eventually go down if the underlying company is losing money or struggling), so stick to quality stocks to truly optimize the long-term benefits that a megatrend can provide.
The problem is that when a stock has little substance behind it (the company is losing money, growing debt, and so on), its up move will be temporary, and the stock price will tend to reverse in an ugly pullback. Just ask anyone who bought a dot-com stock during 1999 to 2001 (that’s right — that guy softly sobbing in the corner). The rising-tide-lifts-all-boats idea is a powerful one, and when you have a great company that will only benefit from this type of scenario, your stock price will go higher and higher.
Find out more about megatrends and other factors in the big picture in Chapters 13 and 15.