Stock picking is an important skill for anyone who wants to invest in the stock market and buy individual stocks. Back in the old days, anyone who wanted to buy stocks had to use a broker and pay some hefty fees. Now, however, you have a choice between many online brokerages that can offer smaller fees for trades. I started out with Scottrade which offers very low fees and is increasing its research abilities; however, it was not great when it came to options trading. Thus, I recently switched to OptionsXpress. Although it is 14.99 per trade (as opposed to Scottrade's $7.00 per trade), it offers me more information on options' trading. I DO NOT RECOMMEND THAT ANY OF YOU BEGIN BY TRADING OPTIONS. They are a lot to learn about and I have not yet decided whether or not buying options makes sense in my portfolio. I will get to that at a later date.
For those of you who want to learn about how to find a good stock (for investment or trade), here are my steps (explained in detail).
So, these are my steps:
1. READ, READ AND THEN READ SOME MORE. In order to research a stock, you need to really get a list of names to research. Where do you get those names? There are lots of places: my favorites are thestreet.com, the Wall Street Journal, Motley Fool, SmartMoney.com, Smart Money Magazine (my absolute best picks have come from there), Money Magazine, MSN.com's top 50 picks, and shows on CNBC such as Mad Money and Fast Money. Every day I read the Wall Street Journal, the NY Times Business Section and, every Saturday, I go out and buy myself a Barron's (which may be one of the best stock market publications out there). I used to put all my ideas on pieces of paper; now, I try to write them in a journal. I can then put all my research into the journal as well as an idea of what would be a good price to pay for the stock and a target price for exiting the stock position.
Do you need to use all these sources? No. But if you don't have a broker, you need to start reading and making note of stocks that seem to have something good going for them. I probably go a bit overboard, but I am cautious about my stock picks and naturally curious. I also pay for some other research: a premium service from thestreet.com, Real Money Silver -- however, I only recently added that. I don't think you should pay for advice until you are making some money and have a system.
2. FUNDAMENTALS MATTER. What is it you are looking for in a stock? Many people have many different ideas about what matters in choosing a stock, but what you are trying to do when you research a stock is figure out what the company does, who is going to need what it is offering, how much need there will be, and how well they are managing what they do. Obviously, markets change all the time; thus, what's in favor today may be out of favor tomorrow and vice-versa.
It may sound simple, but, regardless of everything else, you are looking for a company that will have a higher stock price from where you are buying it within a certain period of time. Even if you tend to buy and hold, you want to be holding a stock that is going to raise in value at some point in time. That may mean buying something today that is out of favor, because you think it is a good strong company. But certainly, you expect that company's stock price to go up. Otherwise, why buy the stock?
Thus, how much it a stock "costs" now compared to where it "should" be is a factor. However, many believe that the market is "efficient" and prices stocks correctly every second of every day. Obviously, what you want is to find a stock in a company that is growing, or a stock that has, for some reason, gone on sale. Either of those two things will, presumably, get you a stock that, over some time horizon, ought to go up.
Your time horizon is important; I like to think about 3-6 months out for a "trade," and years out for an "investment." While many people believe in buy and hold, and, I may be coming around to that belief in my IRA account, I really prefer to manage my money by getting into positions at what I believe to be a good price and getting out of them in one of two events: something changes my opinion about the company, forcing me to sell at a loss, or, I've made what I think I can make from the company at this point in time.
If you find a great stock that is growing, however, there is an advantage to buy and hold: the stock market moves quickly, and, if you get out of a stock thinking it has to come down and you can get back in later, it may zoom up without you ever having a chance to get back in on a downturn. Thus, I am moving to an idea of feeling confident with my decisions, and, at that point, keeping the stock until something changes my opinion about the company's prospects or I have wrung out of it all that I want to get out of it. That does not mean the stock may not go higher: it just means that I made a significant amount of money on the stock and can, therefore, let it go (at least for now). If you never take profits, I'm not sure that you can make money in the stock market. Plus, if you do not have cash "on the side," you'll never be able to buy something "on sale."
