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Try to buy the industry leader or, at the very least, a company that has an important position in its industry.
Look for an industry with a limited amount of competition.
Avoid an industry that is an essential part of the Gross National Product or the Consumer Price Index, such as autos or steel. Reason:
Highly visible companies are easy targets for government pressure.
Stick to stocks that have price/earnings ratios lower than that of the Standard & Poor's 500 index. See pick stock for more information.
The company should have a record of significant dividend increases.
The market price of the stock should be close to book value per share.
Both the industry and the company should have growth rates higher than the median of American business. One rule of thumb: Sales and earnings ought to have doubled over the past decade. If they haven't, you probably won't be able to keep ahead of inflation in the years ahead.
Stay away from companies that are too heavily in debt, especially in relation to industry-wide standards.
Look for companies where managers are owners, too. Nepotism can be a danger in such situations. More often, though, owner management is a big plus. Owner-managers have a real incentive to keep the company growing, as well as to boost the stock's value.
While you may not find a stock with all these characteristics, insist on at least these two: It should be in a growth industry with owner-management.
When you are considering a growth stock it should meet all or most of the following characteristics: (1) A dominant position in a growth industry. (2) A long record of rising earnings and high profit margins. (3) Superb management. (4) A commitment to innovation and a good research program. (5) The ability to pass on cost increases to the consumer. (6) A strong financial position. (7) Ready marketability of the stock. (8) Relative immunity to consumerism and government regulation.
When analyzing small, fast-growing companies you should look for the following:
Balance sheet. The current ratio (current assets matched to current liabilities) should be at least two to one. The company should have no long-term debt. Preferably: No short-term debt, either. The return on shareholders' equity should run at least 22 % and, ideally, 30%.
Ideal: As few shares outstanding as possible. (This is where the real leverage comes in.) If a company has only 250,000 shares, a fast growing rate will have a real impact on the equity position. Try to stick with companies that have less than one million shares outstanding, and preferably less than 500,000 shares.
Income statement. Look for a company with very high profit margins. An after-tax profit margin that is over 10% is excellent. (By the same token, avoid those companies that have after-tax margins that are 1 Yz % to 2 % or less.)
Pay attention to the company's tax rate.
Many investors buy the stock of a company with very high after-tax profit margins only to realize a year or so later that the tax rate was artificially low. Then, when the tax rate returns to normal, the margins shrink dramatically. Thus, if a company pays a full tax rate, give it more points in your rating system than a company with a low tax rate and a higher profit margin.
Management. This is the hardest to evaluate, but the most important. Prime management ingredient:
Integrity. The best way to check on honesty is to get hold of the annual reports for the last five to ten years. Read the president's letter to the stockholders. How many of his predictions came true? Did he consistently make outlandish statements that never came to pass? Did everything that he forecast happen?
Try to find out what motivates the chief executive now. What might motivate him in five years? All too frequently, a company president suddenly decides to sell out, and the company loses its momentum.
Focus only on companies in which management holds a very large interest (50% to 70% of the stock). That way, you can be sure they will do everything in their power to get the stock up. That's your goal, too.
When to sell. Many entrepreneurs don't have the ability to take their company beyond a certain annual sales level. The first major hurdle is $10 million in sales; the second is $50 million. Be sure to watch the company closely as its sales volume approaches these points. If the company gives signs of languishing there, it's probably time to sell.
Here's how institutional investors think: High priorities for institutional investors in selecting stocks for their investment portfolios: Price/earnings ratio, current and projected earnings, and management competence. Least important: Product quality, the state of the US economy, and the industry group. Middle ranking: Balance sheet, price per share, and long-term earnings record.
The stock market overvalues reported earnings ... and discounts cash flow. But earnings are a function of past actions. What the investor should try to ascertain is earnings two years from now. That's usually a function of current expenses.
For that reason, I'd rather have cash flow than earnings. When I buy a stock, I pretend that I'm buying the entire company at that price. And, in analyzing cash flow, I focus on earnings, depreciation and deferred taxes.
I like to buy stocks at less than three times annual cash flow per share when the depreciation per share is bigger than earnings per share. What if the company's earnings go to zero? I want to know how much cash the company is generating and whether it can pay its obligations.
To find stocks, I go through Value Line and Standard & Poor s every day. I look at a company's price chart. Is it up or down? Then I look at its depreciation and the number of shares outstanding. If anything comes close to three times depreciation per share, I take a second look at it.
Every six months or so, a stock group is really down ... that's when investors can get in. Two years ago, the airlines were undervalued. Almost half of that group was selling for at least three times annual depreciation.
In these cases, I totally ignore earnings. All sorts of investment analysts are trying to figure out the next quarter's earnings, and I don't want to be following the herd. I plan to hold a stock for at least three years. . . and my clients know that. Virtue: It takes away the pressure of worrying about earnings for the next quarter.
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