Day # 175: Stock Picking

I have had a fever all day ranging from 102 to 103 degrees, so it is difficult to think of 500 words today, let alone string them together in a way that makes sense. However, I made a commitment to write 500 words a day for 365 days and I intend to honor it.

Investment Selection Criteria

With the new year approaching, I REALLY want to get that darn investment policy statement finished. I need to think about how I will select securities for my portfolio and how I will monitor the portfolio over time. I think I will focus on individual stocks instead of mutual funds. Of the thousands of stocks available, how will I choose? I suppose the first thing I must do is decide on my investment style. Am I a value investor or a growth investor? That is, do I want to buy stocks at a good price or reasonably priced stocks that are expected to rise over time? As a bargain shopper, it is only natural that I would look for value in the stock market as well.

Screening
How do I find strong companies whose stock price is temporarily depressed? The easiest way to do this is to use one of the many stock screeners available on the Internet. Yahoo! Finance has a nice one and you can even screen stocks using pre-determined criteria. So, once you determine if you are interested in value or growth (or maybe growth at a reasonable price), you can screen to determine which stocks meet that criteria.

Other Considerations
Some other things to consider are:

Price – it would make sense to consider only stocks that are priced over $5 per share. Low-priced stocks tend to be quite volatile and should be avoided.

Return on Equity – this statistic shows how much profit a company generates with the money shareholders have invested. It is calculated as net income divided by shareholder’s equity. Many investors prefer firms with an ROE of 10% or more.

Free Cash Flow – this tells you how much cash a company has after operating expenses and capital expenditures. Since companies need cash to invest in projects that increase, value, this statistic is pretty important.

Forecasted Earnings Growth Rate – analysts tend to consider several growth rates. One is the earnings growth rate. Are earnings projected to rise or fall in the future? Value investors tend to look for earnings growth of at least 7% per year.

Leverage – this refers to the amount of debt in a firm’s capital structure. Leverage can be good because it can decrease a firm’s cost of capital but too much debt can be dangerous. It is safest to look for firms with no more debt than equity so that their debt-to-equity ratio is less than 1.

Dividend Yield – the ratio of dividends to stock price provides a useful way to compare dividend-paying firms. Growth investors tend to seek low dividend-yield firms. Value investors, on the other hand, look for dividend yields of at least two-thirds of the long-term AAA bond yield.

Market Capitalization – market capitalization is a measure of firm size. It is calculated as stock price multiplied by the number of shares outstanding. The largest firms (large cap) tend to be the most stable while the smallest firms (micro cap) tend to be quite volatile and should be avoided.

Price/Earnings Ratio – there is no magic number that investors should look for in a P/E ratio, but value investors tend to prefer firms whose P/E ratio is below average and preferably in the lowest 10% of all stocks.

Revenue Growth Rate – similar to the earnings growth rate, it is useful to know if revenues are expected to grow in the future.

Perhaps with these guidelines in mind, I’ll be able to find some good prospects for my portfolio

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