Also, sometimes, you can compare: it's your money you are trying to make grow; thus, if a stock you are in is not going to grow as much as another stock you are researching within the same period of time, you should sell the one and buy the other. But you should be confident, because, despite what the market appears to do on a regular basis, i.e., rise, it is not easy to find a great stock that is not too far overpriced that you cannot get in before it starts to go down. When you find such a stock, you might decide to stick with it through its ups and downs.
3. What are the steps to researching a stock? My method is to look at stocks through a series of moves all of which can be done on line. To show my steps, I will give you two recent example of stocks that I researched. My father-in-law, a great long-term investor, asked me to look at two stocks he was considering. Because he doesn't use the internet, yet, he wanted me to do my thing with my research before he made a decision. One of them is called Dryships (DRYS) and the other AngioDynamics (ANGO).
What did I do? First, I tried to get a feel for the stocks and how they have been doing lately. I usually start at Optionsxpress.com (my online broker) to get my first set of information: Cost, charts (which I'll get into later in the series) and basic financial information. I like to play with charts, but I'm really just getting a feel for the company. I read the news information on that site, and I look at the analysts' recommendations. All of that is right on my broker's web site.
My next step is msn.com (other people really like yahoo finance, and there are probably dozens of sites on the web in which to get basic information on the stock). Why do I use msn.com (money section)? I put the symbol of the stock in and poof, a wealth of information is at my fingertips. I look at their Stock Scouter rating (which tends to favor momentum stocks, but gives me a sense of what's going well and poorly for the stock). But I am not looking for msn's opinion. I am doing some analysis of a few key numbers for me, reading the editorial commentary and news and heading off to the company's website.
I look at company websites for a lot of different reasons. I view this research as similar to what an analyst would do if he/she were visiting the company. The website usually tells me a lot about a company: their style as well as substance." Actual analysts get to meet with company executives, tour their plants and look at their operations. They listen to their conference calls and go through their financial filings carefully. I try to do something to that effect on the computer. A web site gives me a feel for the business and helps me to see what the customer base is. I want to see if they are in the business I think they are in and how well they are executing their business.
Next, I head to CNBC.com. There I find out two things essentially: What Thompson financial thinks is the future price of the stock and how it has really done in the past few months/year period compared to peers. This is under the profile tab of the stock quote section.
4. What am I looking for? While I will later write a series of articles to explain a lot of different things I have learned about researching stocks, including mistakes as well as successes, here I just want to give you a basic sense of the types of things I look for before I decide to invest in any stock. Taking the two stocks, ANGO and DRYS, I'll tell you why I called one a "buy" and one a "watch."
First, as I said earlier, I am trying to answer the question: What does this company do and why is that business a good one in which to invest? AngioDynamics makes "replacement parts" for the body. It is in an excellent business right now because it plays on the theory of the aging baby boomer with their used up knees and hips from all of the activities in which we have participated. So far, so good. Dryships does exactly what it sounds like: it is a Greek company that ships dry goods around the world. That is clearly a growth industry given that the US economy is increasingly dependent on globalization. Hence, it is part of the cycle of imports/exports on which our economy relies and is in a good position to benefit from one of the major themes of our economy.
Secondly, I am trying to figure out: Is this company well run? That's where the "news" and editorial commentary come into play and where I heavily rely on the msn website. I can see if there are problems with the way the company does business. Their financial information is crucial (I will explain what you want to look for in a different article), but there are a host of things that can tell you whether or not it is a well-managed company. The news information is essential. For example, I learned that ANGO has patent litigation pending and the way I read the information, instead of dealing head on with their patent problems, they deflected questions about it. However, the patent dispute was in the area of a varicose vein procedure -- something that I actually think is a good business to be in and one I did not know, from the website, this company was in (again, that made me a little wary of the management of the company). Dryships, on the other hand, was much more postive. It seems to be a good company which executes its business very well.
