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10 ways to kill stupid stock ideas
Growth-stock investors must sort through thousands of candidates. Eliminating the losers quickly is a key part of the process. Here's a handy, 10-step checklist.
By Harry Domash
Investors seeking growth-stock stars are well aware that the more they know about their candidates, the better their chances of picking the best stocks.
But there's a spinning universe of growth stocks out there, and researching each one takes time. So why not eliminate the truly bad ideas quickly? Send them into a black hole. Once you've sifted out the true potential stars, you can spend lots more time figuring out how brightly they shine.
Following are 10 quick checks you can perform to eliminate stupid stock ideas in less than two minutes.
You can make all these checks by starting with MSN Moneys Company Report feature. (Get there by typing in your first stock symbol in the quote request box on MSN Money's Investing page. When the quote page appears, select Company Report from the menu on the left.) On the Company Report page, scroll down the "Stock Activity" section and look at the price and volume data for the first good clues.
A growth stock checklist
To qualify, a stock must pass all of the following tests.
1) Price chart: Last price above both the 50- and 200-day moving averages
2) Daily trading volume: 50,000 shares minimum
3) Annual sales (12-mo.): $50 million minimum
4) Net income: $0 minimum
5) Sales growth (5-year): 15% minimum
6) Income growth (5-year): 15% minimum
7) Institutional ownership: 30% minimum
8) Long-term debt/equity: 0.4 maximum
9) StockScouter rating: 4 minimum
10) Forecast earnings growth: 15% minimum
1. Uptrending price chart
Theres nothing worse than seeing your new stock get hammered after the company announces unexpected bad news.
Maybe that new hot gizmo due out next month doesnt work as expected, will be months late to market, or isn't generating a flood of orders. Possibly a major customer is experiencing financial difficulties and is cutting back on orders.
Some folks knew the bad news was coming before the company made it official. They may have been customers, suppliers and, of course, company employees and management. Not always, but sometimes the word spreads, and in the know investors start selling, pushing the stock price down weeks before the announcement.
Thats why you should check a stocks price action before starting your research. A growth stock should be in an uptrend, reflecting the markets optimism about the company's outlook. A downtrending or flat chart signals that at least some investors smell trouble.
Chart mavens analyze price charts to find out which way the stock is trending. But interpreting the chart is a subjective exercise. Its not unusual for two people to draw different conclusions from the same chart. Further, your conclusion depends on the time span displayed. For instance, a stock can be in a downtrend on a three-year chart, but in an uptrend on a one-year chart.
You can avoid these complications by comparing a stocks price to its moving averages. Most agree that a stock is in an uptrend if its latest share price is above both its 50- and 200-day moving averages. You can see all three in the Stock Activity section.
Smart move: Disqualify any stock trading below either its 50- or 200-day moving average.
2. Sufficient trading volume
You want mutual funds and other institutional buyers to buy your stocks, because its their heavy buying that pushes share prices up.
Because they have millions to invest, most funds must buy hundreds of thousands of shares to establish a meaningful position in a stock. But funds must limit their purchases to a small percentage of the total number of shares traded; otherwise, their buying will drive the stock price out of reach.
Same thing in reverse! Imagine how long it would take for a fund to unload 500,000 shares of a stock trading only 10,000 shares daily without upsetting the market. So mutual funds prefer stocks with enough trading volume so they can rapidly move in or out of positions.
The average daily volume is the average number of shares traded daily over the past three months. At the very minimum, you want stocks trading at least 50,000 shares daily, and more is better.
Smart move: Avoid stocks with less than 50,000 shares in average daily trading volumes.
3. Annual sales (revenue)
Now, it's time to check the sales, sales growth, income, and income growth figures listed in the "Financials" section on the same Company Report page.
Beware: Stock scams abound on the Internet. Most involve companies that, according to the promoters, have just developed a fantastic new product, such as a cure for cancer -- but that in fact produce little or no sales.
You want profitable companies and profits that come from selling products or services. Most publicly traded firms rack up sales well in excess of $100 million annually. Smaller companies are risky propositions, and you dont need more risk. In my experience, any company worth looking at sells well in excess of $50 million annually.
Smart move: Disqualify companies with less than $50 million annual sales.
