6 Indicators To Value Stocks

I hope everyone had a wonderful holiday. I hope everyone on Wall Street got a nice sized lump of coal in their stockings this year, however, something tells me they probably got much cooler stuff than us folks. For the wing nuts at AIG who paid bonuses with bail out money, coal simply won’t do. Too bad I do not believe in damnation, because I could take comfort that the AIG executives would be getting the express elevator straight to the seventh ring of hell when they each kick the bucket.

Anyway, the past is the past. As promised from my last post; we’ll discuss how to pick solid stocks. If you looking for ways to time the market and jump in and out like a day trader, then read no further. Day trading is like gambling; eventually, you’ll lose. The odds are stacked against you. Sure, you can day trade in the short term successfully, but only a handful of people on the planet can do it. Day trading too long (or at all) will sooner or later land you in a big long line at soup kitchen. To sum up how I feel about day trading, I’ll borrow a line I heard from Buffalo Sabres play-by-play announcer Rick Jeanneret. Given the choice between the two, “I’d rather sandpaper the butt of a bobcat in a phone booth.”

Now that the wannabe day traders have fled this forum, I’ll discuss some of the indicators that can tell you if a stock looks good or looks bad. I know I said last time I would discuss specific stocks I own and other companies that look good, but are not. I decided to leave that for my first post of 2009.

Back to business. Now just to be clear, this is not an exact science. These indicators can tell you if a stock has a good chance of going up or a good chance of going down. Just remember these indicators are only part of the story. Further investigation is required to see if the underlying fundamentals support the direction of where the indicators are saying the stock is going.

The first indicator I look at is “Free Cash Flow”. This is the amount of money that is left over after paying all the company expenses. What this shows us is that if they company has a large amount of free cash flow, then it has the ability to expand it operations and buy other companies; essentially it shows it has the ability to grow. If a company has a low or negative free cash flow, then it is an indicator that it will not grow and is most likely leveraged to the hilt and not solvent. Determining how much free cash flow is a lot depends largely on the size of the company.

The second indicator is the Debt/Equity ratio. The lower the ratio generally means the company is managing their money well and should have money to invest in other ventures and/or pay out healthy dividends to shareholders. Remember that a low ratio does not necessarily mean the company is performing well and a high ratio does not necessarily mean it is doing poorly. Investigate why the ratio is low or high. A high ratio may indicate the company is financing expansion and a low ratio could mean the company is hoarding cash, which is good for stability, but idle money does not facilitate growth.

The third indicator is Enterprise Value. This is the estimated cost that it would take to buy a company completely and pay off any outstanding debts (at market value), minus the company’s cash holdings. In other words, it is the Net Present Value (NPV) of the company. This can help you gauge if the company’s stock is priced correctly. If the enterprise value is more than the market cap, then that is generally an indicator the stock price is cheap. Many people think a low P/E ratio is an indicator that a stock price is cheap. You must compare the P/E ratio of a company with that of its competitors and the company’s P/E ratio history. High growth sectors tend to have higher P/E ratios relative to low growth sectors, so you must take into account those factors when determining if the P/E is low or high.

The fourth indicator is current debt compared with current assets. This can be found on the company’s balance sheet. The current debt is debt that is due within the next 12 months. The current assets are assets that can be converted into cash within 12 months. Current assets are typically made up of cash, cash equivalents and accounts receivable. If a company has a significantly higher amount of current assets than current debt, that generally indicates they have a solid balance sheet and are generating enough revenue to pay their short term liabilities. If the opposite occurs, then the company can be in serious (or Sirius) trouble. This means the company will have to attempt to refinance their current debt to prevent defaulting, sell off some of their assets, raise additional money through a sale of treasury stock to the secondary market or attempt to merge with another company. If none of these can be accomplished, there are three alternatives: ask Buffett to purchase preferred stock or convertible bonds at ridiculous interest rates, file for bankruptcy or the trendy choice of requesting a government bailout. As we have seen, with the economy receding and the credit market tight as a drum, the only realistic options are bankruptcy or a government bailout. If you are a goliath of a company, then bankruptcy is basically the only option.

