Thoughts on Individual Stock Selection

Many investors choose their stocks because they 'like their business or products'. Others search out companies that have high ROIs, ROEs, profit margins etc.

What's wrong with that? Posting good numbers in those parameters is certainly a positive thing.

But…

None of those things vary with the share price.

With today's extreme volatility, many big-name stocks can have yearly highs and lows that are as far apart as 50% – 100% or even 200%. So the same share might be both a great buy and a screaming sell in the same 52 weeks.

The company's business, its ROI, ROE and profit margins are all constants even as the shares gyrate wildly. In mathematical equations anything that is a constant can be disregarded in comparisons.

What I like to use for stock picking are valuation measures that do change with share prices.

My four major gauges are Price/Earnings, Price/Cash Flow, Price/Book Value and Dividend Yield. I then compare their current levels with that same stock's valuation at previous best and worst historical buying points in the past.

I've picked out a dozen of the DJIA stocks to show how widely stock prices and price/earnings can vary during market cycles. [All data below is split adjusted and as of April 1, 2008].

Even a casual glance at the very high P/Es on these shares at their 1998 – 2000 highs shows how pricey they were back then. Great business models and high ROEs etc. could not save investors who drastically overpaid on a valuation basis.

Buyers at the cycle lows [mainly hit in 2002] were able to purchase the shares of the same great companies but at fractions of their peak valuation levels.

At the subsequent highs every single stock listed was selling at a P/E that had expanded from the cycle low valuation. It should be noted that each company's earnings changes do not account for the variation in its P/E. The expansion and contraction of earnings multiples is a combined function of investor psychology and the ambient interest rate environment.

The lesson to be learned from this whole exercise:

A sound business model and favorable metrics are good qualities to look for in stocks you are considering for purchase.

• Companies that meet your qualifications should then only be considered when they sell for substantial discounts to the 'normalized' valuation metrics.
• A good guide to use for decision making is to check to see what the stock in question looked like at previous 'best buying opportunities' as judged by future actual stock price performance.
• Every stock can get overpriced enough to become a sell regardless of how much you love it. Don't hold shares that are clearly too expensive. Otherwise you'll probably ride them back down.
• Virtually all stocks go through overpriced/under priced cycles. If you are patient you'll get a chance to buy almost everything you'd like to own.
• Don't make buy or sell decisions based on data that does not vary with changes in share price.

The recent market sell-off has created lots of bargains based on the system outlined here. Instead of choosing a stock to own regardless of valuation, why not keep a list of companies you'd like to own at particular valuation levels and then let 'the market' tell you when it's ok to load up?

Comments

[granger]

What is the best source for finding that old information of prior buying opportunities or cycles?

for example old historic PE's, P/B, etc.

Thank you.

[Paul Price]

I use Value Line and Standard and Poors reports. Value Line gives data back around 15 - 16 years on most stocks.

They show all company data for a particular year directly under that same year's stock chart which is quite useful.

I hate VL's rating system but love their data presentation.

[JW - PVB]

Paul,
Great article! It is reminding all of us what the purpose of the stock market was: Owning a piece of a company and its profits.
Unfortunately, as you stated:” The company's business, its ROI, ROE and profit margins are all constants even as the shares gyrate wildly” because many people and institutes live on the manipulation of stock price and they will use any reason to do so.
Just a thought: Imagine what the market would look like if stock trading would only be allowed after it was held for 3 months. A lot of people would be looking for a job!
JW - PVB

[s.frankola]

morningstar.com also has 10 year valuations

[drwater]

what are the ranges for these

My four major gauges are Price/Earnings, Price/Cash Flow, Price/Book Value and Dividend Yield.

[Paul Price]

I'm not sure what you mean by 'ranges'. I look for lower than normalized P/Es, P/CFs, P/BVs [compared with the same company's historical levels] and a higher than typical yield [on dividend paying stocks.

If a stock usually trades at 15x EPS I might be very interested if it's not at 9 - 12X. If it typically yielded 2% I'd like it much better with a 3 - 4% yield at the present time.

[Paul Price]

not should have read 'now' - sorry.