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What to do if you get a good stock tip

longoJohn062711_optBY WARREN BOROSON 
NEWJERSEYNEWSROOM.COM 
BOROSON ON MONEY

You get a stock tip from someone whose opinion you respect. What research should you do before actually buying that stock?

Of course, before buying such a stock you should check:

  • Whether your asset-allocation model indicates that you need more exposure to stocks. Or would you have to sell a good stock you already own to buy this one?
  • Whether you are already heavily weighted in the stock's industry.
  • Whether you are considering other stocks that seem even more attractive.
  • Whether the stock's price has been declining -- which might indicate that someone is selling a big bloc. Or that something is amiss with the company that you don't know about.
  • There's also the question of what kinds of stocks you prefer to buy. Growth stocks, those of healthy, growing corporations? Value stocks, where you must wait until other investors finally recognize the value of the stock? Or just a steady-Eddie stock, perhaps one that regularly pays a decent dividend.

So it’s not an easy decision.

I asked several respected money managers what further research they would do before buying a stock -- what things they would concentrate on. Say, with a stock like Host Hotels & Resorts (recommended by someone in last week’s column). And what they might do that’s different. Here are their answers:

John Longo, Ph.D.

Chief investment officer of the MDE Group in Morristown and professor of finance at Rutgers Business School.

(pictured with Warren Buffett)

“The first thing I look at is the valuation, since I do not want to overpay for a stock. The valuation metric depends on the industry, but the most popular are price to earnings and enterprise value to EBITDA. I look at the current valuation for the firm vs. its historical valuation and the valuation of its peers. For example, Intel is trading at 10 times earnings, while historically it has traded at more than 15 times earnings.

“I then try to assess if the firm has reasonable growth prospects. Many companies, such as Kodak, appeared cheap, but kept getting cheaper since their business has changed (e.g., flash memory in digital cameras replacing traditional film). To assess their growth prospects, I look at management and analyst projections, as well as my own analysis of the industry. Porters 5 Forces is a common approach for analyzing the competitive pressures, structure, and profitability of an industry.

“I then look at the strength of the company’s financials. If it has high profit margins, that is a positive, since it can still do well if the economy falters. A firm with a low profit margin (e.g., less than 10 percent) can turn from making money into losing money if the economy were to fall back into a recession.

“I also look at the company’s debt ratios. Too much debt (once again vs. its industry) is a bad sign. As Peter Lynch said, a company with no debt can’t go bankrupt.

“After a company announces poor earnings, it is usually too late to get out. So, two popular indicators of future trouble are inventory/sales and accounts receivable/sales. If inventory/sales is abnormally high, it may indicate that the company is having a hard time selling its merchandise. It might have to lower prices, or write down the value of its inventory. If accounts receivable/inventory is high, then the company is having a hard time collecting on its sales. (e.g., Lucent had a hard time collecting from Internet firms during the Internet bubble, and the stock ultimately crashed.)

“Technical analysis can aid in the timing of an investment. If a stock is falling, often you want to wait until it starts moving up before purchasing it. A common technical metric is: If the 50- day moving average is higher than the 200-day moving average, that is a bullish technical sign.”

Brian Kazanchy, CFA, CFP

Chairman of the investment committee

RegentAtlantic Capital, Morristown

“When analyzing a stock, I first take a quantitative approach to review the value and quality aspects of the stock.  From a valuation perspective, I tend to focus on three ratios:

  • Price/Earnings
  • Price/Book
  • Price/Sales

“From a quality standpoint, I focus on:

  • Return on Equity
  • Debt to Equity

“Using Host Hotels & Resorts as an example, this real-estate investment trust has had negative earnings over the last 12 months. Therefore, it looks really bad in terms of P/E ratio. That is clearly a red flag, but there may be reasons to dig deeper.  Are there one-time circumstances that lead to the negative earnings? In this case, the REIT focuses on luxury hotels.

