In the first four parts of this series of investing in small cap stocks, you learned buying and selling strategies. Now once you carefully research and identify an industry or sector that you are convinced will grow exponentially over the next one to five years, how do you identify the best companies? In this bonus tips article, I’ll discuss how subscribing to the “a rising tide lifts all boats” theory can severely hinder your stock performance.
As of the writing of this article, spring 2006, many sectors look very promising. Precious metals, technology, nanotechnology, renewable/ alternative energy, and so on. But thinking that you can just buy any companies in high-growth sectors without doing considerable research can be disastrous. So here are three tips to help you out in this process.
Tip Number One: In the beginning, think more like an artist instead of an investor.
A creative mind is more important to success in investing than a purely analytical one. If you know creative thinking is not your strength, then interview financial consultants until you find one whose creativity impresses you. Without assessing an opportunity from a creative standpoint, the best stock opportunities will be left undiscovered. When first trying to uncover opportunities within an industry, simply sit down with a pen and a piece of paper and brainstorm. For example, let’s consider the renewable/alternative energy sector that is making so many headlines today. After President Bush mentioned development of a renewable energy in his State of the Union address and when Bill Gates’s planned $84 million investment in Pacific Ethanol (PEIX) was reported, considerable buzz evolved around renewable energy stocks.
To start, write down all the different sub sectors within this niche sector that come to mind. Your list might include wind energy, solar energy, nuclear energy, hydrogen and fuel cells, ethanol, biodiesel, biomass power, hybrid cars, and so on. The point of this exercise is to write down every idea that comes to mind, no matter how silly you may think it is at first glance. Many times, this simple brainstorming exercise has helped me uncover exciting opportunities in sub sectors of industries that I was not even at first considering. For example, just hearing news about ethanol may lead you to a surprising discovery regarding the potential of wind energy.
Tip Number Two: Make a list of the positive and negative questions regarding the industry that interests you.
This exercise is an extremely important one because it is the exercise that will help you sort out the stocks with the most potential versus the ones with the least amount of potential. When first researching companies within a certain industry sector or sub sector, at first, every company may look promising. Using our above example, you may think that wind, solar, nuclear, and biomass energy all look like winners. However after doing this exercise, the picture will become a lot clearer for you. A partial list of your positive question list may appear as follows:
What is the estimated market size of this industry in the next five years? Who are the potential buyers of this product? Will sales of this product have domestic or global appeal? Will this be a revolutionary product and why? Any countries or markets already adopting this product and if so, what is the adoption and growth rate in these markets?
A partial list of your negative questions may appear as follows:
What is the timeline for adoption of this product? Is it one to two years or more likely to be five to ten years from now? How is research in this industry funded and are these companies’ funding sources sustainable and reliable? Does the product have limited specific appeal or wide commercial appeal? What is the political attitude towards this industry globally? What are the driving forces of potential profit in this industry and how do the companies I am considering meet or benefit from them?
Again, in this exercise, don’t worry about writing down silly questions. It is more important to note every question that you can imagine until all avenues are exhausted. When you are finished compiling your question list, then go to the internet and start “Googling” away to find the answers to your questions to help you narrow down your list to the top three sub sectors. Again, using the energy example, you may discover that while there has been a lot of hype surrounding biodiesel, ethanol, and hydrogen and fuel cells, that wind, solar, and nuclear energy are the most realistic industries for immediate adoption and have already experienced some significant sales and applications (this is just a hypothetical scenario, and not necessarily the reality, to illustrate a point).
Furthermore you may discover that certain governments have already dedicated portions of their budgets to the development of specific energies, making those sub sectors more attractive. Studying government timelines for development of alternative energy sources can even provide a rough guideline to the immediate profitability potential of specific sub sectors. Then, given your findings, identify the top ten companies that are global leaders for each sub sector in your pared down list.
Tip Number Three: Answer the questions you prepared in step number two for your top ten lists.
All companies are not created equal. That is why it is so important to identify the right companies within the right sectors, because there are a lot of wrong companies within the right sectors. To illustrate my point, let’s consider precious metals. Some “mining” companies in the same precious metal niche can have drastically different operations and strategies that create huge gaps in their attractiveness. For example, one mining company may have huge overhead from ownership of heavy machinery and the costs of metal extraction. Another mining company may have zero production costs because it owns no mines, no equipment, and has just negotiated contracts with mining companies to purchase the metals that they extract. Because of these drastically different operations choices, two companies that appear similar on the surface may have net profit margins that differ by 40%.
Furthermore, one must understand where the potential benefits lie in such markets and research how well these companies’ strategies meet these challenges. Is the metal in question soaring in price? If so, has the company you are researching washed away most of tomorrow’s profits by locking in future sales at today’s metal prices? Or do they remain unhedged in their future sales, allowing them to benefit from the growing surge in metal prices? This one strategy alone could separate a huge winner from a huge loser although both companies reside in the same metal industry.
