How an Individual Investor Picks Stocks
Forget the "lost decade." For investors, this has been more like the Jaws decade. The moment investors think it's safe to go back in the water, some issue -- whether international or domestic -- materializes, sweeps through the markets and devours everything in its path.
Between the euro mess and the U.S. debt crisis, there has been plenty to keep the waters treacherous. My "Practical Investing" portfolio experienced its first major setback when Corning (symbol GLW) announced in late November that it was cutting sales projections for a key glass product used in electronic devices. (Notwithstanding the hit to Corning's stock, my portfolio was running ahead of the overall stock market through December 2; see all of my purchases.)
But if you understand the fundamental reasons you bought a stock, it's easier to stay the course when the market gets stormy. And the way I identify companies to invest in is something I haven't taken enough time to explain in previous columns. So let's go through the six factors I consider before I buy a stock.
Price versus earnings. Emotions buffet share prices over the short term. But over the long haul, stock prices generally reflect expectations of a company's future earnings. Companies and industries that generate volatile results or rely on leverage to boost profits (think banks, for example) typically command lower share prices in relation to earnings than do companies that produce steady profit gains. I look for stocks with price-earnings ratios that are lower than normal for the company and for its industry.
Growth. If a firm's growth has stalled, a bargain price may be misleading. If a company selling for 10 times earnings is growing at a 3% rate, its stock is not cheap. Look for companies whose earnings-growth rates are higher than their stocks' price-earnings ratios.
Dividends. Don't underestimate the importance of dividends. If you buy a stock that yields 5%, its price needs to rise only 5% in a year for your total return to match the market's long-term record. So although I will occasionally buy stocks that yield nothing, I prefer companies that share the wealth. (See STOCK WATCH: 8 Dividend-Growth Stock Picks.)
Cash flow. Before you get too hung up on dividends, make sure the company can keep paying them. Focus on free cash flow, which is operating cash flow (earnings plus depreciation and other noncash charges) minus capital expenditures. Ideally, free cash flow should be much greater than dividends paid.
Let's examine Lockheed Martin (LMT), a stock I wrote about in 8 Blue Chips to Buy Now and one I'm likely to buy once Kiplinger's rules allow. Click on the boldfaced ticker symbol in the previous sentence and scroll down the page. You'll see that cash from operating activities in 2010 totaled some $3.5 billion. Reduce that by $319 million in capital outlays and investments. The $3.2 billion that was left was three times greater than the $969 million spent on dividends in 2010. That's a nice cushion that should allow Lockheed to keep paying the current rate under all but the most dire circumstances.
Industry trends. Why does Lockheed sell for 10 times earnings? Because most of its business is with the federal government, which is threatening to cut back. So, you have to decide whether you think that will decimate profits. If you think the market has overreacted, as I do, you'd call Lockheed a buy. If you think Uncle Sam might cancel Lockheed's lucrative F-35 contract, you will want to stay away.
Governance. My final criterion is subjective. I look at several issues, from how a firm pays its executives to whether it has a strong board of directors. All things being equal, a company with a board that provides an effective check on management is likely to be a better investment than a firm with a weak board.
Kathy Kristof is a contributing editor at Kiplinger's Personal Finance and author of the book Investing 101. Follow Kathy on Twitter.