“The revenue of the company peaked in 2007 and has dropped significantly due to the recession. It has started to recover.  This information can be found on the company income statements.

“With a negative P/E, it is important to look at the price/book and price/sales ratios. These ratios indicate that they stock is overvalued relative to its industry peers. From a quality standpoint, the return on equity is negative due to the negative earnings. The debt to equity is 84 percent, indicating that the company is very highly levered.  Ouch, the stock does not look good from a value or a quality perspective!

“So far, we have identified a lot of red flags. This would be enough for me to avoid the stock.

“However, if you wanted to press on, then I would suggest some qualitative analysis. Is their business model sound? Do they have a moat around their business? (I.e., How hard is it for new competition to emerge in their business.)

Overall, there are some significant barriers to entry in this business.  Host Hotels has some prime locations in the U.S. and several other countries. If demand for high-end hotels picks up, they will be a strong position to capitalize. However, in order for demand to pick up, we may need to see a more robust economic recovery then is currently taking place.

“I would take another look at this stock down the road if it takes a big dive in price.”

“For financial data, Yahoo finance, Wall Street Journal online, and Morningstar are great places to look. You can find key ratios on all of the sites.  Yahoo provides convenient links to company regulatory filings, showing comprehensive data on the companies. WSJ online and Morningstar provide nice summaries of income statements, balance sheets, and cash flow statements.”

Charles B. Carlson

CEO of Horizon Investment Services

“The first thing we do when analyzing a company is see how the company scores in our firm's proprietary stock-rating system, Quadrix. Quadrix ranks more than 4,000 stocks based on more than 80 different variables. We typically don’t even consider stocks that don't score at least 80 (out of a possible 100) in Quadrix. Of course, this probably is not exactly helpful for an investor who doesn't have access to a stock-rating system like Quadrix.

“Basically, I like to look at (1) earnings growth track record, (2) debt levels, (3) insider ownership, (4) valuation (p-e ratio relative to historical levels and peer group), and (5) earnings estimates trends (has the firm beaten the consensus earnings estimate, are estimates rising?).”

David G. Dietze, JD, CFA, CFP

President and chief investment strategist

Point View Financial Services, Summit

“As you know, there is still a hot debate going on as to whether experts can in fact regularly and successfully analyze stocks with a high enough success rate to justify the effort.

“I am of the belief that 60% of any stock’s movement will be due to the market. Another 30% may be due to the stock’s industry. So, it is first critical that you determine a stock’s industry – energy, financial, health care, tech, utility, etc. So, start by figuring that out and making sure that you are diversified across industries.

“Also, figure out if you have market bellwether or not. The larger the company, the more prominent the player, the more you have an investment that most likely will move with the industry.

“Then I think you have to focus on the financial numbers of the company. I focus on financial metrics, as opposed to, say, qualitative metrics, like the quality of management. First, ultimately your investment success, and the company’s success, will depend on generating cash. Second, many of the qualitative factors, like strength of management, should be reflected in the financial numbers. If not, you may want to question the relevance or quality of that indicator.

“There are two aspects to analyzing a company’s finances. First is the current financial situation of the company. Second is the prospective one.

“As to the current financial situation, you want to look at revenue per share, cash flow per share, profit per share, and compare that with other companies in the same industry. You will want to look back over several years to make sure that what you are looking at isn’t just a temporary aberration.

“You will want to also ask yourself, particularly with smaller and newer companies, does the business plan make sense? For example, with the new LinkedIn service, will many people use it, will they pay for it, what is the chance that others can replicate?

“Then, you want to look at the balance sheet. In particular you want to look at leverage. All things being equal, you want a situation that can generate results using less debt. Compare the debt levels with those of other companies and the same company over time.

“Next, you want to make a forecast of all these financial numbers, or review others’ forecasts.

“Take all this with a grain of salt. After all, no one can predict the future. Compare these forecasts with the forecasts for others in the same industry or consolidated forecasts for the industry.



 

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