The following question from JS is about stock picking:
I often see people talking about finding and purchasing undervalued stocks or stocks that are inexpensive given the performance of the companies they belong to.
I’m curious as to how one sets about finding such stocks. I understand the idea behind examining the fundamentals of a company and tracking their P/E ratios, but I’m curious as to how one finds the company to begin with. Does one suddenly say one day, “I like Coke. I’m going to check their fundamentals today to see if they’re undervalued, and if so, I’ll invest.” Or are there tools/web sites that list companies that are currently considered to be undervalued?
I’ve picked stocks with mixed success before (US stocks outperformed S&P index, Canadian stocks under performed TSX index) and I heavily used ValueLine Investment Survey’s screening tool (you local public library might have a subscription) as the first step in my research. From the ValueLine screen, I looked for “fallen angels”, companies that are in trouble for some reason that, in my opinion, can be fixed. This strategy led me to Altria Group, AIG, Home Depot, Anheuser-Busch etc., stocks that I still own and am reasonably happy with just holding. Other investors use similar screens: some use dividend yield signals of a small group of stocks (in Canada, it is fairly easy to come up with a short list), some use price-to-earnings, price-to-book ratios etc.
Whatever method you think will be successful (many methods mysteriously stop working as soon as they become popular), you should realize that even professional investors find it difficult to beat the underlying index. It is also time consuming to keep track of the news flow, read the annual reports and periodically check that your investment thesis is still solid. Despite all this effort, it is still possible that stock picking is akin to a chimp throwing darts and you run the risk of badly trailing a low-cost, diversified portfolio of index funds.
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6 responses so far ↓
1 Canadian Money Blogs Reviewer // Apr 12, 2007 at 8:32 am
I’ve had decent success using investment newsletters like Investment Reporter. I’ve also tried looking at pure “technical investing”, but it feels more like gambling to me.
2 Dan // Apr 12, 2007 at 10:19 am
That is a great question from JS. There are many free web sites in which a person can screen for a stock. I know of Yahoo.ca, The Globe and Mail, Stockscores.com to name a few. What I feel is a big part of investing is to know when to “SELL”. It is very easy to buy, it is much, much harder to admit that you made a mistake, sell for a loss (hopefully a small one), and move on. When you can learn to do this, you will vastly improve your returns.
3 Canadian Capitalist // Apr 12, 2007 at 10:32 am
Dan: You’re right about the sell part. Wish I had parted with NT and JDS early. I would have great returns on Canadian equities too. I think MSN has a decent stock screener as well (available here).
CMBR: I’ve used Investment Reporter occasionally. Its one of the best newsletters because it focuses on long-term investing with minimal turnover.
Still, stock picking is a very difficult game to play and in my opinion, it is better to invest only a small portion of portfolio in individual stocks.
4 Yielder // Apr 12, 2007 at 11:15 am
I think that you start by asking yourself what kinds of companies you want to own. Do you want to own well-established companies with long track records? Do you want to own emerging companies? Do you want to own cyclical companies including natural resource companies? Do want to own large caps? Mid-caps? Small caps? Micro caps?
My focus is first on risk and then on return. I also want to keep portfolio turnover down and thus reduce costs. By focusing on risk, I look mostly at large and mid cap companies with strong balance sheets (D/C
5 MikeH // Apr 12, 2007 at 11:53 am
Here’s a strategy that’s worked for me:
1 ) Invest in companies with a history of profitability. One or two bad quarters is fine, but if they’re bleeding money, don’t gamble.
2 ) Look at the Dividends - consistent payout history is a sign of health. (The dividend doesn’t need to be large, just consistent.)
3 ) Lower than average P/E ratios compared to peers signal possible undervaluation. I find that risk increases dramatically with P/E that drift above 20.
4 ) Avoid companies that are getting big handouts from the government. Such handouts suggest - to me - that the company is in serious trouble. (I got burned by Air Canada, and I’m tenuously holding on to Bombardier…)
5 ) Invest in companies that you can explain to your spouse. If you don’t know what the company does, don’t buy it.
6 Phil S // Apr 12, 2007 at 2:57 pm
I pretty much agree with MikeH, but I would rearrange the order and add a few things:
1. As part of the “initial screening” process, I start with looking at P/E ratios. I like to use the big banks as what the “proper” P/E ratio for a company should be. Any company trading significantly below what the banks are trading at I would consider undervalued.
2. After the screening in Step 1, next consider the market cap, past track record, dividend yield and liquidity of the stock. Do they have a long history of increasing earnings? How big of a company is it and are you comfortable investing in a company of that size? What is the spread between bid & ask and how many shares trade daily - and what level of liquidity are you comfortable with?
3. After Step 2, you need to consider what industries that the remaining companies are involved in. Go to their website to see what kind of business they are engaged in. If it is commodity based, are you comfortable with the future prospects of the commodity that they sell? Are you OK ethically with what the company does? Eliminate all of the ones you aren’t comfortable with.
4. After Step 3, you probably have a very short list. From this very short list, you can go to SEDAR and look up the most recent quarterly report and last annual report as well as the management’s discussion and analysis paper. Check the numbers on the balance sheets and cash flow statements to confirm that the P/E ratio and market cap is accurate. Read the management’s analysis to understand what they consider a risk and what they’re doing to countermeasure it. If you don’t like what you read, or if they aren’t giving you enough details about what you want to know, then strike that company from your list.
In my past experience, by the time you finish Step 4, there are usually less than 10 companies left on my “buy” list! Then I pick the one that I think has the best future prospects.
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