Where do we find these wonderful picks?

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Where do we find these wonderful picks?

Post  Max on Thu Nov 25, 2010 4:04 pm

OK, so we have posted a number of analysis for different stocks, covered a lot of basic education, but as a trader, there is one critical piece of information that is missing: Where do I find good stock picks? Are they being manufactured (pump it and others will come)?, is there a secret place to go find them? Are you in fact in the matrix and everyone who is picking winners is just part of a computer system messing with you and it is really not possible?

The truth as I know it is that there is no magic formula to find a WINNER, it is mostly chance and lots of time spent on research. However, there are a lot of things you can do to find potential winners:

1) Stock Screener. Luke provided a link to the TMX stock screener, which I feel is pretty good. You can punch in the criteria and out comes a list of stocks. Obviously you should not instantly buy everything on that list. It is only to give you leads, not to do the analysis for you. This is personally my primary source and I do what is called Bottom Fishing, which is looking for beat up stocks at a discount to their book value + expected earnings.

2) News (TV/Reuters). As riddled with pumpers (those who promote stocks they own, often without justification) as the news is, it is also a great source of ideas, and helps to see which stocks are being talked about. More than I would like to admit, it is often a popularity contest for which stocks do well rather than people paying attention to fundamentals like the balance sheet and income statement.

3) Websites focused on specific investments. Google search for "value stocks", "green stocks", "energy stocks", and see what you get.

4) Newspaper, investment websites or magazines. These will have a lot of ideas, but tread carefully, because the authors of these articles are all mutual fund managers trying to pitch their star stock of the week.

5) Mutual fund prospectus. You can often see the top 10 holdings in mutual fund prospectuses. Word of caution, this information is old, and it doesn't tell you at what price they bought. In fact, most mutual funds just buy the stocks that make up the index, so they don't really care at which price they bought, since they need to be fully invested and have new money coming in all the time. Still if you find that a lot of the mutual funds own the same obscure stock, it may be a stock worth looking into.

6) Word of mouth. Sometimes, as in this very site of ours, some nice person will go out and do all the research for you. Of course the rule of thumb is that your decisions are your own, and no matter what analysis you rely on, things can and do go wrong, and you cannot blame the analyst. Also, the analyst also has their own motives and may or may not own the stocks they are recommending, so you need to be careful and validate all the research they have done. Still, if you find an analyst you like and trust, it makes it that much easier, because you can more quickly double check their work and then make your decision. It is expected to be a reciprocal relationship, so an analyst will appreciate any questions (even and sometimes especially hostile ones) that show you have taken the time to read what they have wrote and have something to add. Things become much clearer on a big picture basis than they are for the analyst who is buried in the details, so often a fresh look will come up with interesting questions.

Hopefully some others will post any additional resources they use to develop ideas.

OK, so now we have a big list of potential stocks, how do we filter it down and weed out the losers quickly? You should add filters to get the list down to a manageable size (I refine by industry and exchange), and then proceed to analysis. The entire analysis process described below can take as much as 1-2 hours (much less if you find a loser, since you wont go through with the entire thing). I will speak about fundamental balance sheet and income statement analysis, and leave charting to someone better equipped to comment. In fact, my analysis is relatively simple and primitive. I don't get too deep into ratios and other things like that (which I feel can be misleading more often than not), and instead go by feel for the most part. But there are certain things I need to quantify as part of my due diligence.

1) Shares outstanding. This is a critical # with which to make most of the analysis. It is the share you are buying, so you should be able to compare the price you are paying per share with what you are getting per share. The # of shares should generally be bumped up, sometimes significantly, depending on the # of outstanding options, warrants, and agreements to issue shares that the company has. Also, in the case of ADS (American Depository Share), like in Tenaris, you need to be sure you convert everything to the number of shares listed on the stock exchange and not the number of shares shown on the balance sheet (I have made this mistake and it cost me a lot of money).

2) I like to look at cash, debt, total liabilities and book value (all on a per share basis) as well as current assets / current liabilities. This gives me a feel for the company's overall value, and how their valuation is likely to change in a crisis. The more the total book value consists of cash and current assets, and less debt and total liabilities, the better.

