Introduction
One of the frequently asked questions is how do I select stocks to trade? This
page provides information on building a core group of stocks, ones you
will want to hold for the long term. That may mean a year, three years, or longer.
Michaels Stores, for example, was a stock bought out in 2006 that I have owned since
1989. So, yes, you can hold onto a stock for the very long term, and the
longer you hold, the more likely it is to double, triple, or perform as well as
Michaels. I bought and held shares from 1990
at a split-adjusted price of 88 cents and the buyout was at 44. That is nearly a 5,000%
increase, and that is the type of return I seek from my core holdings.
One Approach
There are many approaches to stock selection and one that does NOT work is searching for stocks on the monthly scale,
then the weekly, and finally the daily scale. What looks great on the monthly scale is trash on the daily scale.
Instead, do the reverse. Find a stock you like on the daily scale (or the scale you normally trade) then check the
higher scales - weekly and monthly - to be sure the story is still compelling. If so, then consider buying.
Another method is to bottom fish. Look at stocks grouped by industry. If you find a stock making a new yearly low
but it is the only one in the industry doing so, then stay away from it. Chances are it is a dog, a stock that may stay
down for a long time while the others soar. Clearly, there is something wrong with the stock or else it would not be
trading near the yearly low.
Look for entire industries that are weak. Then find a compelling situation within that industry. Take your time
before you buy. Weak stocks have a tendency to get weaker and make new lows. When the bottom comes, price will make an
ugly double bottom.
The other stocks in the industry will be showing higher lows, too. If so, that might be the time to
start nibbling. Price might still collapse, so be careful. Over the long term, a year or two, you will be buying near
the bottom and setting yourself up for the double, triple, or better.
Buying an industry that is doing poorly takes courage. It is a dangerous play, but one that can lead to large
profits over the long term.
Industry Selection
I use a top-down approach,
getting the big picture and drilling down to the individual stocks. I consider
demographics, population trends, and other
factors when I examine industries I think will do well over the long haul.
First, where do you find a list of industries? Yahoo!finance is a good place to
start. They have an extensive list of industries:
http://biz.yahoo.com/ic/.
As you scan down the list, ask yourself how you think the industry will do in
the next 3 to 5 years. Will rising energy costs, an aging population, increasing
medical expenses, the health of the economy, and actions by big government, hurt or
help the industry?
Once you find an industry of interest, click on the profile (generally located
in the center bottom of the web page) to read of developing trends in
the industry. Not all industries have a profile, and many are duplicated.
Then, go to the library and pull out Value Line (VL). VL is a newsletter,
nothing more, so treat it as such. But it does have a good reputation even though
I have found it optimistic in its projections.
At the end of the company index (on page 24), VL shows industries ranked in
order of timeliness. Timeliness is an industry rank of the stocks in that
industry for price performance over the coming 6 to 12 months. VL recommends you
pick stocks from the top 6 industries, but
I pick from industries I like and think will do well. From those industries I
select companies.
Company Selection
Let’s stay with VL. When evaluating a stock, I look for the following on
the VL pages.
- I read the industry comments at the start of each industry/company list, just
to see if I am making a
mistake or not. I also look at the relative strength (RS) graph on the industry
page. If the industry RS is going down, then
I may reconsider buying any company in that industry. I like to see RS trending
upward. If you think of bottom fishing, think
again. A falling RS may turn flat for years before beginning a new up trend. Look
at several industry RS charts and you will
see what I mean.
- Flip to a company page. In the upper left are the rankings. You will want to
select stocks ranked 1 or
2 for performance and considered safe. VL recommends safety ranks of 1 or 2 for
conservative investors or 3 to 5 for aggressive
ones willing to assume more risk.
- Immediately below the rank are the 3-5 year price projections. If the stock
does not have a good price
target years out, then skip it unless you think otherwise. The projections as
guesses, so keep that in mind.
- Below the price projections are the record of insider trading. If the company
officers are dumping the
stock, should you be buying? I like to see knowledgeable people buying the stock.
If they are not, then that is unfortunate, but acceptable.
- On the price chart, I want to see a stock that has a heartbeat -- price looks
like waves approaching
shore or is trending upward at a good clip. Along the top of the chart are the
yearly high and low prices. Look for doubles
and triples between the yearly low and high. The company may be a dud but if you
can buy near the yearly low and double or
triple your money in a year, then that’s good. Avoid stocks that are flat (
unless they pay big dividends and you are interesting in collecting divs) or
trending downward. Focus on stocks with price trends moving up.
- At the top of the page, it shows the P/E ratio and relative P/E ratio. If you
see NMF (not meaningful) in one or both entries, then turn the page unless you have
a strong feeling about the company.
- In the tables, look for higher earnings each year without any or few recent
deficit years. As a good rule of thumb, the last 3 years should show higher
earnings. If the economy was in a recession or the industry was having
problems, then make allowances.
- Look at the annual sales. You want to find a small company. They are the ones
that do well in a growing economy. The big caps are good when the economy/stock
market tumbles. Many mid caps stocks are good, just not as good as the
small caps. My book Trading Classic Chart Patterns looks at market caps and
invariably, chart patterns in small cap stocks perform best in a bull market.
- On the middle left, where VL talks about capital structure, you sometimes find
the market cap category. Again, small caps do best, then mid caps and then large
caps in a rising stock market. In a falling stock market, the order
reverses. Large caps retain most of their value and small caps get wasted.
- Look at the long-term debt. I like to see small amounts, like none. And the
smaller the debt is to capitalization, the better.
- Below the rows of numbers is the “Business” section. At the end of
this section, it shows how much of the company stock the insiders and institutions
hold. I like to see insiders holding lots of stock. That way,
they feel my pain when the stock tumbles, and I want their blood mixed with mine
when it happens.
- In the same section is the company address. I avoid foreign companies. I once
received a dividend notice from a company in Canada and my dividend check was kept
by the government for taxes. I could ask for a refund by filling out
a form and mailing it in, but the cost of doing so was more than the dividend was
worth. I skip that hassle and just invest in U.S. companies.
- Dividends. If a company pays a dividend, that is a plus for mature companies
but a detriment for young companies. You want to find the fast growers, the ones in
which earnings are exploding. If companies pay out their earnings
in the form of dividends, then they are not investing as much in the company.
Don’t misunderstand: I like companies that pay dividends, just not
when they are starting out. When growth slows and they start loading
up on div payments, then send me the check!
- Be sure to read the comments about the company in the lower middle of the page,
but recognize that they are just guessing about trends. VL reviewers are optimistic,
meaning they make statements that do not materialize. Just read
some VLs that are years old and you will see what I mean.
These are the steps I go through when looking for stocks to add to my portfolio.
Whether they will outperform or not is a different question. By ‘add to my
portfolio,’ I mean I may monitor the stock for years and never buy it.
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