The fifth indicator is the percentage of shares being shorted. What this indicates is that if the percentage is high (10% or more), that means the people shorting the stock (hedge funds, investment houses, private equity firms, etc.) feel the stock is heading down in price. The way money is made off of shorting is that the stock is borrowed from an investor (generally an institution) and sold into the open market. If the short works, the stock price will fall and the entity shorting the stock will buy back the same number of shares they originally borrowed at the lower price and return the shares back to the owner. The entity shorting the stock keeps the difference. If the amount of shares being shorted is high, then that means that there are a lot of shares being sold into the open market, which increases the supply and drives the price down. Theoretically, large institutions could crush a stock price, if they all decided to short the same stock and were able to borrow enough shares to flood the open market. If a hedge fund has a huge stake in one company and other hedge funds were aware of it, they could combine their efforts and short the stock and put huge downward pressure. It would not matter if the company is in good or bad condition; simply that the increase in available shares on the open market would drive down the price. If the hedge fund did not realize why the price is nose diving, their whole position could run right to zero and possibly force the fund to close up shop. You want the short percentage to be as close to zero as possible.

The final indicator I look at is the sector itself. Some sectors flourish in bull markets and others flourish in bear markets. Some are linked to the business cycle and others are independent of it. Remember that a sector is not the same as an industry. Industries are basically sub-sectors. Energy is a sector and oil is an industry. Agriculture is a sector and farming equipment is an industry. Take a look at how the sector is growing overall and then try to investigate why it is growing, the catalysts that can grow the sector and also the ones that can destroy it. Once you have found a sector to invest in, take a look at the different industries in the sector and perform the same investigation into each industry to see which industry is performing the best. Once you establish that, then take a look at the companies competing in that industry and try to decide which company best fits your investment strategy.

Overall, this is a daunting process, but the more you do it, the faster and more efficient you will become at it. Using these indicators can give show you if a company deserves more investigation or if it should be ignored.

Be on the lookout for my New Year’s post. I’ll be listing my 10 predictions for 2009 and discuss 10 possible resolutions you can adopt to improve your financial health. Until next time, peace and I’m out!

Recessions Occur More Often. Here's Why!

Happy Holidays!! Like how I used the P.C. version? Anywho, here's the deal. As we, or I actually, discussed last time concerning the economic cycle, there is a disturbing trend. In our roughly 200 year history of the stock market, we had been averaging a recession/depression every 25-30 years. Over the past 35 years, we have been averaging a recession/depression approximately every 10 years. Why and how did that happen? Economists and financial academics have been trying to figure that out for the past couple of decades. I'm sure these guys are very intelligent, perhaps too smart; they are thinking far too hard on the subject.

Since, I'm not too smart, I've figured the problem out. Here's the deal kids. The problem is the rise in the number of mutual funds, hedge funds, availablity of deferred compensation plans [i.e. 401(k)]; basically investing by the middle class. Back in the day, investing was only done by people who had significant disposable income. Everyone else was stuffing money in matresses. About 50 years ago, 80% of a household net worth was the equity in their home. Buying stocks was considered gambling; especially prior to 1933, since the whole stock market was unregulated. I've got to slow down here, I've used 3 semi-colons already.

Everyone and their brother has some sort of stake in the stock market and the number of mutual funds and hedge funds (I'll tackle what these are exactly soon) has multiplied several times over in the past 20 years. Pensions are out and 401(k)'s are the drug of choice for both private and public companies. Mutual funds and hedge funds are in the game to attempt to make as much money as possible for their share holders. The reason is that their compensation is mainly related to how well their fund performs. In order to maximize performance, these funds are almost entirely invested (nearly all assets are invested) and in the case of hedge funds, they are leveraged to the hilt. When someone transfers money out of a mutual fund and invests it into another mutual fund, two things happen; first the mutual fund you have must sell off some of its investments in order to cover the redemption and second, the mutual fund accepting the transfer invests all or most of the funds coming in. This affects the market because when a stock is sold, the price goes down, because the amount of float shares available for purchase increases (supply and demand) and when a stock is bought, the price goes up for the opposite reason. What this creates with more people and more mutual funds, hedge funds and institutions investing is a more volatile market. Not to mention the fact that people are stupid (present company excluded) and they tend to buy when the market is rocking and sell when the market is sinking. Obviously, that is the opposite of what you should be doing. With all of this market volatility, the spending habits of the public is affected. When the market is down, people feel they have less money, when in fact they have the same amount of cash no matter what the value of their porfolio is. Hence, they spend less. The increase in the number of people investing has sped up the economic cycle, so that the peaks and valleys occur more often and for shorter periods of time. The main cause of that is the speed that information reaches people. New news doesn't exist anymore. Once you hear news or read news, it is already old news. This makes it much more difficult to time the market (which you should never do) and day traders (idiots) go from rich to poor on a daily basis. Day traders are the rabbits and the smart folks who tip-toe in and tip-toe out of the market are the turtles and we all know who wins that race.

