Wednesday, May 20, 2009

A Stock Investing Methodology

When investing in a company, I am usually looking at the price of the stock at the end of my analysis and it makes total sense. As many value investors know, price is only a way to figure out if you are getting a bargain relative to the underlying value of a business. That value is almost always an estimate, but when you compare it to the price of the company some bargains become screaming bargains. By that I mean that their price is so attractive that even the most pessimistic estimate of their future earnings offers a margin of safety. Let’s look at the process:

The best tools an investor can use while searching for interesting stocks is usually a stock screener. The best performing one I have used to date is the one provided by Yahoo! Finance.

When searching for a new stock to invest in, the first ratio I look for is return on equity. The higher it is, the better. After reading many books written by famous investors, it has appeared to me that most of them tend to choose companies with an average return on equity for the last 5 years of at least 10%. Because they had a better track record than me, I tend to overlook companies with a return on equity of less than 10%. When he uses a stock screener, this will clear almost 50% of publicly listed companies’ from your investment possibilities, since most of them fail to sustain such a high return on equity for prolonged periods. An important point to raise here is that the company must preferably be very lightly leveraged, because that is the corporate equivalent of performance enhancing drugs, as investor Jim Chuong puts it.

Another determining factor is the net profit margin of the company. Once again we look over that metric for the last five years to get an average number. This shows me the strength of the earnings of the company. Investors with a great track record tends to choose companies with a net profit margin of about 8% to ensure that the company’s profits will not be affected much by an increase of their costs (inflation).

My holding period for a stock will usually range from 3 to 10 years. I start by estimating the free cash flow per share of the company over the next 10 years and discount them to their present value. My objective, when doing that, is to get an estimate of the intrinsic value of the stock. Then, I want to know if I have a margin of safety. It is only at this step that I will need the current price of the stock. If the stock is trading at 70% or less of its intrinsic value per share, I will be tempted to make a purchase, as long as the price remains attractive.

I also want to have a target for a price at which I will be selling the stocks that I own. To get that figure, I use a modification of the Gordon Model. Using a predetermined capitalization rate, I will divide the present value of the free cash flow at the year following the year I intend to sell and then. I then add the value I just got to the sum of present value of free cash flow per share of the company. Now we have a long term target selling price.

After that, what is left to do is to check those stocks on a periodic basis and make the necessary adjustments. Buy if the price gets even more interesting. I acquired my definition of the time to sell from Philip Fisher; who advised to sell at the moment the stocks reach a high price because of mass market speculation. For more on the reasons that would really justify selling a position, I recently provided an article explaining the methodology of the late Phil Fisher. There is a lot to be learned from this successful investor and the way he went at finding attractive stocks at fire sale prices.

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