Professionals rely on procedures. When an airplane is going to land, the pilot goes through a checklist carefully to make sure that the landing is safe. When a competitive tennis player begins a match, he exercises a mental rehearsal process to make sure he is in a correct state of mind. It is the same for a prudent investor who studies a stock in a logical way, instead of relying on tips and guesswork.
So how can you evaluate a stock systematically? Here is a very useful acronym: LINE, which summarizes 4 very important elements of a good stock and each letter represents one element.
L. – Leaders Only
This is the principle that conglomerate wizard Jack Welch valued the most, as he believed that if you cannot be the number one or two in the industry, then do not bother. Following this principle, he turned General Electric into one of the most successful conglomerates in the world.
However, the majority of the participants do not think like that. Suppose you want to buy a stock in the retail industry. If you buy the leading security in the group and your timing is sound, you have a crack at real price appreciation. If, on the other hand, you buy equities that haven't yet moved or are down the most in price, because you feel safer with them and think you're getting a real bargain, you're probably buying the sleepy losers of the group.
The fact is that strong stocks tend to be stronger while weak stocks remain weak. For example, in the bull market in the early 1980s, there were true winners as well as laggards in the computer industry, belonging to the former category were Wang Labs, Prime Computer, Datapoint, Tandem Computer, and the like which made the capital gain return of as high as 700%, whereas the latter group, like IBM and Burroughs, just sat there and were far from comparable.
Divergence is a simple concept that allows you to spot a leading stock technically. Basically, it compares the price of a stock to others within the same industry, or against benchmark indices like the Dow. Say, if stock A is advancing when the Dow is ranging, or if stock A outperforms 90% of its peers in the industry for a given period, then it is fair to say that stock A is a leader.
So here is the first rule of investing victory: avoid laggards and go for the leaders!
I. – Investment from Professionals
Warren Buffett is the most famous investor of his generation. Whenever he decides to buy a stock, thousands of people follow him to buy that stock, even though most of them have no idea why Buffett was doing it, because they simply believe that if Buffett is buying it, it must be good. This almost unjustified faith comes from nothing but the impressive track record of Mr. Buffett for the many years in which he accumulated his wealth.
There are certainly other less well-known, yet equally competent fund professional investors in the world. Your job is to sort through and recognize that them who have a stronger performance record and are better at choosing stocks than others. After that, whenever they buy a new stock, you may consider following them.
Financial services such as Morningstar publish holdings and performance records of various hedge funds. Performance figures for the latest 12 months plus the last three- to five-year period are usually the most relevant. However, you should be aware of significant changes like key portfolio managers leaving for another position somewhere else, as it can nullify all the previous record.
Professional investment is an important part of your wealth-making. Firstly, if a stock attracts no professional participation, the price can hardly go higher, and even if they are proven wrong, their position size is still enough to get out before the price drops further. Secondly, those professionals provide liquidity when you want to get out of your position, because many of them, just like the public, love buying on pullbacks, and when it is time to sell, you can always find them to unload your shares to.
Another important thing to know about is the number of institutional investors in the recent quarterly trend. Is the number of sponsors increasing or decreasing? Those so-called “professionals” may include the less experienced managers who also make mistakes like the public, i.e. buying at the top. When the number of institutional investors has reached an all-time high, yet the price action shows that the uptrend is exhausting, it is probably time to sell.
N. – Novelty in Industry or Company
Important changes in the fundamentals in a particular industry or company are not very often, but when they happen, they are always reflected in a sharp change in share prices. In face, most of the stunning winners in the stocks market are associated with either had a novelty in the company (e.g. new products, new management) or in the industry itself (e.g. new scientific discoveries, new laws, new global politics).
For example, in 1963, the pharmaceutical company Syntex launched the oral contraceptive pill, and the stock five-folded within half a year; and in the late 1970s, Wang Labs created a new type of word-processing machines for offices, and their B-share grew more than 10 times; and with the birth of microprocessor gaming devices, International Game Technology rose more than 15 times in 1991-1993.
Therefore you should always search for corporations that have a key new product or service, new management, or changes in conditions in their industry. The world is always changing, so if you can keep a keen eye, you may spot a few potential big winners.
E. – Earnings
Finally, earnings are the most important thing you should look at, because if the company does not make money, no one will buy its stocks. When you look at earnings, you should concern about two things: firstly, whether there are consistent earnings in the past, and secondly, whether there is a recent and significant increase in quarterly earnings.
As a minimum, the annual compounded growth rate of earnings in the best firms should have at least 20% per year over the last 3–5 years. In addition to the percentage increase in earnings, it is also important to look into the stability of the past five years’ earnings. It can be roughly determined by plotting quarterly earnings for the last 5 years and fitting a trend line to see how much deviation is there. It goes without saying that you always want to choose the stocks that have good earnings without sacrificing consistency.
It is also important to make sure that the earnings trend is continuing, so you should also look into the latest quarterly earnings. It should show a major percentage increase in the current quarterly earnings per share when compared to the same quarter last year. As a rule, only a difference at least 15% should make you consider buying it. Sometimes the quarterly earnings figure could be affected by seasonal factors, so to be safe, you should compare the data of two consecutive quarters.
Conclusion
If you have the discipline to only select stocks with proven growth records, you will avoid many false opportunities that can cost you a lot of time and money. You should always remember that you only invest in exceptional stocks instead of the lesser ones, so set your standard and only look for the superior stocks, because even though they are not very common, they are there waiting to be discovered.
Victor Chan Wai-To is an active trader in Hong Kong.