Tactical Investor's  Instablog

Suggested guidelines for spotting new investment ideas

We generally base our choice on the following factors.

Net income - It should be generally trending upwards for the past 3-4 years.

Cash flow per share - It should be trending upwards for the past three years.

Total cash flow from operating activities - It should be trending upwards for the past 3-4 years.

Current ratio - Should be above 1.

Interest coverage ratio - When available, any value above 1.5 is OK, but we would aim for 2.5-3.00 as our starting range. The higher the number the better.

Sales - They should generally be trending upwards for the past 3-4 years.

Levered free cash flow - This is the icing on the cake. If a company meets most of the above requirements and also has a positive levered free cash flow, it can generally be viewed as a good long term buy. Two examples are Leggett & Platt (LEG) and Procter & Gamble (PG).

The following criteria apply only to dividend paying stocks and not to growth stocks that might not payout dividends:

Payout ratio - It should generally be below 100%, but a ratio below 70% is optimal. Payout ratios are not that important when it comes to MLPs/REITs as they generally pay a majority of their cash flow as distributions. In the case of REITs by law they have to pay out 90% of their Taxable income as dividends. Payout ratios are calculated by dividing the dividend/distribution rate by the net income per share, and this is why the payout ratio for MLPs and REITs is often higher than 100%. The more important ratio to focus on is the cash flow per unit. If one focuses on the cash flow per unit, one will see that in most cases, it exceeds the distribution/dividend declared per unit/share.

Dividend growth rate - It should be at 5% or higher. A high yield with a low dividend growth rate is not good in the long run, but neither is a low dividend yield with a high growth rate; one needs to find an equilibrium here. And there are exceptions to this rule, some stocks appreciate rather rapidly and so a low dividend could be offset by the capital gains.

Five year dividend average - We generally aim for stocks that have a yield of 4.5% or higher. There are exceptions to this rule. Some stocks appreciate very fast, so even though the yield might be low, one can more than make up the difference through capital gains. One example is Jarden (JAH).

An early warning signal that the company could be in trouble is when the total cash flow generated from operating expenses is not enough to meet the dividend payments. This information can be gleaned by looking at the cash flow statement. This is readily available at Yahoo Finance. In the example below we used LEG and the data was obtained from Yahoo Finance.

The cash flow in this case was more than enough to easily cover all the dividend payments for all the above years; in this the time period was from 2008-2010.

Many traders use other metrics and that is fine; we are just trying to provide a guideline. As you get better handle of the ratios explained below you can create your own list of criteria. If you would liked to kept abreast of any new developments consider joining our free newsletter

The covered call strategy is a great way to open a second stream of income and minimize the impact of volatile gyrations on one's portfolio.

What are covered calls?

An investor basically writes a call option (sells calls) that is backed by with the equivalent number of shares, hence the name covered call. If the stock is purchased at the same time a call contract is sold it's often referred to as a "buy write". On the other hand, if the shares are already from a previous purchase, it is referred to as "overwrite." This is the most basic and widely used strategy, which combines the litheness of options with stock ownership.

When you write a covered call income is generated in the form of the premium paid by the option buyer. If the stock trades above the strike price, then the owner will have to sell the shares at that price, if not the owner of the stock gets to keep the premium. The risk of stock ownership is not eliminated. If the stock drops significantly, then the net position will likely lose money, however, using this strategy would reduce the loss factor by the amount in premiums the owner of the shares received for each call he sold. The main risk of a covered call strategy is that the stock might decline significantly in value; in other words, the same risk any share holder bears but with the added benefit of receiving a premium for the calls you sold.

Let us look at an example

Let's say you own 300 shares in SDRL, which is currently trading at 38, and you think that there is little chance that the stock is going to hit 45 in the next six months. You can then sell calls with a strike of 45; the premium you receive is yours to keep. If in the next six months SDRL does not trade above 45 (usually the stock has to trade above the strike price on the last trading day), then you hold onto the shares as well as the premium.

Benefits of employing this strategy

Income generation

Each contract trades at a premium (the higher the beta the higher the premium), and the buyer of the contract pays you that premium for the right to purchase 100 shares of the stock at the strike price. The premium is deposited immediately into your brokerage account.

1) Downside protection and reduction in Portfolio volatility

If the stock drops in value, the premium collected at least some type of return, and it can offset all or part of the loss depending on how severely the stock has pulled back. For example; if you sold a covered call against a stock when it was trading $20 for a premium of $2.50, then as long as the stock does not drop below $17.50 you are okay. In essence, you have reduced your entry price to $17.50. If this strategy is actively employed, then you could in general significantly reduce the volatility your portfolio is subjected to.

