The COSC (concentrate on the strongest candidates) analysis process is described in Chapter 16 and Chapter 17. Although describing two very different selection strategies, both employ the same analysis tools detailed in Part 2.
The COSC process consists of 11 steps, each using a corresponding analysis tool. For instance, Step 7 involves analyzing a candidate's financial health, and employs Tool #7, Financial Strength Analysis. The analysis tool chapters describe step-by-step procedures for performing each analysis, while "COSC Growth" and "COSC Value" describe how to apply the results to each investing style.
Obviously, you'll need to be familiar with the appropriate analysis tool to perform the corresponding analysis step.
Eliminate a candidate when it fails any step. For example, don't carry a candidate to Step 2 if it failed Step 1.
Step 1: Analyzing Analysts' Data
Market analysts are employed by brokerages and other firms to evaluate and rate publicly traded corporations. Start your detailed analysis by reviewing market analysts' buy/sell recommendations and earnings and revenue forecasts to determine the level of market enthusiasm for your candidate. The best value candidates are the ones 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 gauge of 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 strong growth prospects.
Step 2: Valuation
Would you buy a stock if you knew that the company would have to grow its earnings 75 percent every year merely to justify its current stock price? In this section, you'll determine the earnings growth implied by your candidate's current stock price. This will help you gauge whether there's sufficient upside stock price potential to justify further research.
Step 3: Establishing Target Prices
Many value investors use target prices to establish buy and sell points for otherwise-qualified stocks. For instance, a stock may be an attractive candidate, but its current stock price is too high to provide the needed margin of safety. So the value investor will wait for the stock to come down to the preestablished target price before buying. It isn't bought if it doesn't reach the buy target. Once purchased, the stock is sold when it reaches its predetermined sell target price.
Although setting buy and sell targets is a linchpin of the value strategy, growth investors would benefit by following the same procedure. Doing that would have helped investors avoid many of the disasters that marked 2000 and 2001. Tool #3, "Setting Target Prices," makes it easy.
Step 4: Industry Analysis
Companies are more likely to achieve success and make money for their shareholders if they're selling into fast-growing market sectors than if they're mired in a slow growth or stagnant industry. You'll analyze your candidate's industry growth prospects and other factors that affect industry player's success prospects in this step. Pinpointing attractive industries is all for naught if you pick the wrong companies. Thus, your analysis will also include identifying the strongest players in each industry.
Step 5: Business Plan Analysis
Microsoft is one of the world's more profitable companies, while Gateway Computer struggles. The difference is in the business models. In this step, you'll determine if your candidate is more like a Microsoft or a Gateway.
Step 6: Assess Management Quality
Many money managers consider gauging management quality an important part of the analysis process. You don't have time to visit candidate's 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 rum of key executives and directors, measuring the firm's accounting quality, and completing other easily accomplished checks.
Step 7: Financial Strength Analysis
You lose big if one of your holdings files bankruptcy. But a firm doesn't have to go bankrupt to ruin your day. Just the rumors that it might are enough to sink its stock price. Market analysts typically don't bother to check a firm's financial strength before recommending a stock. That's why so many advised buying Enron, Kmart, Global Crossing, 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 section.
Step 8: Profitability & Growth Analysis
In the end, stock prices follow earnings. In this step you'll analyze sales and profitability trends to determine whether your candidate's earnings are more likely heading up or heading down. You'll also find out if your candidate is really profitable, or just gives the appearance of making money.
Step 9: Detecting Red Flags
It's a disaster when you learn that your stock just dropped 40 percent because it reported disappointing earnings, or management cut future growth forecasts. These disasters usually don't come without warning. In this step, you'll check for red flags signaling future disappointments before they sink the stock price.
Step 10: Ownership Considerations
Despite the advantages of the Internet, mutual funds and other institutional investors have access to better information about stocks than individual investors. Therefore, analyzing institutional ownership data can help you decide whether you're on the right track.
Insiders are directors, key officers, and large investors. Naturally, you'd like to see that key officers own their company's stock, but too much insider ownership signals danger.
This is where you'll sort out institutional and insider ownership data to determine if it's favorable or unfavorable.
Step 11: Price Charts
Believe it or not, occasionally knowledgeable insiders withhold important information that would affect your investment decision until they've had a chance to act by dumping or loading up on the stock. In these instances, the stock's price action is your only clue that something is going on.
That's why it's important to check a stock's price chart before buying. In this step, you'll ascertain whether the stock chart is signaling that it's okay to buy.
You'll find separate scorecards in Appendix B for the growth and value analysis strategies. Make copies and fill out the appropriate scorecard when you analyze a stock. You'll be amazed how just filling out the scorecard will improve your analysis.