Selecting stocks from the myriad of choices is more of a craft than a recipe. It takes time to learn the ability to look through the profile of a company and determine that it is worth making an investment, let along timing when to make that investment. Even when you’ve gotten enough experience to choose stocks, not every pick will work out immediately, and some will never work out. That’s the reason to bet on more than one horse.
Many people look for hot stock tips. They just want someone to tell them what to buy and when. If you look to CNBC or another news outlet to do this, there are a lot of other people out there who hear the same report; therefore, it is unlikely you’ll get anything like a good price for the stock. If you get a tip from a friend, the advice may be questionable. It is therefore best to learn how to pick your own stocks.
A good thing to do if you’re just getting started in stock investing is to try things out on paper first. Pick several stocks, pretend that you bought some shares, and just watch what happens to your account balances over a period of a few months to a year. There are even stock picking contests in which you can participate. Note though that real investing is long-term – several years – so unless you are willing to try things out on paper until you are forty (which is not recommended) you’ll get more of a feel of what the day-to-day movements of your holdings than really be able to see if your picks pan out. Another idea is to look at past successful stocks (Home Depot, Apple, Microsoft, Wal-Mart, Clorox, McDonald’s) and see what their balance sheets looked like early in their development.
Today I’m going to discuss the process I go through in selecting a stock, using The Kroger Company as an example. Note that I am not recommending this as a pick for anyone – every individual has his/her own special situation and everything must be taken into account before buying a stock. The point is simply to describe the process.
The source of data I normally use is The Value Line Investment Survey. They have an online edition, but I normally just use the print edition (I like being able to flip through the pages quickly). There is some merit to using an online tool and various screening parameters to narrow down the search, but I find a strong factor I use is the shape of the price history of the stock, so I like to be able to flip thorugh pages.
This week I noticed that the Kroger Company had a 1 for Timeliness (a Value Line proprietary measure which shows which stocks have good momentum – i.e. are likely to do well in the next year). Looking at the full-page company analysis, the first thing I notice is the price chart, which shows that the company has been fairly flat for the last several years. Normally I would turn the page at this point since I’m looking for companies that are growing over the long-term. Ideally there would be a long, slow increase in price with the price doubling or tripling over the ten-year period shown.
In this case, however, the long-term appreciation potential, as shown by the 3-5 year range on the chart, and the Annual Total Return projections in the upper left, show a return of between 18 and 24% per year. Given that the average stock market return has averaged somewhere between 10 and 15%, this is a good return and makes the stock worth a second look.
The next thing I notice is the yield, which is currently about 2.4%. Given that bank accounts are currently paying nothing, this is a nice yield. It means that even if the stock sits there and the price doesn’t move, I’ll still be doing better than I would be parking the money in the bank. Of course a small decline in share price could quickly eliminate the gains from those dividends, so holding a stock for dividend yield is a long-term strategy.
Next I look at the earnings per share history. I see that the company has had increases in earnings since 2003, and they mainly had increasing earnings in the years before that, albiet with a couple of bad years. This shows that the company is growing in either market share or the number of stores open. Looking at the number of stores, I see that it has held steady somewhere between 3500 and 3700 for the history given. This means that the company is not growing but perhaps they’re becoming more profitable – or they are buying back shares and increasing the per share earnings that way. Looking at common shares outstanding I see that this is the case. They have decreased from 758 million shares in the early 2000’s to 561 million shares today. So, they have been buying back shares with excess profits rather than expanding dramatically, which makes sense since this is a well established business.
Looking at earnings growth rate, I see that a rate of 10% growth in earnings but 12.5% growth in dividends is expected over the next five years. Since share price grows at about the rate of dividends for well established companies, I can expect the share price to also grow at about 12% per year, give or take. I look at PE ratio history and see that it is trading at a PE of 9.3, versus a historic average of around 14, saying that the stock is undervalued (hence the large potential return over the next 3-5 years). I look at debt, which is substantial (no debt is good). Finally, I look at the financial strength, which is B++ (A+ would be better).
This stock appears to be at a good entry point since there is a large possible return over the next five years. It looks like they are buying back shares and increasing their dividends with the excess cash they are generating, but they are not opening more stores. It therefore won’t be a dramatic growth stock, but it might be a good income stock. I would think about adding this stock to a tax advantaged account such as an IRA (since the dividend rate is fairly high, I don’t want to pay taxes on the dividend each year, particularly with talk about raising the dividend rate back up to ordinary income levels). I would hope to get a fairly good return over the next few years as the share price catches up with earnings, and then it will hopefully continue to pay a good yield as earnings grow and these earnings are primarily paid out as dividends.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.