2) Predetermined rate of Return

This strategy gives you a decent idea of your rate of return on your investment will be. Regardless of what takes place you still get to keep the premium. If your shares are called away from you at the strike price, it is easy to figure your profit; this is the difference from what you paid for the stock and the strike price you sold the option, plus the premium you collected. So let's take the above example. If SDRL trades above 45, your shares are called, and you are out at 45. So your profit is 7 plus the 2.50 which you received in premium for a total gain of 25%.

If the stock starts to drop in price, you lose money on paper (much like any other share holder) when price of the stock falls in excess of the premium you received.

3) Converts a common stock into a dividend paying stock

The moment you sell the call option, the stock you own, in essence, has turned into a dividend paying-stock; if it already pays a dividend you have turbo charged your gains.

4) Repeat the process all over again

If your shares have not been called away from you, you can repeat the whole process again with the same shares of stock you own. Utilized properly this strategy can produce an income stream that can surpass the dividend paid out by that specific stock. If the stock does not pay out a dividend, you have just converted into one that does. If the stock is called, there is nothing to prevent you from buying another good stock and repeating the whole process again.

5) Buy back the call

If you sold the call for a premium of 2.50 and the call is now trading at 1.00, you could buy the call back, and you still get to keep the difference, which in this case amounts to $1.50. You could take things one step further and start the whole process again by selling calls that are fetching higher premiums. For example, you sold calls on stock X when it was trading at 37 with a strike at 40 for a premium of $2.50. The stock is now trading at 34, so you buy the call back and sell new calls with a strike at 37.50.

We have posted several key ratios on each of the five stocks covered in this article. Investors should familiarize themselves with some of these ratios as they could prove to be extremely useful and helpful in the selection process. Understanding what these ratios mean could make the difference between spotting a winner or a loser.

Enterprise value is a combination of the market cap, debt, minority interests, preferred shares less total cash and cash equivalents. This provides a better picture because it is a more accurate representation of a company's value contrary to simply looking at the Market cap.

Free cash flow yield is obtained by dividing free cash flow per share by the current price of each share. Generally lower ratios are associated with an unattractive investment and vice versa. Free cash flow takes into account capital expenditures and other ongoing costs associated with the day to day to functions of the business. In our view free cash flow yield is a better valuation metric then earnings yield because of the above factor

Levered free cash flow is the amount of cash available to stock holders after interest payments on debt are made. A company with a small amount of debt will only have to spend a modest amount of money on interest payments, which in turn means that there is more money to send to shareholders in the form of dividends and vice versa.

The payout ratio tells us what portion of the profit is being returned to investors. A pay out ratio over 100% indicates that the company is paying out more money to shareholders, then they are making; this situation cannot last forever. In general if the company has a high operating cash flow and access to capital markets, they can keep this going on for a while. As companies usually only pay the portion of the debt that is coming due and not the whole debt, this technique/trick can technically be employed to maintain the dividend for sometime. If the payout ratio continues to increase, the situation warrants close monitoring as this cannot last forever; if your tolerance for risk is a low, look for similar companies with the same or higher yields, but with lower payout ratios. Individuals searching for other ideas might find this article to be of interest 5 Super Stocks Sporting Stellar Records And Splendid yields

Current Ratio is obtained by dividing the current assets by current liabilities. This ratio allows you to see if the company can pay its current debts without potentially jeopardizing their future earnings. Ideally the company should have a ratio of 1 or higher.

Interest coverage is usually calculated by dividing the earnings before interest and taxes for a period of 1 year by the interest expenses for the same time period. This ratio informs you of a company's ability to make its interest payments on its outstanding debt. Lower interest coverage ratios indicate that there is a larger debt burden on the company and vice versa. For example if a company has an interest ratio of 11.8, this means that it covers interest expenses 11.8 times with operating profits.

Inventory turnover is calculated by dividing sales by inventory. If a company generated $30 million in sales and had an average inventory of $6 million; the inventory turn over would be equal to 5. This value indicates that there are 5 inventory turnovers per year. This means that it takes roughly 2.4 months to sell the inventory. A low inventory turnover is a sign of inefficiency and vice versa.

Asset turnover is calculated by dividing revenues by assets. It measures a firm's effectiveness at using its assets in generating revenue. Higher numbers are generally better and vice versa. In general companies with low profit margins have higher asset turnover rates then companies with high profit margins.