3) I like to look at the interest rate on their debt. This tells me what the bank (and their professional analysts) think of the company. Now, this is likely to be a very conservative analysis and if you are dealing with a junior miner, this has less weight. Still, it is usefuly to have a second opinion and can be compared between companies. Also, an excessive interest rate can mean that they will have difficulty obtaining further financing and are more likely to issue shares. Also, it can obviously affect profitability.

4) I like to check the amount of options the company has outstanding, and exercise prices if possible. Since most of the options are issued to top management, or those who can influence top management, there is a general incentive for top management to keep the stock price above the exercise price so that they can take advantage of the options. This can also affect cash flow, since the expense has already been recognized and will not show up on the income statement (in fact their is an actuarial formula to determine how much they can expense each year and there may be some balance remaining to be expensed). This shows potential for dilution in ownership.

5) I take a look at the net income (and annualize it if it is for a quarter), and compare to previous years. I like to look and see if there are any one-time expenses not expected to be recurring. I like to see if most of their expenses are in cost of goods sold (variable) or selling and admin (fixed). Unless I see something reall crazy, I dont look much deeper than that and take a conservative estimate based on these numbers and other comments to see what I expect future earnings to be.

6) I like to subtract the book value from the share price and then divide by the expected earnings per share to determine the PE ratio (which for purposes of differentiation I will call: Max PE). The is in contract to the PE ratio quoted by all other analysts (we will call: Actual PE), which is just the price dividend by earnings. This is a difference in philosophy, where the actual PE is assuming that nothing else matters except for earnings. This occurs because the book value will be permanently invested in the company, and the only addition of value to the company will come from earnings (these are can be distributed as dividends). However, I do not agree with this assumption, since for example, a company with a $50 book value and EPS of $1 should have a higher share price than a company with a $5 book value and EPS of $1. Book value matters and represents the value of the company if it were to liquidate and I feel should be included in the share price. Now, book value may need to be adjustmented down to reflect the fact that accounting value for things may not represent reality. This is a little more subjective and where I tend to go by feel based on the asset class and the type of business the company is in.

The Max PE should give me better picture of whether or not the company is cheap than actual PE. I need to keep in mind that the rest of the market does not see things the same way, and a company I assign a Max PE of 5 (cheap) may have an actual PE of 50 (expensive). Historical PEs depend on industry but are somewhere around 15 (high tech is often around 50 given the accelerated growth rate of earnings).

7) After these numbers are out of the way, I read the entire management discussion and analysis, and the notes to the financial statements looking for explanations to any problems flagged in the numbers or for any additional concerns. Some companies will have very insightful comments here that will warn you completely off the stock. Others will give very little information or have an overly positive spin on everything. I try to sift through it and learn what I can with a very pessimistic filter. If after reading all the comments, I find any problems adequately explained and temporary in nature, then I expect the stock to bounce back. Otherwise, I will likely pass on the stock unless the numbers reveal a deep discount that is too big to pass on. However, this second scenario is often dangerous and referred to as a value trap, since the stock price will not recover until a catalyst generates investor interest, and a permanent decline does not offer investors much to be happy about. In comparison with recent history, all the numbers will look bad, and a lot of investors focus on this kind of analysis.

Cool After looking at all this information and identifying a stock I like, I will then go to the charts and see where the price has been in recent and long term history. Here is where I think chart analysis fits into the overall picture, but I dont have much skill at it. I take a very primitive look at the charts to decide if I should wait for a better deal or buy now based on the long term assumption the stock will rise. Finally, if I am following discipline, I decide price targets to buy and more importantly to sell. This is based on the financial analysis as much as the charts. Based on the exchange, volume, and recent price history, I will determine if I should buy in slowly or put a lump sum in.


Thats it. The rest is sit and wait, checking the stock price and news to see if there have been any developments. If it is a large cap stock with sufficient volume, I will place limit orders for buy and sell targets. Otherwise, I will ride it through whatever comes until the news or updated analysis changes my mind.

Max
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