Stocks Beyond Numbers - 5 Golden Rules To Consider

Includes: MCD, STX
by: The Dividend Guy

By Mike

When we discuss stock analysis methods, we often (read always) refer to numbers. How does the price earnings ratio look and the fwd P/E ratio for valuation? How are profits, earnings per share, sales, dividend payout growth over the past 5, 10 years? Numbers are definitely important. More than simple numbers, identifying trends is even more important. Solid companies will continuously improve their financial results while hectic growth could lead to poor investment decisions. But beyond the numbers, there are several other factors to consider. Here’s a list of my favorites:

No 1 Consider the Sector Before the Stock

I strongly believe in sector investing for many reasons. The first one is that even the worst stock of a flourishing industry will rise. If you want an example, read my thoughts about the food industry, you will see that after Warren Buffett bid on Heinz (HNZ), most companies in the same sector surged automatically.

If a sector is doing well, there will be hype around these companies. This is why any stock picks will do well if you pick the right sector. Unfortunately, the opposite is also true. If you pick a strong company in a bad industry, chances are your stock appreciation will be minimal.

Golden Rule: Never invest all your stocks in the same sector

It is very possible you will find 4-5 great companies to buy in the same sector. If you do so, you expose your portfolio to high volatility. Even worse; you are wrong in picking the right sector, you will suffer important losses. Diversification is the key, always consider in which sector a company operates compared to what your portfolio looks like before making a trade.

No 2 Ability to Find Future Opportunities

One of the reasons I sold Seagate Technology (NASDAQ:STX) not so long ago was because I had a hard time finding future opportunities for this company. Techno stocks have the ability to grow faster than most industries, but their products and services can become obsolete pretty quickly. STX’s main challenge is to find another niche product beside hardware storage. If this mission fails, the stock will eventually tumble as sales will slowdown and along with profits.

Golden Rule: Read about the company and the industry to find opportunities

You don’t need to be visionary to find future opportunities for companies. If you read stock analyses, financial analyst comments and the annual financials, you will find out where the company is putting its cash flow to create future growth. Depending on the business model, these are sometimes easy, sometimes pretty hard to estimate.

While reading about STX, I noticed the company was working on other projects. Most projects were based on innovative technology. This is always a risk as it’s hard to assess if the technology will deliver what is expected. On the other hand, if you pick a company such as McDonald’s (NYSE:MCD), you can see its growth will come from healthier menus and natural growth of the number of consumers. Not as exciting as a new technology that could boost their sales by 30% but easy to understand combined with very solid assumptions.

No 3 Understand the Business Model

The first factor I consider prior to investing my money is understanding the business model. I didn’t always think that way and it had cost me a few thousand in losses! I happened to buy stocks based on “potential returns” without truly understanding how their business model worked or how the sector reacts to the economy.

Golden Rule: If you cant explain how the company makes money and how its industry works in two minutes, dont buy this company

This golden rule is inspired from famous investor Warren Buffett who always invests in companies he understands. This is the reason I’m not afraid to invest in techno stocks or banks but I will forget about looking at insurance companies. In my opinion, the way they value their assets and manage their portfolios to pay the benefits requires too much of my time to understand the various impacts. Consumer goods (cyclical or not) are easy industries to understand and requires less attention from investors.

No 4 Consider the Dividend Policy

Dividend growth and dividend payout ratios are definitely at the center of any dividend stock analysis. However, it doesn’t mean that only the numbers matter when it comes down to determining the future dividend payouts. I also like to see the payout trends over 5 – 10 years to see if the management team is inclined to concentrate its profits toward investors or keep them to fund future projects.

Golden Rule: Find more info about the dividend policy from the management team

I like to read financial statements as they often clearly state the management team’s dividend policy. If it’s clearly mentioned that it is proud about the dividend payout or dividend growth over the years, it gives you a great indication that it will continue on with this focus. Other companies could prefer funding new projects or start a share buyback program. If you are looking for revenues (e.g. dividend payouts), a company focusing on its projects or buying back shares won’t help you achieve your investing goals.

No 5 What Can Go Wrong With a Company?

I don’t know about how you deal with your investments , but I often tend to see more positive than negative points when I’m ready to buy a company. Potential problems could be seen within the numbers. Obviously, if you pick a company with sales heading downhill year after year, you might not want to continue your analysis. But sometimes, problems could come from outside as well.

Golden Rule: Dont only look at the tree, look at the forest as well

I try to draw the worst-case scenario for most of my stocks. It’s important for me to know what could possibly go wrong with companies I’ve selected. Can Chevron (NYSE:CVX) and Husky Energy (HSE) survive a lawsuit or an oil barrel price slump? How will Apple (NASDAQ:AAPL) react to lower sales for its iProducts? How will National Bank (NA) and ScotiaBank (NYSE:BNS) react in the event of a housing market collapse in Canada? These are questions requiring answers. I’m trying to find how the company could go through a maelstrom and how it will find its way out. Among the greatest companies of all time, you will find those that perform well during bullish markets but also outperform their sector during bearish ones. It is true in sports, but it’s also true for stocks: offense (profits) gets you into the playoffs but defense (strategy, business model strengths) wins championships.

What do you look at beyond the numbers?

As you can see, there are several other factors you can consider prior to buying a stock. They are harder to describe as they are not quantified. And it doesn’t mean they are not important either. I believe a successful investor looks at both the numbers and the company as a whole.

Readers: do you spend a lot of time thinking beyond the companies financial statements to make your investment decisions? What factors do you consider?

Disclaimer: I own shares of MCD, CVX, HSE, AAPL, NA, BNS.