When was the last time you truly grilled stock candidates? In relationships and stock picking, you have to date a few duds before the darlings. Here's how.
Stock picking is a little like dating. Plenty of fish. Big sea. And, yes, changing tide. And just like the dozens of dating sites that slap a formula on matchmaking, there’s some science, especially social science, behind building a portfolio that you might just fall in love with. At least until the next ticker stops you in your tracks.
1. First, decide your type, if you have one. Think broadly. You’re just getting started. This might include targeting an industry. Maybe that’s home builders because you believe they could benefit from low interest rates or the retailers you believe to be oversold as a group. You may land on a theme instead—supportive services for an aging population, for example.
2. Size matters? Kind of. Are you targeting companies categorized as micro-, small-, mid-, or large-capitalization? Some portfolios may have a mix of sizes; larger companies may be more familiar to you, and some pay dividends. Smaller companies may just be the nimble dancer to help target very specific market segments. Age may matter, too. More mature companies are typically expected to display slower growth, but at a steadily rising rate. Younger companies, and those in a high-growth but volatile business, tend to reinvest free cash flow back into the company. That can make them less shareholder-friendly in terms of dividends and other perks. Are you okay with this?
3. Time for get-to-know-you questioning. Yep, time to drill that candidate sitting across from you: Cash flow? Valuation? How about dividend increases in the past three years? Some stock pickers are only interested in beta below 1 (versus the S&P 500). What about revenue growth for the past three years? Gross and/or operating margin growth for the past three years? Price-to-book-value ratio below that of the peer group? Price-to-cash flow below that of peers? Now, whether you want your candidate to check some or all of these boxes is up to you.
4. True tests. Wow, things are getting serious already. Some investors screen companies by getting right to the financial skeletons in the closet. This includes researching liquidity ratios, or a company’s short-term assets, namely cash, relative to its short-term liabilities. This also includes debt ratios, which cover the company’s ability to service its debt, meaning pay interest and any other obligations. It also covers how much debt a company has relative to its overall equity. Finally, some investors hope to uncover profitability ratios, which cover the return on assets employed, money invested, or equity held.
These are simply market “dating” rules of thumb, some handed down by market veterans, some possibly too old-fashioned for today’s market newbies. They’re all simply meant to get investors thinking harder about this important relationship and digging for deeper knowledge of the companies they’re investing in—that’s the fun part.
These tests speak little about you, and you’re a big part of this relationship. What’s your time horizon, and do the stocks you have your eye on fit within those goals? What’s your risk tolerance? Your tax situation? You probably don't need to be reminded, but: you often have to date a few duds before finding the darlings. Even candidates that match your criteria might not deliver as anticipated (or pass your mother's scrutiny). Ultimately, deep research should back up any hunches and a solid risk management plan can help you survive to date another day.
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