Question: Thank you for your article, entitled “A Surefire Way to Win with Stocks.” However, I feel I need more details on how to go about discovering the right stocks to buy or sell. Can you give specific tips on the matter?–asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.
Answer: To answer your question, I will split my answers into two major groups, fundamental and technical analysis.
For fundamental analysis, let us rely on the teachings of three of the greatest minds in investing: Warren Buffett, Benjamin Graham and Peter Lynch. While the list of teachings is not comprehensive, it should be empowering enough to lead to a winning portfolio.
Warren Buffett has a few rules on the companies to focus on and the strategy to take in investing:
1. Buy easy to understand, solid and enduring companies. The business must be easy enough for you to comprehend. The earnings and cash flow must be so solid that it will lead the company to last beyond 10 years. This means the company’s product or service must be perceived as a need by its target market, not have any close substitutes, and not be subject to price regulation. The business must also not be too capital-intensive.
2. The company’s management must be after shareholders’ interest first. The company must be able to resist the institutional imperative of merely reinvesting earnings for reinvestment’s sake. If the company cannot earn a decent return on shareholders’ money, then this should be paid out in the form of dividends. Buffett focuses on the discounted value of cash that a business can pay out throughout its remaining lifetime. More importantly, the current market price should be at a substantial discount to the company’s intrinsic value.
3. Ignore macroeconomic factors, stock forecasts and short-term price fluctuations. Buffett advises investors to do a semi-bottom up approach to investing where more focus is given to factors that directly affect a company and the industry it operates in. At the same time, he instructs investors to avoid market “noise” and stick to the basics.
For his part, Benjamin Graham identified two types of investors: the defensive and the enterprising. The defensive investor should abide by the following rules:
1. Create a 50:50 portfolio allocation between high grade bonds (e.g. government securities) and stocks. The stock allocation can be brought down to 25 percent in good times and back up to 50 percent in bad times.
2. Don’t be too diversified. – Have at least 10 but a maximum of 30 stocks in a portfolio.
3. Buy only the leaders in an industry.
4. Go for companies with a long record (i.e. 20 years) of continuous dividend payments.
5. The current market price of the company should not be more than 1.5 times its book value.
6. The current market price of the company should not be greater than 15 times the average earnings of the past three years.
For the enterprising investor, Graham recommends the following:
1. Create a 50:50 portfolio allocation between high grade bonds (e.g. government securities) and stocks. The stock allocation can be brought down to 25 percent in good times and back up to 75 percent in bad times.
2. Current assets must be at least 1.5 times current liabilities.
3. Total debt should not be more than 110 percent of net current assets for industrial companies.
4. There should have been no losses for the last five years.
5. There should be some dividend payments and strong earnings growth to explain the low dividends.
6. The current market price should be no more than 2/3 of the estimated fundamental value.
For Peter Lynch, the ideal company is one that:
1. has a boring name, does something equally boring or depressing and is even into a business that can be disagreeable (e.g. funeral services company);
2. is a successful spin-off from its parent company;
3. is not owned by institutions and not covered by analysts;
4. has a niche through a patent or an exclusive license;
5. is a user of technology; and
6. has products or services that are constantly in demand.
Unlike our three great investors, technical analysis does not attempt to establish a company’s intrinsic value.
Technical analysis involves the study of a company’s historical stock prices in an attempt to establish trends within channels (i.e. the area bounded by the resistance and support lines). Depending on the price movements that are sometimes run through statistical models, technical analysis establishes the buy and sell signals of stocks.
In my view, the best strategy is a combination of both fundamental and technical analysis, especially for a stock market where volatility is the norm. Fundamental analysis can tell you which company to buy or sell while technical analysis helps in determining the entry and exit points.
To learn more about ways to invest in the stock market, please visit www.personalfinance.ph. There are free stock investing tools available. You can also attend our EnRich™ Wealth Management training in Davao on Aug. 8, 2015 or our Financial Planner’s Training program for the cities of Davao, Mandaluyong, Cebu, Iloilo, Cagayan de Oro and Baguio. Check our web site for the details.
(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or emailed to efren@personalfinance.ph. To learn more about value investing strategies, attend FREE stock market investment talk on Aug 12 pm at PSE Center. For more details, inquire at info@rfp.ph or text <name><email><AFA> at 0917-3464126.)