4. Net income
Net income is a company's bottom line profits after paying all expenses including income taxes. The market has little patience for money-losing companies these days. So avoid those rascals and require positive net income over the past 12 months. At this stage of your research, any positive number suffices. You can analyze the earnings in more detail later.
Smart move: Disqualify any company with negative 12-month income.
5. Sales growth
Growth investing is about finding companies that are growing earnings, but earnings come from sales. Sure, a company can grow this quarters earnings by cutting costs, but in the end, sales growth drives earnings growth.
How much growth is enough? Opinions vary, but insisting on at least 15% annual earnings growth is a good place to start, and that translates to 15% sales growth. Of course, more is better.
Smart move: Avoid companies showing less than 15% sales growth, on average, over the past five years (5-Year Growth).
6. Income growth
Companies growing income at least 15% annually make the best growth candidates, and higher is better.
Note: Newer companies may not have been profitable for five years, and the report will list NA for five-year income growth in theses instances. Do not disqualify these stocks at this stage.
Smart move: Disqualify companies with less than 15% income growth, on average, over the past five years.
7. Institutional ownership
Now, check for sufficient institutional ownership in the "Institutional Statistics" section.
Institutions are mutual funds, pension plans and the like. Because they trade millions of shares monthly and generate huge commissions, institutional buyers are wired into the system. Theyre aware of every stock, and they tend to know all the latest gossip.
Institutional ownership is the percentage of the total outstanding shares held by these in-the-know buyers. Most in-favor growth stocks have institutional ownership in the 40% to 95% range.
Lower numbers mean that mutual funds and other institutional buyers dont find the stock attractive. If institutions arent buying, you shouldnt, either.
Smart move: Disqualify stocks with less than 30% institutional ownership, and higher is better.
8. Long-term debt
Now it's time to check the debt level and the StockScouter rating in the "Fundamental Data" section.
The long-term debt/equity ratio compares a company's long-term debt to shareholders equity (book value). A zero debt/equity ratio indicates no long-term debt, which is the ideal condition. D/Es around 0.5 suggest moderate debt, and D/Es above one reflect high debt.
High debt isn't necessarily a bad thing. It makes good business sense to borrow at, say, 5% if you can turn around and reinvest the money and score a 10% return.
However, from a shareholders perspective, high debt adds risk, especially now. An unexpected business slowdown could reduce a company's cash flow to the point where it cant service its debt, triggering credit-rating downgrades, and even the possibility of bankruptcy.
Further, interest rates, currently at historic lows, are likely to move up. When that happens, high-debt companies will face rising interest costs, which subtract from earnings. Unless you want to spend your time analyzing financial statements, its best to avoid the issue by sticking with low-debt companies.
Smart move: Avoid companies with debt/equity ratios above 0.4, and lower is better.
9. StockScouter rating
MSN Moneys StockScouter rates a stocks six-month return potential based on fundamental and technical factors. The stocks are scored on a 10-point scale where 10 is best. The computer-generated scores are far from perfect, but high-rated stocks, as a group, have been shown to outperform low scorers.
Thus, you increase your risk by picking low-rated stocks. What is too low? There is no hard and fast rule, but most would agree that scores of 3 and below signal risk.
Smart move: Disqualify stocks with StockScouter ratings below 4.
10. Predicted earnings growth
Finally, it's time to check the forecast earnings growth rate in the "Earnings Estimates" section of the Company Report.
A growth stocks share price is usually based on the assumption that its historical earnings growth will continue indefinitely. So the last thing you want to see is slowing earnings growth.
Check the analysts take on your candidate's growth prospects by comparing the next fiscal years expected earnings per share to this fiscal years number.
For instance, clothing retailer Chico's (CHS, news, msgs) is expected to earn $1.13 a share in its next fiscal year (ending 1/05), compared with 95 cents a share this year (ending 1/04). You can use your calculator to figure out the growth rate, but its easier to click on the "More Analyst Estimates" link and simply read it off the chart (19% growth rate for Chico's).
Smart move: Disqualify stocks with next fiscal years forecast EPS (earnings per share) growth less than 15%, and higher is better.
Ive given you my rules of thumb, and you may want to modify them as you gain experience with the checklist. Whatever numbers you use, following a fixed set of qualification rules will help you keep your emotions out of the selection process.
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