Four Questions to Ask Before You Buy
Increase the odds of avoiding loser stocks by following these four buying basics.
By Elizabeth Frengel
March 16, 2005
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The long bull market that ended three years ago was remarkable for a lot of reasons, not the least of which is how many investors mustered the confidence to pick their own stocks.
Then it seemed easy, since following the money -- and the barrage of analysts' bullish signals -- was a pretty sure strategy for increasing your wealth. Now, deciding when to pull the trigger and buy a stock seems like a dangerously slippery concept.
But if you ask just a few questions, you increase the odds that a stock you buy will keep going up -- not down the slippery slope of inept stock picking. If it's any consolation, many of the same principles in "Learning to Say 'Sell'" apply when you buy; all you have to do is turn them around.
The growth school
Howard Ward, manager of Gabelli Growth fund (GABGX), invests in large companies with potential for long-term growth. So to him (and a lot of other pros), a company's growth rate and earnings are critical. For Ward, the "forward" price-to-earnings ratio (stock price divided by earnings estimate for the upcoming fiscal year), is probably the most important measure of value.
Some practitioners of growth investing barely notice the P/E, but Ward looks for value. He says an individual investor should never buy a stock that's trading at more than 35 times the company's next fiscal year earnings estimate. And he thinks investors should buy only stocks they're willing to hold for the long haul.
Gabelli Growth tends to hold companies with records of above-norm earnings growth, like Amgen (AMGN), which has upped earnings 16 straight years. It's trading at 21 times 2005's consensus earnings estimate. Earnings are forecast to keep growing at an 18% clip over the next three to five years.
The value side
Since his fund searches for small companies that will grow aggressively, Kevin O'Boyle, manager of Meridian Value fund (MVALX), tends to buy stocks of companies that have plenty of potential but are selling for cheap.
"I buy stocks that are out of favor," he says, "usually because of disappointing operating results." But the businesses he earmarks should be able to clean themselves up over the next couple of years. What's crucial for O'Boyle is that the company is a leader (or the leader) in its market, and that the management team has an undisputed record of generating strong return on capital, or income divided the sum of debt and equity. Attractive businesses, he says, generate ROCs in the teens or higher.
Waste Management (WMI) is one of Meridian Value's biggest holdings. The company grew rapidly through acquisitions, says O'Boyle, but the execs that held the reins at the time couldn't integrate them effectively. Profits disappointed, and then some accounting chicanery was exposed, and shares sunk -- from a high of $60 to a low of about $13.
No question Waste Management was in the dumpster, but O'Boyle decided to buy because it had a leading market share in trash hauling and new management took over who showed they could generate cash flow while pulling the company out of the heap. The stock now trades at about $29.
How to avoid a bad relationship
Just as you should get to know your partner before you make a long-term commitment, get to know a company before you start waving money at it. Put it on a watch list, such as the one on Kiplinger.com's Investing page, and keep an eye on it for a while. Then ask these questions:
Does the business make sense? That's probably the first thing you want to ask yourself. Says Ward: "I think it was Warren Buffett who said, 'If it takes more than a couple of sentences to explain a business, then you don't want to own it.'"
Peter Lynch, the longtime manager of Fidelity Magellan, claims in his book One Up on Wall Street (Fireside) that consumers can pick the spectacular performers from their place of business or the shopping mall before Wall Street discovers them. "It's impossible to be a credit-card-carrying American consumer without having done a lot of fundamental analysis on dozens of companies," he writes.
Is there anything fishy in the financials? O'Boyle looks at free cash flow (net income plus depreciation and amortization minus capital expenditures) to gauge whether there's enough for the company to pay down debt and make dividend payments. O'Boyle's method requires delving into a company's annual report, which might seem like a pain -- but it's worth it. Remember that lack of cash is what brought down Enron.
Another way to check: If a stock pays a dividend, make sure that the company's earnings per share can cover it. "If dividend per share is $2 and EPS is $1.50, there's a good chance the company will have to cut the dividend," which is a bad sign, says Ward.
Ward also looks for red flags like profit growth that's disproportionate to the business's primary market. Again, Enron is a good example: "Was the utility market really growing at the 25% rate that Enron claimed it was? No way. Try 2%," says Ward. "When something doesn't add up like that, it should tell you something."
Also check to see if profits and revenues are in line. If you see eye-popping earnings but no revenue growth, accounting could be amiss.
Is the company growing? Both managers say that at least one of the business's indicators should be on the rise, whether its earnings, revenues or return on capital. But don't rush to buy. Once you have your eye on a company, monitor its progress at least once a quarter, says O'Boyle. Read earnings reports and visit the company's Web site to listen to conference calls that might give earnings guidance. If management says profitability looks good down the road, you probably want to buy.
Are you paying a premium? Don't buy a stock when it's trading at an all-time high while earnings are going nowhere. But once you've decided to buy, try to wait until the market has a bad day. Sometimes bad news from one company can trim stock prices throughout an entire sector, and that's a good time to buy.
The most important thing, says O'Boyle, "is to be objective about your appraisal of a stock. Business conditions can change, and your reasons for wanting to buy the stock can be wrong." The best strategy for buying, he says, is to be informed.
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