Quick ratio or acid -test is obtained by adding cash and cash equivalents plus marketable securities and accounts receivable dividing them by current liabilities. It is a measure of a company's ability to use its quick assets (assets that can be sold of immediately at close to book value) to pay off its current liabilities immediately. A company with a quick ratio of less than 1 cannot pay back its current liabilities. Additional key metrics are addressed in this article 5 Interesting Communication Plays

Statoil ASA (NYSE: STO is our play of choice for the following reasons

It has a massive levered free cash flow of $11.6 billion

A very strong quarterly earnings growth rate of 167%

A very low payout ratio of 23%

A magnificent interest coverage ratio of 65.1

A decent quick and current ratio of 1.0 and 1.2 respectively

A good 3 year total return of 67%

A good ROE of 30%

It is focusing on the unexplored areas of the Norwegian Sea and is seeking to recover 4.2 million barrels of oil or oil equivalents over the next few years. Management wants to its oil recovery rate to hit 50% by 2020.

It has set a goal of achieving an equity production rate in excess of 2.6 million barrels of oil or oil equivalents by 2020. This growth is expected to come from new projects (2014-2016) and this should produce a CAGR of above 2% during this time period.

100K invested in STO for 10 years would have grown into a whopping 544K

Black Hills Corporation (NYSE: BKH

Industry : Electric Utilities

Levered Free Cash Flow: -266.87M

Net income for the past three years

2008 = $105.08 million

2009 = $81.56 million

2010 = $68.69 million

2011= it stands at $24 million as 9/31/2012

Total cash flow from operating activities

2008 = $145.65 million

2009 = $270.51 million

2010 = $147.76 million

2011= It stands at $207 and could come in as high as $232 million

Key Ratios

P/E Ratio = 27.3

P/E High - Last 5 Yrs = 28.1

P/E Low - Last 5 Yrs = 6.9

Price to Sales = 1.05

Price to Book = 1.23

Price to Tangible Book = 1.83

Price to Cash Flow = 6.9

Price to Free Cash Flow = -4.4

Quick Ratio = 0.4

Current Ratio = 0.7

LT Debt to Equity = 1.18

Total Debt to Equity = 1.18

Interest Coverage = 1.7

Inventory Turnover = 9.1

Asset Turnover = 0.3

ROE = 5.32%

Return on Assets = 3.09%

200 day moving average = 2.35M

Current Ratio = 0.75

Total debt = 1.77B

Book value = 27.57

Qtrly Earnings Growth = N/A

Dividend yield 5 year average = 5%

Dividend rate = $ 1.48

Payout ratio = 118%

Dividend growth rate 3 year avg = 1.4%

Dividend growth rate 5 year avg = 1.91%

Consecutive dividend increases = 40 years

Paying dividends since = 1942

Total return last 3 years = 78%

Total return last 5 years = 8.21%

Notes

The pay out ratio is a bit high however it is cash flow is more than enough to cover the dividend payments. It is a dividend champion as it has a stellar record of consecutively increasing dividend payments for 40 years.

