Monday, March 7, 2011

6 Criteria You Can Use to Pick Winning Stocks (Part 2)

Click here for Part 1

To recap, here's what we had last time:

1. Stock quality. Avoid speculative stocks.
2. Profitability. Only pick companies that actually do make money.
3. Dividends. Stable, consistent dividend payments signal a firm's health.

In this post, we round up the list with the last three criteria you can use to choose winning stocks.

4. Business life-cycle stage

I'm leaning more towards the mature, "cash cow" firms, if you take criteria 3 above as a hint, and I'm sure many, many others will disagree. Conventional wisdom says pick "growth stocks", which, like most things that come from conventional wisdom, is easier said than done. Growth potential is precisely just that--potential; one can be 100% sure only after the fact, and by then the proverbial ship will have already sailed and the stock will already be too expensive. And remember, there's an underlying logic behind growth: investments in research and development, a culture of innovation, unsaturated markets, low competition--it doesn't grow on trees. And these prerequisites are things most, if not all, of the listed stocks in the Philippines are short of.

Cash cows, as the term suggests, are firms that just rake in the money, mainly because of two reasons: one, almost always they are market leaders (see criteria 5), or are in very favorable competitive environments (monopolies or collusive oligopolies); and two, because they have tried-and-tested business models. The only thing you need to be careful of is if a company is too heavily reliant on a particular product or service that's at the risk of becoming obsolete soon. Although, if you're investing in the Philippines, things that should already be obsolete usually get to live on for a few more decades, as long as they still make money; think along the lines of the jeepney or the much-debated (and frustratingly heavily-protected) plastic bag.

5. Market position

Nothing beats being number one. The most important advantage of a market leader is that it can be a price setter, as long as the industry is not regulated. A friend who worked at KFC related how someone from Jollibee would call their office from time to time to tell them about an impending price increase, just so they could adjust their prices accordingly. Having this kind of control on pricing would ease the pressure on your margins, even if you're in a competitive industry, and result in more stable earnings or even earnings growth.

Also, a market leader would most probably have a large, deeply loyal customer base that would be the source of consistent and considerable earnings. And as long as the firm takes care of this valuable asset and does not screw things up too much, its stock wouldn't go anywhere but up.

6. Relative price

As measured by a readily available metric, the P/E or price-to-earnings ratio. Two kinds of P/E are often quoted: the true P/E is equal to the stock price now over the forecast earnings per share (EPS) next year; the trailing P/E uses the last quoted EPS instead of the forecast. The theoretical advantage of the P/E is that it's forward looking since it takes into account expected future earnings; the very real disadvantage of it is that forecasts are usually nothing more than guesses that are heavily weighted on past performance anyway. So in my opinion, trailing P/E is actually more reliable; if you have any reliable information that a company's earnings will rise considerably in the coming year, then by all means, adjust the trailing P/E accordingly.

Using the P/E ratio is not an exact science, but rather involves crude rules of thumb; my crude rule of thumb is that if a stock has a significantly higher P/E than the index (e.g., PSEi) P/E, then it's too expensive and I wouldn't consider buying it. In any case, the logic works like this: if a stock has a "high" P/E, it could only mean one of two things: the stock has low earnings at a particular price or a high price given a certain level of earnings. If it's the former, then clearly the stock is no good; if it's the latter, then the high price should reflect the stock's potential for growth as seen by investors (they set the price, remember?), which is definitely good, or that the stock is just overpriced, which is definitely bad. Examples of stocks that would justify high P/Es would be tech stocks--but we don't have those in the Philippines, or anything that closely resembles those, do we? So when something has a high P/E I would just take it to mean that the stock is overpriced, which is bad. But you already know that, which is good.

There you have it. Six "rules" that can help you construct a winning portfolio.

By the way, some of you may ask, how are we going to make money out of these stocks? There's no growth!

Right, there isn't. Which is a good thing, since then there would also be little chance that you'll lose everything when global markets go crazy.

We make money two ways: first, earn modest returns from dividends, slowly but surely; second, make a killing when the market becomes irrationally exuberant and everything goes up.

That's it. I hope all of this makes sense and is not too crazy.

Anyway, good luck to us. In investing, it's something we can never have too much of. :)

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