5 rules to follow in selecting good stocks to invest

Q: I HAVE been an OFW for many years and I have some savings that I am planning to invest in the stock market. I want to grow my savings by making money from stocks. How do I choose the right stocks? Are there guidelines to follow?—Zerah by e-mail

A: There are many ways to select stocks depending on your investment objectives. Some people want to buy riskier stocks for higher returns. Some are more conservative and opt for blue chip stocks for safety. Some want to trade for quick profits while others prefer to hold stocks forever.

Regardless of the investment goals, every investor wants to find promising stocks that offer value in the future. How much is the expected value of the stock? How much gain can you make from the current share price of the stock?

But how do you know which stocks will be winners? Here are the five criteria that you can use in selecting stocks:

Rule No. 1 – Select stocks with strong cash flows

Track record of consistent growth in earnings is not enough. Earnings can always be manipulated by creative accounting. It is possible that a company reports positive sales and earnings every year but with consistent negative operating cash flows. Look for stocks that generate historically high operating cash flows because they are harder to maneuver. These can be found at the firm’s cash flow statement.

An important ratio that you can use to analyze the quality of earnings of stocks is the operating cash flow-to-net income ratio. A ratio of more than 100 percent shows that the company has strong ability to fund its activities through generation of internal cash flows.

To illustrate, the property sector’s average operating cash flow-to-net income ratio for the last three years was 59 percent. Among the eight major property developers in the sector, Ayala Land (ALI) has the highest ratio of 194 percent while two firms in the bottom suffer negative ratios.

Rule No. 2 – Select stocks with rate of returns above its cost of capital

Companies that report high earnings growth does not necessarily mean they are creating value for shareholders. This happens when the rate of returns from reported earnings fall below the cost of capital.

Let’s say you are earning 10 percent a year from your money market portfolio but you need to pull out the cash to invest in a franchise business. Would you be happy if your franchise business give you returns of 5 percent after one year? What if in the following year your earnings increased but your returns on investment (ROI)  is only 8 percent? There is no value created when ROI is below opportunity cost.

There are many stocks in the market that earn below their cost of capital. Some barely earn their cost of capital. The average weighted cost of capital among PSE index stocks is about 8.5 percent while average returns on invested capital is 11.7 percent. This yields average excess returns of 3.1 percent. Among index stocks, Meralco creates the most value to shareholders with 27 percent net returns.

Rule No. 3 – Select stocks with sustainable competitive advantage

There is no guarantee that firms that perform financially well today will continue to do so in the future. There will always be new competitors that will enter the game and seize a share in the market. Choose companies that can sustain above-average profits for the longest time possible due to its strong barriers to competition. These can come in the form of having strong brand, huge economies of scale or being a market leader. Examples are Jollibee, SM Prime, BDO and PLDT.

Rule No. 4 – Select stocks with promising growth outlook

The challenge in investing is being able to identify emerging dominant players in their particular markets. Buying stocks that are likely to generate strong cash flows, enjoy excess returns and build sustainable competitive advantage in the future provide the largest possible profits over the long-term.

It is important that you are able to identify future growth drivers when screening stocks to invest. Value drivers such as sales growth from opening new markets, improving pricing power, widening economies of scale, declining operating costs and rising investment efficiencies are important factors that will give you reasonable basis to expect future values of stocks.

Rule No. 5 – Select stocks that provide reasonable margin of safety

Stock picking is more than buying the safest stocks in the market. It is not only about having the discipline to study and research the financial performance  of a stock but also about the right timing. It may be good to accumulate value stocks at their low prices when no one is noticing. This helps provide huge margin of safety to your target price. However, it is equally good to buy aggressively when the stock that you have researched is just about to go up. A stock on the uptrend could mean the market is beginning to validate the emerging fundamentals of the company.

There is always something to learn when you invest. If you feel you lack certain skills, do not hesitate to invest in educating yourself.

Henry Ong is registered financial planner of RFP Philippines. Stock data and tools are provided by Technistock. To learn more about stock valuation and analysis, attend the 9th Accredited Financial Analyst (AFA) program this Sept 10-Oct 15. To register, e-mail [email protected] or text <name><e-mail> <AFA> at 0917-9689774.