No Time for Shortcuts

Laura DeVoy
Laura has worked as an Equity Analyst in Goodbody Stockbrokers Private Clients for the past 5 years and is a member of the Investment Committee of the Private Clients Department.
She has specific responsibility for sectoral research and research of companies that are included in the Private Client Buy List.
Laura obtained a BBS from DCU and a MSc in Investment and Treasury, for which she obtained a scholarship. Laura is a part qualified CFA having completed two of the three levels.

September 2004

No Time for Shortcuts : Stock Selection

Many readers have enquired how to 'simply' choose a valuable stock. Of course any investment requires thorough research and analysis, so we have sought this contribution to explain the factors to be considered in choosing the right stock, assuming that prior consideration has been given to which sector to invest in.

Operating Metrics: When researching a company it is key to build a picture both in its own right and relative to peers. A good starting point is to look at the operational metrics such as sales, earnings, margins and dividends, over say five years historically, a two year forecast period and to ascertain the rate of per annum growth. The annual report can be appropriate for establishing the company's record of increasing turnover, profits, dividends etc. This allows the deduction of whether the company is in a strong growth phase or whether it has peaked in terms of sales and is now in a slowdown mode or in need of an acquisition to boost organic growth. Summarising this information should allow the investor to narrow down the possible universe.

From the metrics table, company A has been very strong in the past and looks good over the forecast period. However, the P/E (or price to pay for the expectation they will deliver on growth) is quite high. Company B may be a better alternative as it still offers attractive growth but is not priced for perfection.

Focus: It is important to gain a flavour of company activities both by sales and profit. Recognise, but don't place too much emphasis on recent headline press. A good example of this was the launch of Johnson and Johnson's drug coated stent. From press coverage one could easily conceive that this was their core business. Yet, in reality it accounted for less than 5% of sales and profit. So for example, when looking at a Telecoms company with fixed line accounting for only 10% of sales and 20% of profit, with the remainder accounted for by mobile operations, then the focus should be on trying to build up a picture of the latter. This information is available to all investors and is typically found in the annual report.

Results: Recent results, either quarterly in the US or half yearly for UK and European companies allow us to evaluate profit, sales expenses etc. not just compared to the previous quarter but also the previous year. Important things to watch for:

• Has a company met, beaten or come in below expectations?
• Has it achieved its earnings figure via sales increases, cost reductions or both? If a company meets expectations purely by cutting costs, this is not as good insofar as there is only so much fat that can be taken out of an organisation.
• Is increased R&D or marketing spending paying off in terms of increased sales?
• What is in the outlook statement?
• Following the results, are future EPS figures being revised up or down by the analyst community?
• What is the company's guidance as opposed to analysts for sales and EPS? Management tend to be conservative to avoid disappointing the market.

Balance Sheet: It is important to view balance sheet metrics (often over looked) such as debt and cash levels. If debt is high this may limit the expansion plans of the company, particularly with regard to potential acquisitions etc. Look at interest cover - net profit/interest on debt. The higher or more times this is covered the better and the more likely that they will be able to take on further leverage. A strong cash position implies that the company will be able to:

1. Pay dividends,
2. Reinvest in the company by e.g.
(a) a new factory, equipment or (b) acquisitions or;
3. Return funds to shareholders via either a share buy back (increases EPS as the number of shares outstanding falls, given that EPS per share = earnings/no. of shares) or a special dividend.

A SWOT analysis is often useful. Within opportunities there may be new product launches on the horizon that may deliver a significant uplift to earnings. Similarly the impact of any potential changes in regulation may present a threat.

Valuation should look out over two years and include P/E and PEG factors (P/E divided by long term growth) as a stock may appear expensive on the first measure but cheap relative to the growth it offers. Metrics should be included for peers via a comparative table. Be careful of when companies have their respective year-end to ensure you are comparing like for like.

When looking at companies that have yet to make earnings, price/sales multiples or price/cashflow should be used. This also avoids inconsistencies that can arise in earnings comparatives due to diverse tax and depreciation policies in different jurisdictions. Relatives are also important. Ideally, we would like to buy a stock when the P/E relative to both the sector and the market is at the lower end of historic ranges.
As the line goes down Stock A is cheaper relative to the FTSE (see graph). As the line goes up Stock A is dearer.In this case Stock A looks expensive relative to the FTSE, nearly back to previous highs. You may really like a stock and decide it's too richly valued so recommend buy on weakness.
So as you can see, apart from investing your money, it is also important to invest your time!