Third, is this company in good financial shape? In terms of financials, which I'll explain in more detail in later posts, I am generally looking at cash flow, debt, margins and growth. This is why MSN's website is very good: on the side of each stock's page is a list of things to look at including the financial information that has been previously reported. Another excellent aspect of the site is that it shows very clearly the predictions about future growth.
Going back to my earlier examples of ANGO & DRYS, both companies looked good in terms of the financial information I like to use. Dryships has huge margins, and, while Ango has a huge gross margin, it seemed that its net margins were very low. That concerned me although I do not know whether or not this is typical of its business or whether this is a result of management inefficiency. Two things aided me there: first, CNBC allows comparisons to peers on a whole range of metrics. In this case, though, I used the CAPS service of Motley Fool and found out that the company had recently acquired another company and was having a bit of trouble integrating the new company. Hence, looking at gross/net margins might not really be meaningful for a few more quarters, while it settles in with the new purchase. Now, Dryships had a different issue that needed further research: debt v. cash flow. I prefer companies that have very little debt. Dryships has debt and later research revealed that its owner was the owner of an earlier shipping concern that had a lot of financial difficulties. The article did satisfy me that Dryships did not have the same concerns as the earlier company; however, the debt is a negative in my mind.
Finally, what do the analysts say about the stock's prospects? Every one of the websites I have mentioned generally gives you an overview of analyst opinions about a stock. Thus, you can see how many analysts rate it a strong buy, buy, hold, sell, or strong sell. Second, I like to know what thestreet.com's investment team thinks of a stock so I generally research it on there. Third, I use Motley Fool's CAPS system. It has a rating system, and, while I have not so far found it to be of much use, I can see if it agrees with my assessment of a stock or there is a bad rating in that community of stock pickers. Also, if a stock has very little coverage, it may see some good spikes in price as more analysts catch on to the stock and begin rating it a buy or strong buy.
Assuming my fundamental analysis looks good, I have to then look at price.
5. Should I buy this stock at this price now? This may be the toughest part of the decision-making. I really do a few calculations and look at estimates of the stock's price for a year down the road to see if it is currently selling for a fair value or if it is too high. When it seems too cheap, I often go back to my research to see if I missed something in my analysis that would show why the stock is out of favor. (Sometimes, it is just an awesome experience: you research and are convinced; however, the analysts have not yet caught up to the stock for some reason -- that is how I was able to buy EMC for $14.40 and watch it trend back to $13.30 before it moved up to it's current price of $19.60; I've had that same experience with Apple, AMSWA & Tasr -- it seems nuts but sometimes you can get in before the crowd). For me, price is a combination of factors: P/E ratio, PEG ratio, and the expected price in a year (according to various analysts).
What does the P/E ratio tell you? It is a multiple of how high the price of the stock is given the company's current earnings. While it is very important if it is high compared to other companies in the same industry indicating the stock may be overpriced, standing alone, it does not necessarily mean that you are paying too much for a stock. I am not at a point now where I can yet say that a certain type of company generally trades for X PE, although the S&P 500 is supposedly trading for about 18 times earnings at the moment. However, financial stocks and energy stocks tend to trade for less, while technology stocks tend to trade for more. Whenever the P/E looks either too high or too low, though, you need to investigate further.
What does the PEG ratio tell you? This is a much better measure of whether the stock is fairly valued. Wall Street analysts take information from the company to try to estimate what the future earnings will be. If you look at the growth rate of the company and compare it to the PE multiple, you get the PEG. When stocks are growing fast, Wall Street usually pays more for them because they will be worth more in the future (assuming they meet their estimated earnings). So, a high PE does not necessarily mean the stock is overpriced: you have to divide the PE into the expected growth. Thus, if a company trades for 20 times current earnings, but it is expected to grow at 20% a year, its PEG is 1 which is generally a bargain (because as it gets greater earnings, its share price will go up to reflect that). So, I really like to look at the PEG ratio. A PEG of 1 or less is fantastic unless the company has a history of disappointing expectations. A PEG of 1-2 is fine for a company that is really growing. Anything above that is a red flag that the company is overpriced (although there are some exceptions for companies that are experiencing a phenomenal growth surge especially from unprofitability to profitability).
