Part II of this book, containing Chapters 4 through 14, describes 11 different stock analysis tools that can be applied to both the value and growth investing styles. Chapter 16 describes how to apply these tools to analyze value candidates. Chapter 17 does the same thing for growth candidates.
The value and growth analysis strategies both consist of 11 steps, each step using the corresponding analysis tool. For instance, Step 7 involves analyzing a candidate's financial health and employs Tool #7, Analyze Financial Fitness.
You'll get the best results by familiarizing yourself with each of the 11 tools described in Part II before attempting to analyze value and/or growth candidates.
Eliminate a candidate as soon as it fails any step. For example, don't carry a candidate to Step 2 if it fails Step 1.
Step 1: Analyze Analysts' Data
Brokerages and other firms employ stock analysts to evaluate and rate stocks. Start your detailed analysis by reviewing analysts' buy/sell recommendations and earnings and revenue forecasts to determine the market's enthusiasm for your candidate. The best value candidates are stocks that analysts don't like. Conversely, growth investors need to see some, but not too much, enthusiasm for their candidates. The Sentiment Index, described in Chapter 4, is a useful tool for gauging analysts' enthusiasm.
Analysts' earnings growth forecasts are another measure of a stock's suitability as a growth or value candidate. Strong forecast earnings growth disqualifies value candidates but identifies good growth prospects.
Step 2: Valuation
Valuation is an important issue for both growth and value investors, but for different reasons. If you're looking for growth, checking valuation tells you whether you've arrived too late at the party. For value candidates, valuation analysis tells you whether the upside potential justifies the risk.
Step 3: Establish Target Prices
Value investors typically set target prices to establish buy and sell points for qualified stocks. For instance, a stock may appear to be an attractive candidate, but a target price analysis might find that its current share price is too high to offer the needed risk/reward ratio. If so, the value investor might wait for the stock to come down in price before buying. It isn't bought if it doesn't reach the required buy price. Once purchased, the stock is sold when it reaches its calculated sell price range.
Although setting buy and sell targets is a linchpin of the value strategy, growth investors could benefit by going through the same analysis. Tool #3, Establish Target Prices, makes it easy.
Step 4: Industry Analysis
For growth investors, companies operating in fast-growing market sectors make the best candidates. By contrast, value investors find the best prospects in slower-growing markets. In this step, you analyze your candidate's industry growth prospects and related factors. If you're looking for growth candidates, picking an attractive industry is all for naught if you pick the wrong player. Consequently, the industry analysis also describes how to pick the strongest player in an industry.
Step 5: Business Plan Analysis
Wal-Mart dominates the retail industry, while former champ Kmart has fallen by the wayside. The difference is in the business models. In this step, you determine if your candidate is more like a Wal-Mart or a Kmart.
Step 6: Evaluate Management Quality
Many money managers consider gauging management quality an important part of the analysis process. You don't have time to visit candidates' plants and schmooze with key executives, and you don't have to. You can evaluate management quality from the comfort of your own home by reviewing the relevant experience of key executives and directors, measuring the firm's accounting quality, and completing other easily accomplished checks.
Step 7: Analyze Financial Fitness
You lose big if one of your stocks files for bankruptcy. But it doesn't have to go bankrupt to ruin your day. Just the rumors that it might are enough to sink its share price. Stock analysts typically don't check a firm's financial strength before advising buying. That's why so many advised buying Fannie Mae, Freddie Mac, Lehman Brothers, and other recent bankruptcies just months before they failed.
You don't have to be a victim. You can measure any public corporation's financial health using the strategies described in this step.
Step 8: Profitability and Growth Analysis
In the long run, stock prices follow earnings. In this step, you analyze sales and profitability trends to determine whether your stock's earnings are more likely to head up or down from here. You also find out if your candidate is really profitable or just gives the appearance of making money.
Step 9: Detect Red Flags
You lose big when your stock reports disappointing results or management cuts growth forecasts. Those disasters usually don't come without warning, however. In this step, you check for red flags signaling future disappointments so that you can act ahead of the news.
Step 10: Ownership Considerations
It may not be fair, but it's a fact of life that mutual funds and other institutional buyers have access to better information than individual investors. Thus, it makes sense to see what the big players think of your stock before you buy.
Insiders are directors, key officers, and large investors. While it's good when key officers and directors hold big positions in the company, too much insider ownership signals danger.
This is where you sort out institutional and insider ownership data to determine if it's favorable or unfavorable.
Step 11: Price Charts
It's against the law, but sometimes investors who are privy to market-moving news about a company's prospects act on that information before the news gets out. When that happens, the stock's price action might be your first clue that something is going on.
In this step, you learn how to find out whether the stock chart is signaling that it's okay to buy.
Chapter 18 includes separate scorecards for growth and value analysis candidates. Make copies and fill out the appropriate scorecard when you analyze a stock. You'll be amazed how just filling out a scorecard will improve your results.