COMPANY SELECTION
The goal of stock market investing is to purchase the earnings growth (capacity utilization) of companies. Value investors tend to purchase the stocks of larger companies; they concentrate upon company valuation in order to purchase bargains. Growth investors tend to purchase the stocks of smaller companies with higher earnings growth rates; they concentrate more upon the factors that suggest continued high growth. Value investing is usually more conservative.
In
the following we discuss the important company issues of earnings growth
(capacity utilization), valuation (as previously discussed), soundness, and
diversification.
EARNINGS
GROWTH
It
is said that the ideal investment is a well located rock quarry. Consider the
advantage. Rock is heavy therefore its transportation costs are high. Within
limits, the owner of a rock quarry can charge what he wants. In textbook terms,
he has a monopoly. In business terms; his sales will increase, margins will be
high, and his earnings will increase.
Business
establish and maintain their advantages through R&D, merchandising, or location.
You and the company's management should be able to state in one or two
sentences the company's advantage over the competition, what unique and
sustainable benefits the company offers its customers.
VALUATION
Many
investors consider only the above and not the following, the market may have
already valued the company's reasonable growth prospects. Consider the simple
identity:
Price = Earnings per Share x P/E
stock
where: P/E is the stock's P/E ratio,
a measure of valuation. If you
are valuing a cyclical company,
you might want to consider average
earnings per share over a single
economic cycle.
If
a stock's P/E ratio is very high, an investor will make a profit only if
earnings per share increase according to market expectations, and if the very
high P/E ratio does not fall. If an investor purchases high earnings growth at
a lower P/E, he has the chance to profit from both earnings growth and an
increase in the stock's valuation as the company's prospects improve.
A
company's P/E ratio is a function of the expected rate of growth in the
company's earnings (dividends) and the risk adjusted long term bond rate. If
there is an adequate margin of safety between the calculated price and the
market price, capital is likely to be protected; and the stock should be a
profitable investment as the market recognizes the company's value.
Those
who invest in financial companies and other asset based businesses should look
at a company's market price relative to its book value. A company's book value
is its accounting net worth divided by the total number of common stock shares
outstanding. A sound financial company selling at or below its book value is
likely to be a good investment when interest rates are decreasing.
SOUNDNESS
Although
some investors try to benefit from a company's improving soundness by
purchasing high yield bonds, most investors are better off purchasing the
stocks of sound companies of which there are many. Although companies in
different industries tend to carry different amounts of leverage, an obvious
sign of a company's soundness is its low or decreasing debt burden, both long
term and short term debt. A less obvious sign of a company's soundness is the
accounting principles that it chooses to employ. A useful rule of thumb to
assess the realism of these principles is as follows: if a company reports
increased earnings, did it actually pay more taxes. Companies usually disclose
actual taxes paid in the Income Tax footnote to the annual financial
statements. The line entry to look for is titled "Current Provision for
Income Taxes."
These
two considerations help to define a company's financial character.
DIVERSIFICATION
To
reduce the volatility of your stock portfolio, you can diversify by company and
by industry. It is always a good idea to maintain company diversification. You
can concentrate your portfolio if you know your companies very well and have
considered the effect of the business cycle upon their stock prices.