Although ANGO's P/E ratio was high, its expected growth means it deserves to trade at a bit of a higher multiple (27 P/E with something like a 30% rate of growth). Dryships ratio was not so high especially when measured against 2007 expected earnings (19 PE but only 10 PE when compared to estimates of 2007 earnings).
While you are reading about the stock, you may find that it is high or low priced based on other multiples which are important to its industry (for example, multiples of book value or cash flow are measures commonly used in analyzing stocks -- I just store that information as part of my decision-making because it is too variable for just a regular person such as myself. Thus, when I listen to CNBC, I will listen to the different measures analysts use and decide whether those measures are just a way of justifying a too-high multiple or if they make sense to me; I do not, however, use them to decide if the price is good).
On MSN's site, you can find the earnings estimate and the growth rate. Sometimes, I just look at the 2007 FY estimate and multiply by the growth rate and see if the stock is trading higher or lower than that. Then, I look at the 2008 FY estimates and multiply those by the predicted growth rate and see where the stock would be trading by that very simple measure of growth times earnings (as though its PEG would be one by the end of this or next fiscal year). If I have already decided that it is a well-managed company, those are good calculations because it should be able to make those estimates (or beat them). That gives me a rough idea of what the stock might be trading at within a year. Sometimes, I calculate today's PE against future earnings to get the same kind of analysis of where the stock might go.
Often, however, I let the analysts tell me. In my IRA account, I have access to research from S&P & Reuters that give me a predicted price. I can use Morningstar in my regular trading account. And, very simply, CNBC.com gives you Thompson's estimate of the price (within a 12 month window). If you go to the profile section of a stock's page, and scroll down, there's a little box that says the expected price of the stock. That is an awesome tool -- there have been many times where I stock I am reviewing is 20% or more below its expected price or where the expected price has already been reached. That definitely gives me pause. Remember, you want your money to be making money: thus, if the stock is an awesome stock but it has finished its growth for now, you may want to put it on a watch list to see if its earnings go up more than expected, something happens to make the stock more valuable than predicted or it pulls back a little off of its highs.
That said, sometimes, momentum is huge and a stock that is moving up often keeps moving until it gets "overbought," at which point, it might pull back. But sometimes, it just seems to keep flying right on past all the prior predictions for the stock. If you know that the stock has room to grow, and you can be patient, and you want to buy, go for it. You may end up following it down a bit and then, later, it might shoot up or you may get to see it continue up for a while.
Another option is to do some technical analysis: there are simple things that charts can show about whether a stock is done going up or about to trend back up as well as whether or not there is an "overbought/oversold" condition on the stock at the moment. Technical analysis is VERY COMPLEX and, while used to make a lot of money for a lot of traders, is unlikely to be helpful to an individual novice. As you get more sophisticated, there is a lot of great information that you can get from the charts. But, in my admittedly limited experience, fundamentals trump technicals because the fundamentals tell you that you are buying a solid company with good potential: the technicals merely help you to determine that you are buying a good stock. Good companies will eventually have good stocks: good stocks of bad companies will eventually go down!
My examples of ANGO and DRYS are telling: Ango's price target, according to Thompson is $21.92 on expected earnings of $0.12 for the quarter. On the day I did the research, ANGO was selling for 17.99 (thus, it had a potential 20% upside assuming that Thompson was correct and that ANGO met expectations). The problem is that ANGO recently indicated its earnings were going to come in lower than expected. The price target for DRYS was $62.00 and $1.62 in earnings and, on that day, the stock had pulled back a bit and was trading for around $56.00.
