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This chapter is from the book

Quick Prequalify

Use the quick prequalify test to rule out 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. For instance, perhaps they're worthwhile value candidates, but you're a growth investor.

Here's what's included in the quick prequalify tests:

  • Company and industry overview: Learn about the company's business and industry. It may be in a market sector that you favor or one that you want to avoid. For instance, some pundits say that demand for crude oil will exceed supply for the foreseeable future, driving up all energy prices. Others disagree. So your take on that topic would influence how you view deepwater drilling companies and energy stocks in general.
  • Market capitalization defines a company's market value. It's how much you'd have to pay to buy all the 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 potential risks and rewards. Generally, larger companies are safer investments, but smaller firms offer more growth potential. That said, even these generalities vary with 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 decide, in this step, rule out the candidates that don't fit your requirements.

  • Valuation ratios such as price to earnings (P/E) or price to sales (P/S) tell you how market participants view a stock. High valuations reflect in-favor stocks with strong growth expectations. Thus, they 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 category, 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 is the average number of shares traded daily. Low-trading-volume stocks are a bad idea because they're subject to price manipulation. Further, mutual funds and other big players 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 considered unavailable for trading. The float is the number of outstanding shares that insiders don't own, and thus are 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, investors looking for stocks with maximum growth potential often seek out stocks with much smaller floats, typically below 25 million shares. With relatively few shares available, small float stocks could take off like a rocket when the company reports good news and the demand for shares overwhelms the available supply.

  • Cash flow: While reported earnings reflect myriad accounting decisions, cash flow is the cash that actually flows into, or out of, a company's bank accounts from its operations. Because it's based on actual bank balances, cash flow is the best measure of profits.

    Except for the fastest growers, viable growth candidates should be reporting positive cash flow, meaning that cash is flowing in, not out. Thus, this is the step where growth investors would rule out cash burners. On the other hand, value investors would take a longer view and overlook negative cash flow triggered by short-term problems.

  • Historical sales and earnings growth: Whether you're seeking out-of-favor value prospects or hot growth candidates, your best prospects are firms with a long history of solid sales and earnings growth. In this step, you'll dispose of stocks that flunk this basic requirement.
  • Check the buzz: There's no point wasting time researching a stock if its main product has just been rendered obsolete by the competition. This is where you catch up on the buzz surrounding your candidate. If you're looking for growth stocks, negative buzz is bad news and disqualifies them. For value prospects, negative buzz reflects the market's disenchantment with the stock, thus making it a better value candidate.

You will eliminate many of your bad ideas during this quick prequalify check. Once you get the hang of it, you'll be able to run each stock through this test in less than five minutes. Take your survivors on to the detailed analysis.

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