Even if you employ a financial consultant to invest your money, you need to probe to understand what your financial consultant understands. Because many financial consultants are salespeople, they hear about a growth sector and merely find a leading company in that sector and believe that you will benefit. Their recommendations and explanations may even sound logical to you, but never agree to buy into a stock position unless your consultant can specifically answer questions as to why the industry is poised to grow so much, and how the specific company he or she is recommending is strategically positioned to benefit from the growth of its industry. Remember, here you always want specific over general explanations.
In summary, (1) Creative thinking will uncover the best opportunities because often the best opportunities are not your original ideas, but are the ones associated with your original ideas; (2) Unconventional questions will assist you in drilling down wide lists of prospective companies into a narrow list of top prospects; and (3) It is not being invested in the right sectors that will give you great performance, but specifically being invested in the right companies with the right management with the right strategies and right opportunities within the right sectors that will yield great performance.
? 2006 Global Market Opportunities, Inc.
About the Author
J. Shin Kim is the founder of Global Market Opportunities. If you’re tired of measly 6%, 7%, or 10% annual returns from your stock portfolio, learn more about how to identify stocks that significantly beat the market indices by clicking the following link, Learn to Invest Money and Achieve Financial Freedom. Also, follow this link to subscribe to our free investment advice ezine.
In a previous article, we discussed Ben Graham’s Net Current Asset Value
(NCAV) strategy and how it works. Here we will revisit Graham’s rules, which
were fairly severe in their original form in that they required the price of the
stocks under consideration to be trading at less than two-thirds of their NCAV
or Graham’s Number. These he considered to be “Bargain Issues”, and to
quote him: “Our purchases were made typically at two-thirds or less of such
stripped-down asset value. In most years we carried a wide diversification here–
at least 100 different issues.”
In a previous article, we discussed Ben Graham’s Net Current Asset Value
(NCAV) strategy and how it works. Here we will revisit Graham’s rules, which
were fairly severe in their original form in that they required the price of the
stocks under consideration to be trading at less than two-thirds of their NCAV
or Graham’s Number. These he considered to be “Bargain Issues”, and to
quote him: “Our purchases were made typically at two-thirds or less of such
stripped-down asset value. In most years we carried a wide diversification here–
at least 100 different issues.”
Such a wide diversification may seem excessive for most investors, but
with such low-priced stock there were evidently going to be a few bankruptcy
candidates. Graham considered this strategy to be suitable for what he called
“defensive” investors. He did acknowledge, however, that there were some
“enterprising” investors who could afford to be more aggressive from the point
of view of risk. To this end, he suggested a series of less onerous criteria
for selecting stocks which is outlined below.
First, list all stocks with Price/Earnings ratios below 9. Note: Graham was
writing in 1970 when P/E’s as a whole were not as elevated by technology
stocks as they are today. Readers who are less risk-averse or who just want
to consider a wider range of stocks may wish to vary the P/E in order to see
what comes up — perhaps up to 80 percent of the average P/E of the S&P 500
would be a good start. Currently the operating average is around 18 and 85
percent of that figure is just over 15. Graham did not state if he was using a
Trailing or Forward P/E ratio, but most likely he was using Trailing P/Es. I
personally prefer to use Forward P/E ratios, especially if they are significantly
lower than the Trailing P/E as this implies expected earnings growth and
therefore possible increase in the stock price.
Once we have a list of stocks meeting the P/E criterion, we consider the financial
condition of each stock, referring to the most recent balance sheet:
Initially, Current Assets must be at least 1.5 times Current Liabilities. This can
also be gleaned via a stock screener by displaying stocks with “Current Ratio”
>= 1.5. Total Debt must not be greater than 110% of Net Current Assets (i.e.
the sum of Cash & Cash Equivalents, Inventory, Accounts Receivable).
Looking further back, we need to find evidence of Earnings Stability, with no
deficit in the last five years, i.e. no evidence of an annual loss. Additionally,
evidence of earnings growth over a five-year period is a must. This can simply
be the consideration, for example, that 2004 earnings were greater than 2000
earnings.
There should be some current dividend payout. Finally, the current price of the
stock should be less than 120% of the NCAV per share or Graham’s Number.
Where to find this number? From the balance sheet, subtract Total Liabilities
from Current Assets, and divide the result by the number of shares outstanding.
Assuming you have a positive number that is greater than zero, the stock’s price
should not be greater than 120% of this number.
At grahaminvestor.com, we list stocks that are trading within 120% of the NCAV
per share. Since this was an important measure for Graham, you can start there
and work your way backwards through the other criteria.
Graham did not set any lower limit on market capitalization. “Small companies
may afford enough safety if bought carefully and on a group basis.” He meant
that a well diversified portfolio with a fair number of such companies stock would
protect the enterprising investor from the bankruptcy of one or two companies.
(c) 2005 The Graham Investor
You may use this article, as-is, provided this copyright notice is kept intact.
ABOUT THE AUTHOR
John B. Keown is an IT specialist, website builder and private investor who enjoys all things stock-related and in particular seeking out undervalued stocks.
He can be contacted via
http://www.grahaminvestor.com
