Finding future stock winners
“We’ve made a 180-degree turn,” one of my brokers said to me as the market was going through one of its triple-digit dives. “We’ve gone from irrational exuberance to irrational despondency.”
There’s certainly a case to be made for the contention that the pendulum has swung too far, at least for certain stocks. Almost every company connected with telecommunications, the cable industry, power generation, and technology is being punished by investors these days. It doesn’t seem to matter whether they are profitable or have rock-solid franchises. If they’re in the wrong sector of the economy, no one wants to have anything to do with them.
Very few of these companies are going to take the gas pipe. For every Enron and WorldCom that makes the headlines, there will be dozens of corporations in the pariah sectors that will still be standing when all this is over. Many will actually emerge much stronger, having made tough cost-cutting decisions and gained market share as a result of competitors going under.
The key is to identify the survivors now and to gradually add them to your portfolio. This is how the big bucks are made in the stock market – ying great companies while they’re cheap and waiting for the cycle to turn back in their favour, as it inevitably will.
That may sound easy. It’s not. In markets like we’re experiencing, many investors make the mistake of chasing after falling stars, on the theory that the stock has plunged so far that it has no downside left. That’s not necessarily so, as we saw with WorldCom. The bottom is zero.
Your best bets are companies that are fundamentally sound but temporarily out of favour, for whatever reason. Here is a checklist of points to look for in your efforts to separate the stock market wheat from the chaff.
- The company is bottom-line profitable. Second best: it has an operating profit and any loss is temporary, due to write-offs of goodwill, etc.
- The stock pays a dividend. Bonus: the dividend was recently increased.
- The company has a sound balance sheet with a debt/equity ratio of 1/1 or better.
- The company’s business is transparent. You can understand what they are doing.
- The company is an industry leader. Employ the old Citibank rule – only buy the top three companies in any sector.
- Company insiders are buying.
- The company has a share buy-back program in place and is actively pursuing it.Revenues and profits regularly surprise by coming in above projections.
- A balance sheet with a large amount of goodwill. Goodwill is actually “badwill” when it comes to corporate accounting. There are no real dollars there, just numbers.
- Operating losses that continue to rise each quarter.
- A track record of failing to meet analysts’ expectations.
- The company spent freely on acquisitions during the 1990s. It probably paid too much for what it got.
- The dividend has recently been cut.
- The stock is being diluted through new issues and the money raised is being used to sustain operations.
- Corporate insiders are dumping stock.
- There are huge short positions against the stock.
- You don’t understand the business. Does anyone really know to this day what Enron was actually doing?
One more point. Even when you identify a quality stock, don’t expect it to suddenly take off. When a sector falls out of favour, it usually remains in a state of disgrace for a long time. You will need to be patient. But if you choose wisely, you’ll eventually reap the rewards.
Adapted from an article that originally appeared in the Internet Wealth Builder, a weekly e-mail investment newsletter that features some of Canada’s leading stock market experts.