6. Time to make a decision: Now you've done your research, what do you think? I watch the stock a while usually before I buy to get an idea of how it trades. I have learned a few things this summer in the stock market that made me realize that everything has a cycle. When I bought my first house, the housing market was "hot" and we were told that we better make a quick offer if we wanted to get the house we found. It was a terrible way to make a decision. While a stock pick is not the same as a house, you really usually don't have to rush in. If a stock gets hot for a while, it'll pull back. It may not pull back to the price you first found it, but most stocks pause or pull back at some point even in the midst of an upward trend. If you are patient, you may get an opportunity to buy in for less tomorrow than today. Of course, you may lose an opportunity completely if a stock makes a mad dash up -- so, you don't want to "overthink yourself out of all stocks." '
What is it you need to decide? Am I getting into this stock at too high a price, just right, or should I go in despite the fact that the price seems a bit high? Now, if you are in for the very long haul, I'm not sure that a few dollars one way or another really matters. When I first started to research stocks, I really didn't even care about price per se because I see that stocks go up and they go down and I might as well get in and let it catch up to itself if it's a bit overpriced or still on its way down. Honestly, I do not think that hurt me except that my portfolio took a while to catch up in a few cases. Like GE -- I heard good things about it, I did much less research then and did not realize that by paying $37.10 per share when a few weeks before it was trading at $34.00 meant I was paying 10% up for a stock that had not grown in years. I wanted in to the stock and I got in -- had I waited, I'd have several more shares at the lower price. But, now with GE between $40 & 41 -- I'm not sure it will ultimately matter. It is a long term hold and it pays a great dividend. However, tying up your money is a lost opportunity. So, I'd rather hold on to a stock that I got at a good price waiting for it to go up, then have bought too high and have to go down and then back up. When my GE stock went back down to its prior $34.00 (which, in fairness to myself, I could not have necessarily predicted), I needed 20% growth to ultimately get 10% growth. So, price matters, but, in 5 years, if GE grows at 20% a year with its dividend, the 37 I paid will not make much difference. (Not that I necessarily expect GE to do that; for some reason, I truly believe in that company but that stock just cannot hang on to any real movement).
If, however, you are planning on trading the stock in a shorter time frame, you must focus on price and try to find a good entry and exit point. This market has been rewarding momentum (although that could change). Thus, stocks that are going up seem to keep going up (although any major upward move in one day seems to usually be followed by a downward move a few days later). So, now, I even play with charts (much more on that later). But I find it very hard to buy a stock that has had a huge move unless it still has room to grow; if it starts to turn around, it may go for a while before it starts to come back up. I like to see a stock that is trending upward but still has room to grow according to my calculations. (For my investment account, I might like a stock in a company where the stock price has been beaten down a bit). But for my trades, I like to look for companies in a clear upward trend so long as they haven't come too far too fast.
Dryships and Angio-Dynamics represent two different ends of that particular spectrum making them both interesting for different reasons. ANGO is a stock that has come down in recent months. Given that markets are supposedly efficient, the market has already beaten down the stock from a high of $31.07 to the current price (July 18th) of $17.99. Does the stock have further to fall? It might if it does not meet earnings estimates. However, it may make a great trade for a few bucks of profit in the next few months. Based on the fact that the news about its troubles (patent litigation and lowered earnings guidance) is already out there, it might already be priced for its bad news. Honestly, I put it into my watch list and I'm waiting to see if it comes down a little more after its next earnings report.
DRYS was a different story -- In my mind, despite its run up in the past year, I still felt it was a bargain at 56. But, I didn't get in at 56 because I waffled that day. I figured I would watch it for another day -- it had just had a great move up, and then it was down a little, so I thought maybe it could come in a drop more. STUPID. The next day it moved up 11%. That's a trade I would have liked to have a part of but missed out of cautiousness. However, in my defense, this is a market that is so volatile, it usually doesn't hurt so much to be cautious. So, now it is in the watchlist because I am going to sit on it for a little bit.
There are a lot of decisions to make when it comes to picking stocks. I hope that this article helps you to find a system that makes you more comfortable with being your own stock-picker. But be careful: the biggest hyped stocks might be ready for a downturn. That's why it is smart to have your own method of making decisions rather than just listening to others. Whatever you do, do not buy a stock immediately after a Cramer recommendation (it jumps up a few percent as a result of the "Cramer effect," but, it usually comes down). And never buy a stock as a result of an e-mail hype.