Statoil ASA

Industry : Refining & Marketing

Levered Free Cash Flow: 11.61B

Net income for the past three years

2008 = $6.16 billion

2009 = $3.07 billion

2010 = $6.48 billion

Total cash flow from operating activities

2008 = $14.59 billion

2009 = $12.64 billion

2010 = $13.91 billion

Key Ratios

P/E Ratio = 6.6

P/E High - Last 5 Yrs = 26.4

P/E Low - Last 5 Yrs = 4.8

Price to Sales = 0.77

Price to Book = 2

Price to Tangible Book = 2.54

Price to Cash Flow = 4.7

Price to Free Cash Flow = -55.3

Quick Ratio = 1

Current Ratio = 1.2

LT Debt to Equity = 0.4

Total Debt to Equity = 0.47

Interest Coverage = 61.5

Inventory Turnover = 12.2

Asset Turnover = 0.8

ROE = 30.67%

Return on Assets = 16.58%

200 day moving average = 24.36

Current Ratio = 1.16

Total debt = 22.91B

Book value = 15.28

Qtrly Earnings Growth = 167.4%

Dividend yield 5 year average = 3.7%

Dividend rate = $ 1.15

Payout ratio = 23%

Dividend growth rate 3 year avg = -8.47%

Dividend growth rate 5 year avg = -4.62%

Consecutive dividend increases = 1 years

Paying dividends since = 2002

Total return last 3 years = 67.96%

Total return last 5 years = 27.9%

Total S.A. (NYSE: TOT

Industry: Production & Extraction

Levered Free Cash Flow: 5.16B

Net income for the past three years

2008 = $15.45 billion

2009 = $261 million

2010 = $317 million

Total cash flow from operating activities

2008 = $26.32 billion

2009 = $17.74 billion

2010 = $24.81 billion

Key Ratios

P/E Ratio = 7.6

P/E High - Last 5 Yrs = 13.9

P/E Low - Last 5 Yrs = 5.7

Price to Sales = 0.56

Price to Book = 1.37

Price to Tangible Book = 1.63

Price to Cash Flow = 4.7

Price to Free Cash Flow = -22.7

Quick Ratio = 0.9

Current Ratio = 1.4

LT Debt to Equity = 0.34

Total Debt to Equity = 0.5

Interest Coverage = 32.6

Inventory Turnover = 5.6

Asset Turnover = 0.9

ROE = 19.26%

Return on Assets = 10.22%

200 day moving average = 49.53

Current Ratio = 1.36

Total debt = 42.32B

Book value = 39.63

Qtrly Earnings Growth = 12.8%

Dividend yield 5 year average = 5.3%

Dividend rate = $ 4.15

Payout ratio = 37%

Dividend growth rate 3 year avg = 0.43%

Dividend growth rate 5 year avg = 9.03%

Consecutive dividend increases = 0 years

Paying dividends since = 1992

Total return last 3 years = 18.65%

Total return last 5 years = -2.13%

Notes

It has a good 5 year dividend growth rate of 9%, a very good interest coverage ratio of 36 and a decent current ratio of 1.4.

TravelCenters of America LLC (AMEX: TA

Industry: Retail - Automotive

Levered Free Cash Flow: -243.85M

Net income for the past three years

2008 = $-40.21 million

2009 = $-89.88 million

2010 = $-65.58 million

2011= It stands at $25 million and could come in as high as $46 million

Total cash flow from operating activities

2008 = $79.46 million

2009 = $52.71 million

2010 = $28.31 million

2011= It stands at $13 million and could top $33 million

Key Ratios

P/E Ratio = N.A.

P/E High - Last 5 Yrs = N.A.

P/E Low - Last 5 Yrs = N.A.

Price to Sales = 0.02

Price to Book = 0.46

Price to Tangible Book = 0.49

Price to Cash Flow = 3.5

Price to Free Cash Flow = -1.7

Quick Ratio = 1

Current Ratio = 1.7

LT Debt to Equity = 1.1

Total Debt to Equity = 1.1

Interest Coverage = 0.8

Inventory Turnover = 45.7

Asset Turnover = 7.7

ROE = -1.44%

Return on Assets = 0.63%

200 day moving average = 4.47

Current Ratio = 1.72

Total debt = 97.15M

Book value = 11.81

Qtrly Earnings Growth = 362.6%

Dividend yield 5 year average = 0%

Dividend rate = $ 0.00

Payout ratio = 0%

Dividend growth rate 3 year avg = 0%

Dividend growth rate 5 year avg =

Consecutive dividend increases = 0 years

Paying dividends since = None

Total return last 3 years = 183.68%

Total return last 5 years = -86.54%

Notes

This stock does not pay dividends. It was included on this list because it sports a very strong quarterly earnings growth rate of 362% and has a total 3 year return of 183%, a strong healthy inventory turnover rate of 47, and a decent quick and current ratio.

Vectren Corp (NYSE: VVC

Industry : Electric Utilities

Levered Free Cash Flow: -21.98M

Net income for the past three years

2008 = $129 million

2009 = $133.1 million

2010 = $133.7 million

2011= It stands at $95 million and could come in as high as $135 million

Total cash flow from operating activities

2008 = $423.2 million

2009 = $449.6 million

2010 = $384.8 million

2011= It stands at $291 million and could come in as high as $340 million

Key Ratios

P/E Ratio = 16.8

P/E High - Last 5 Yrs = 20.5

P/E Low - Last 5 Yrs = 11

Price to Sales = 1.04

Price to Book = 1.62

Price to Tangible Book = 1.97

Price to Cash Flow = 6.2

Price to Free Cash Flow = -16.6

Quick Ratio = 0.4

Current Ratio = 0.9

LT Debt to Equity = 1.09

Total Debt to Equity = 1.33

Interest Coverage = 3.1

Inventory Turnover = 8.2

Asset Turnover = 0.5

ROE = 9.81%

Return on Assets = 4.63%

200 day moving average = 28.02

Current Ratio = 0.89

Total debt = 1.94B

Book value = 17.75

Qtrly Earnings Growth = 115.2%

Dividend yield 5 year average = 5.2%

Dividend rate = $ 1.40

Payout ratio = 81%

Dividend growth rate 3 year avg = 1.74%

Dividend growth rate 5 year avg = 2.36%

Consecutive dividend increases = 36 years

Paying dividends since = 1946

Total return last 3 years = 33.47%

Total return last 5 years = 24.45%

Notes

It has a strong quarterly earnings growth rate of 115%, a manageable payout ratio of 81%, and stellar history of consecutively increasing its dividend. It sports an average interest ratio of 3.1.

EPS charts were sourced from zacks.com and dividend history charts were sourced from dividata.com

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This list of stocks is meant to serve as a starting point. Please do not treat this as a buying list. It is imperative that you do your due diligence and then determine if any of the above plays meet with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.