The whole point of this post is to let you all know that good and bad times are going to occur more frequently and for shorter periods. Remove emotion and react to the things that matter in the market. Resist the herd mentality and if you feel like you need to buy or sell, sleep on it and then do your homework and if you can rationalize the feeling, then you know that you are making a solid decision. The main problem with the volatility is that even if you make an informed decision, it could still be wrong, because the market is irrational. However, if you do your research, your decisions will be rewarding more often than not. As for next time, I'll be talking about specific companies I am invested in and I'll explain why. I'll also highlight companies that look good, but are not. Peace and I'm out!!

Economic Cycle: Boom and Bust

Hello again. How about the Big 3! Currently the deal is dead in Congress, but the TARP funds might still be pulled by G’Dubya in order to prevent an economic meltdown and pull the US and probably everyone else with us into a Depression of epic proportions. I think not. Everyone talks about the Big 3 “failing” as if the companies won’t exist anymore. Bankruptcy is their option, except it seems that Ford may be able to avoid that without the bailout money. They may actually benefit more without the money, if the other two lose consumer confidence and market share by reorganizing. Anyway, enough about those numbskulls. Now back to what I promised to write about; The Economic Cycle!!

Yes, I know it sounds soooo exciting!! This will not be the text book version; this is my version of the Economic Cycle. (Also, don’t confuse this will the business lifecycle, expansion, trough, etc.). I consider there to be only two phases Expansion (a.k.a Boom) and Recession/Depression (a.k.a. Bust). I group recession and depression together, since no economist can agree on the exact difference between the two. Perhaps any contraction of the economy should be considered a recession and a depression can be characterized what we have been hearing a lot lately as a “deep recession”. I feel as though the economists of today are reluctant to use the word “Depression” to describe the current trend of the economy for fear that it may make things worse, because the public is terribly influenced by silly jargon.

Back on track. When the economy is expanding, there are several characteristics. Job growth, inflation is under control, credit is reasonably easy to obtain, the market is optimistic (stocks up, bonds down), the dollar is strong, and the Fed and Prime interest rates are up, but not too high. This all translates into an increase in the GDP.

In contrast, when the economy is contracting, unemployment is typically up, inflation is either extremely high or even worse, deflation occurs. With inflation, the dollar tends to be weak, which increases the cost of imports, which in turn increases the cost of goods for US consumers. When deflation occurs, demand has decreased so much that the cost of goods freefall. It is a little more complicated than that, but that is the basic idea. Other characteristics are the Fed and Prime rates fall, which decreases interest rate yields on deposit accounts and money market accounts. Credit is not easily available or in bad cases almost non-existent. All this translates to less consumer spending and a decrease in GDP. To sum it up, it is just like now, except now is much worse.

Now to scare you all! We are in a Depression currently. We left Recession a long time ago. I declared the country in a Recession just over a year ago, even though it didn’t meet the 2 or more consecutive quarters of declining GDP. If you insist on calling it a “Deep Recession”, be sure to qualify it by stating it is as deep as the Marianas Trench. Others argue that the unemployment rate is only about 7% currently and during the Great Depression it peaked at 26%. Yes, that is true, but as I always say, statistics are just statistics. Stats can be manipulated if you change the parameters. This is what happened when Wild Bill (Clinton) took office. He changed the way the unemployment stats are calculated. It went from a census of the number of people looking for full-time employment to a census of the number of unemployment filings. The difference is that the current way the numbers are run has the people whose benefits expire are no longer counted, which in turn drastically reduces the rate. If we went with the old calculation, it is estimated the rate would have been in the 16%-18% range. Oh yeah, and guess what else? Think about the number of full-time college students today as opposed to the 1930’s. If the ratio of college students in the 1930’s were the same today, the rate would be very different. In the 1930’s approximately 40% of high school graduates attended college. The current rate is roughly 90%. There are currently approximately 2.5 million students. If we take the difference (56% less) you get an additional 1.1 million eligible workers that you would have to factor into the unemployment equation. There are currently about 4.5 million out of work, either collecting or not collecting unemployment. If you add 1.1 million to the mix, that would increase the rate about 25%, which would put the rate at 20%-22%.

