December 29, 2007
Current Share Prices
Stocks: Reduce Risk Yet Maximize Profits
by: John Lux
It is important to note that every smart investor wants to minimize risk while maximizing profit potential. Yet conventional investment theory tells us that in order to increase returns, you have to increase risk.
You may be surprised to find that this conventional wisdom is not always true.
When I was a professional stock trader, I made most of my profits from appreciation in my portfolio, not in short term trading. In other words, I was a position trader. Any losses in my stock positions were taken out of my paycheck at the end of the month in fact, I had to pay back any loss. If you are in this position, you desperately want to learn all the techniques to make large profits without risking much. I became an expert out of necessity. So while my trading account had virtually no losing months, my gains were as much as 300% per year.
In my stock picking, I first looked for stocks that were so cheap they could not go down. If they did go down, I was happy to buy more because at those prices, you could buy the whole company and sell off the assets for a profit.
From this group of safe stocks, you select the ones most likely to have large appreciation.
A stock is cheap in my book if it sells below the liquidation value of its assets, and most cheap if it sells anywhere near the net amount of cash it has on hand. So the first two measures of value I looked for were book value per share and cash per share.
Book value is the value of the shareholders equity carried on the books of the company. Generally, since you are buying a share of stock, you will want to know the book value per share.
The one caveat to looking at book value is that companies often have intangible assets on the books, goodwill and the like. You have to take these intangible assets with a grain of salt. The safest thing is to look for tangible book value.
Book value per share is often calculated for you in the various Internet financial stock search programs available.
The next indicator to look for is cash per share or working capital per share. Working capital is current assets minus current liabilities. These assets are near to cash or will generally be turned over in one year: receivables, inventory and the like.
To measure the health of working capital, divide current assets by current liabilities to get the current ratio. A current ratio of two to one or better usually indicates a solid company. As long as the company does not have any long term debt, or at least none coming due in the near future, the company is solvent and should be around for a while little or no bankruptcy risk.
Next, we look for low price-earnings (P/E) ratios. In my opinion, buying high P/E stocks to chase growth companies is inviting real risk. If the company disappoints in earnings, not only will the stock drop from lower earnings, the P/E ratio will deflate as well, giving you a double hit.
OK, so you have found a company that is selling at or below book value with a current ratio better than 2:1, and a low, low P/E. It may be that the stock will not go down, but will that stock go up?
Picking growing industries and growth companies is more than I can tell you here, but there are two simple things you can look for first: (1) Is the company buying its own stock, or has it bought its own stock at about this price, and (2) are the insiders making hefty purchases of their stock?
Next, you can look at the ratio of revenues or sales to market values or the dollar amount of sales per share. Generally speaking, the company with a relatively high amount of sales per market value or sales will have more action on the upside. That company has more revenues to make profits from.
After you have narrowed the field using the above techniques, there will be no substitute for intense homework about company prospects to find which of those cheap stocks that truly give you superior returns, what I call my Home Run Stocks.
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About The Author
John Lux is a former OTC Trader and author of the book, How to Find a Home Run Stock. To read the book and find your own Home Run Stocks, click http://www.asklux.com/investing-books/home-run-stock.htm. Email John at john@asklux.com
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This warning goes out to newbie investors, and more times than not, it falls on deaf ears. But I’ll repeat it one more time just for posterity’s sake: if you’re new to investing, be very careful of making investments in penny stocks. You will undoubtedly be very attracted by the potential returns due to the deflated share prices, but keep in mind that things are usually not what they seem to be, and sometimes penny stocks really are “too good to be true.”.
Why do pennies pose such a risk? In a word: reporting. Or more accurately, lack of reporting. Since Over the Counter (OTC) stocks are not listed on any exchange, they don’t have to follow the stringent reporting criteria which we’ve all become accustomed to for major exchange traded stocks. What this means is that these companies generally offer very little financial guidance, and tend to rely much more on hype than exchange traded stocks.
Penny stocks usually have very small floats (the amount of shares actively traded) and for this reason, coupled with thin capitalization, the stocks can be manipulated quite easily by several buyers or sellers, and some news or rumors. Many penny stock companies use spam email to promote their products. They send out to large groups of internet users who end up becoming interested in the stocks. As the emailed people start buying, the price goes up, and the investment starts to look like a great deal. At this point, the pump and dumpers will start selling all the shares they can, and the investment will come back down to Earth. The pump and dumpers make the money, and the investors who come in later are left holding the bag.
These pump and dump schemes are extremely common, and penny stocks are almost always what are used for the promotion. Particularly vulnerable to this ruse are small and new investors who have tiny amounts of capital. Most of these types of investors want to accumulate a large amount of shares with the hopes of turning a meager $200-$500 investment into a retirement nest egg. Most end up losing their capital.
These warnings might seem obvious, but it’s amazing how often people lose their head when dealing stocks. Most people feel that the number of shares is their best chance for making profits. They feel if they can but 100,000 stocks for 0.001 that somehow they’ll get rich if only the stock hits 1 cent! This is true, of course, but almost never happens. Most stocks that sell for fractional pennies are more likely to stay in that neigborhood rather than to rocket to even $10.
Remember that the only metric you need concern yourself with as it relates to investing is total returns. The higher your percentage return, the more money you have. You will never end up concerning yourself with share price if you are a studious investor. It’s meaningless in the final analysis. For savvy investors who do a ton of research, finding a bargain in the penny stock heap is possible. Once you’ve done a few trades of “normal stocks” give it a try, but lay off the pennies until you have a very good understanding of what makes share price move.
About the Author
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