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This chapter is from the book

Quick Prequalify

Use the quick prequalify test to identify the obvious misfits. These may be stocks that would be bad news for any investor. Perhaps they're firms with businesses based more on hype than reality with little or no sales or earnings. Or they could be stocks that simply don't fit your investing style, e.g., maybe they're value stocks, and you're a growth investor.

Use the quick prequalify test to check:

  • Company and industry overview. Find out something about the company's business and its industry. It may be in a business or market sector that you favor or that you want to avoid. For instance, the home building industry usually prospers when interest rates drop and suffers in a rising interest rate environment. So your take on the future direction of interest rates would influence how you view homebuilders.

  • Market capitalization. Market capitalization defines a company's total value (share price multiplied by number of shares). The biggest firms are designated large-caps, and progressively smaller firms are termed mid-caps, small-caps, and micro-caps.

    There is no good or bad market capitalization, but each size has its own pluses and minuses in terms of potential risks and rewards. Generally, larger companies are considered safer, and smaller firms offer more growth potential. However, even these generalities vary with current market conditions.

    You may decide that a particular company size range best suits your needs or, conversely, that you're open to all possibilities. Whatever you conclude, eliminate candidates in this step that don't fit your requirements.

  • Valuation ratios. Valuation ratios such as price to earnings (P/E) or price to sales (P/S) define how market participants view your candidate's earnings growth prospects. High valuations reflect in-favor stocks, that is, those seen having strong growth prospects, and thus appeal to growth investors. Conversely, value players look for stocks with low valuation ratios, indicating that most market players (growth investors) view them as losers.

    Any given candidate will fit into either the growth or value categories, but not both. The valuation ratios give you a quick read as to whether you have a value or growth candidate on your hands.

  • Trading volume. Trading volume is the average number of shares traded daily. Low trading volume stocks spell trouble because they're subject to price manipulation and mutual funds can't buy them. Here's where you'll toss these bad ideas.

  • Float. Corporate insiders such as key executives and board members are restricted as to when and how often they can buy and sell their company's shares. So insider-owned shares are not considered available for trading. The float is the number of outstanding shares not owned by insiders, and thus available for daily trading.

    Acceptable float values depend on your investing style. Large firms typically have floats running from a few hundred million shares into the billions. However some investors seek out firms with much smaller floats, typically below 25 million shares. Since the float represents the supply of shares available for trading, these small floats mean that the share price could take off like a rocket if the company hits the news and the demand for shares overwhelms the available supply.

  • Cash flow. Where reported earnings reflect myriad accounting decisions, cash flow is the amount of cash that actually flowed into, or out of, a company's bank accounts as a result of its operations. Consequently, cash flow is the best measure of profits.

    Except for the fastest growers, viable growth candidates should be reporting positive cash flow. Here's where growth investors should eliminate cash burners from consideration. On the other hand, viable value candidates may very well be reporting negative cash flow resulting from the problems that caused their fall from grace.

  • Historical sales and earnings growth. Whether you're seeking out-of-favor value prospects or hot growth candin dates, your best prospects are firms with a long history of solid long-term sales and earnings growth. In this step, you'll dispose of stocks that don't meet this basic requirement.

  • Check the buzz. There's no point wasting time researching a stock if the company's main product has just been rendered obsolete by the competition. At this point, get up to speed on the buzz surrounding your candidate. Negative buzz is bad news for growth stocks, and you should disqualify such growth candidates. It's a different story for value prospects, however. The negative buzz is part and parcel of the market's disenchantment with the stock, and is contributing to making it a value candidate.

    You will eliminate many of your bad ideas during the quick prequalify check, most in less than five minutes once you get the hang of it. Take your survivors on to the detailed analysis.

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