So, let’s wrap this puppy up. We are in it up to our eyeballs right now. Ironically, the national mortgage debt has decreased 2.4% this past quarter for the first decrease in over 50 years. We are spending less and saving more, but that is a double edged sword. Spending makes the world go ‘round. Reallocate your expenses appropriately and ride this thing out. Don’t go run and hide like everyone else. Be smart with your cash and remember to keep building up your investment cash. This thing is long from over and I may have to reassess my Spring 2009 time table to get back in the game. It could be longer. Keep your eye on your stocks and don’t pay attention to the DOW, S&P 500 or the NASDAQ. There are still some winners out there, but even they are still getting beat up. If you find yourself wanting to buy in, do it incrementally. That is how to stay in and build your positions even during the perfect storm. If you get crazy and go all in, then you’ll end up being angry enough to punch a baby and no one wants to see that. Next time, we’ll talk about a scary trend in the cycle. Peace and I’m out!!

The Big 3. WTF Are These Guys Doing Being CEO's?

Well, the last forty years has given rise to the possibility of me becoming a CEO. I normally don't watch C-SPAN, actually, I've never watched C-SPAN in my life until the other night, when I was so privileged to be in the presence of greatness. Ok, I know they flew in on their private jets a few weeks ago, but they are leased jets and not owned;) Anyway, I typically have a lot of tolerance forBS and I definitely give the benefit of the doubt, but these idiots are so smug and full of false confidence that it made me laugh out loud. The only thing that compared to their poor performance was Congress. Granted, not everyone had the chance to offer questions and speak their opinion, but for the ones that did, it offered a poor sample of their intelligence or at least their dignity they actually possess. We have no one to blame but ourselves, because we voted them in. Enough about these guys.

Here's the deal kids. I should've let the cat out of the bag earlier, but I had to pay attention to current events surrounding this unprecedented event in our economic history. We are indeed headed for the big "D" as in Depression. The question is not if, but when. We are entering a time that is completely different in shape than the big slam of the 1930's. Patience is the key kids. The problem is that people think that stocks which drop are going to go down infinitely and vice vera. Here is the deal, when you first get in, buy in with only 10-20% of you liquid cash. The stock market can make you a great deal of money, but if you are like me, you always stay at least 40% Liquid, unless it is a time like this, which you need to be at least 20% liquid, but no more than 30%.


Wait until next time when I address the current cycle of the economy.

The Year End Rally Will Be Smoke And Mirrors!

Happy December everyone! I’ve just awaken from a turkey coma and have found the market has apparently stabilized, at least in the short term. Nah, I’m just kidding. The market only shed about .5% since the close a week ago. I was expecting the holiday rally to start, but the market is pretty flat. This is not necessarily a bad thing, since a rally would spark silly purchasing by the individual investor. Avoid the herd mentality and keep stock piling cash. The market is going to rally a little and will then retreat back to levels not seen since 1997.

A flat market during this time of year tells us one thing; the big boys are not sure what to do. They are in a holding pattern mainly due to the sales numbers from the holiday weekend. Yes, the numbers were better than expected, but there is a catch. Most of the people that were polled about their shopping expectations this holiday season stated they were about 75% done with their holiday shopping. Historically, the Thanksgiving holiday sales account for roughly 10% of the holiday revenues. Even if the survey exaggerates the claim of most people being 75% done with their holiday shopping, it definitely gives us an indication of the poor numbers to come after the holiday season ends in three weeks.

Stay liquid. You should have at least 25% of your portfolio in cash at this time. Sell your long term losers or take some profits, if you have any short term winners. Don’t be sentimental about your losers. Do your homework and if you have a stock that is beaten up, which you most certainly have, then investigate whether this is a long term loser or simply a stock that is the victim of the current crisis. Purge the dead weight and keep an eye on the market. My next installment will be concerning the new idiots; “The Big 3”.