Avoid Falling For These 'Tricks' When Investing In A Stock

by: Elite Wealth Management

Winning stocks are easy to spot in hindsight. Large earnings increases, strong growth, high margins, low debt, and other positive qualities are all found in these types of companies. It's no surprise why Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are successful and investors are constantly looking for new up-and-coming stocks that might emulate their path.

The stock market is a dynamic, cacophonous environment that can drown out remarkable companies in its background noise. Investors face the daunting task of sifting through the thousands of publicly listed companies to find what they think will be winning investments. Using a stock screener can greatly improve your chances of finding what you’re looking for, but appearances can be deceiving.

Some of the most popular screens to run include stocks with share buybacks, recent or upcoming stock splits, and high dividend yields. There's a wealth of research to support the belief that a stock with these conditions met, will generally outperform the market. However, this doesn't always hold true in practice.

Most investors have owned a stock that met these criteria only to watch its price fall and report disappointing numbers quarter-after-quarter. Was the problem the criteria itself, or was it something else entirely?

The Pitfalls Of Stock Analysis

For the majority of publicly listed companies, growth is synonymous with prosperity. To take it a step further, it's also essential for its survival. Stagnation means losing investors and declining stock prices – death knells for any company.

To that end, it's imperative that quarterly earnings statements fall in line or even exceed Wall Street's expectations. However, if a company can't deliver through internal growth, there are ways of meeting forecasts that don't necessarily imply that a company is performing well.

Using Buybacks As A Booster

A share repurchase program is when a company buys back its own stock through the open market. It's seen as a signal that a company believes its stock is undervalued and is often associated with a stock price rise when announced.

Sometimes though, a buyback plan can be implemented for a less laudable rationale.

Repurchasing stock on the open market reduces the number of outstanding shares available, which is an essential part of how earnings per share (EPS) is calculated.

Let's take a look at how this is done.

If a company reports earnings of $250 million and has 10 million shares outstanding, then its EPS is $25. If the number of shares is reduced through a stock buyback to 9 million, that changes the EPS to $27.78. An increase in earnings has been realized although no real growth has actually happened.

This action affects the price-to-earnings (P/E) ratio as well. Continuing from our previous example, let's assume that the stock's price was $500 a share before the buyback. That would give us a P/E ratio of 20. After the shares are repurchased and EPS increases to $27.78, our P/E would decrease to 18. A lower P/E makes the stock look cheaper and attracts investors, which causes the stock price to go up.

Buybacks And Market Activity This Year

The stock market has been surging forward relentlessly this year despite somewhat muted earnings releases. Signs of slowdowns in Europe and China have done little to derail the market’s momentum and part of that reason can be attributed to share repurchases.

For the first half of 2014, companies have bought back $338.3 billion in stock with 740 companies that have authorized buyback programs. These numbers are the highest seen in six years and have done a good job of buoying prices.

Here's a list of the top 5 companies that have bought back stock:

  1. Apple (AAPL) - $32.9 billion
  2. IBM (NYSE:IBM) - $19.5 billion
  3. Exxon Mobile (NYSE:XOM) - $13.2 billion
  4. Pfizer (NYSE:PFE) - $10.9 billion
  5. Oracle (NYSE:ORCL) - $9.8 billion

According to a report from Barclays, companies with the largest buybacks this year have outperformed the market by 20% since 2008. It also showed that during the 2nd quarter, companies spent 31% of their cash flow on share repurchases reducing cash holdings and driving stock prices up.

In the face of slowing growth, the buybacks may not be a sign of strength, but rather a lack of opportunities elsewhere. Instead of reinvesting into the company or making capital investments elsewhere, management chooses to reduce the number of outstanding shares to inflate earnings and keep the bull market alive.

Cheap Is Relative

Lower priced stocks often appear more attractive than higher priced ones. At first glance, owning 1,000 shares of a $10 stock seems like a better deal than owning 10 shares of a $1,000 stock. Ultimately though, you've invested the exact same amount of money; the underlying stock price is irrelevant.

Taking advantage of investor psychology, a company may decide to do a stock split. Usually a company does this when its stock price has risen far above its competitors and could discourage new investors from buying the stock.

Like a share buyback, a stock split changes the number of outstanding shares. However, the intention with this activity is to lower the stock price to make it seem more affordable. For example, a stock may announce a 2-for-1 stock split. This will double the number of outstanding shares available, while cutting the price of each share in half.

The sudden reduction in price attracts investors who would have otherwise thought it to be too expensive. The new demand lifts the stock’s price even though nothing tangible has changed.

Stock splits may be a cosmetic treatment, but research shows some convincing evidence that companies that engage in it outperform the general market. A research report from the University of Illinois measured the performance of companies whose stock had split and compared them to companies whose stock had not split from 1990 to 1997. It revealed that the portfolio of stocks that split outperformed the market by 8% after one year and 12% over three years.

Misleading Dividends

A stock that offers a dividend yield is an attractive investment. Over a long period of time, you can reap the benefits of both capital appreciation and also income growth. Finding dividend paying stocks is relatively easy with even the most basic stock screener allowing for this type of search.

Calculating the dividend yield is simple. It's the annual dividend per share divided by the stock price. So if a company issued annualized dividends of $2 per share and the stock price was $100, the dividend yield would be 2%. Don't be fooled by the stocks with unusually high dividend yields though. They may look tempting, but there's a good reason those companies don't fall within the curve.

Just looking at the dividend yield as your main criteria can lead to trouble simply because the lower a stock price goes, the higher the yield appears. Taking from our example above, if that stock were to fall into disfavor and drop to $25, the dividend yield would jump up to a whopping 8%. It might seem appealing, but a stock that's in free-fall could continue to sink lower rendering the higher yield useless.

Cash flow is essential for a company to pay a dividend. Look for large amounts of debt or shrinking free cash flows. If funds are tight, how can the company continue to pay out a large dividend?

The payout ratio is a good measure of how a company is managing its dividend expense. This is calculated as the dividends per share divided by earnings per share. A company that pays dividends per share of $0.50 and has EPS of $2 has a payout ratio of 25%. As a general rule, the lower the ratio, the more sustainable the dividend is to maintain.

Consider a company that had earnings of $2 per share but paid a dividend of $2.50 per share. The payout ratio would be 125% – an unsustainable figure. The company would need to increase cash flow or cut its dividend in order to balance itself out.

Avoid Getting Burned

In all three cases – share buybacks, stock splits, and high dividends – there are benefits as well as disadvantages. Not all companies engage in these activities as a way of manipulating their stock price or earnings, most do it as a way of giving shareholders value.

While some companies may use “tricks” to boost demand in their stock, you can determine whether it's for value or manipulation by digging a little deeper.

Share repurchase programs can be a great benefit for investors but take a look at what opportunities the company has. A small, fast-growing company may have a buyback program in place, but it should be small. A large program would be unwise given that it should be spending time and resources on investments and acquisitions to keep growing. A large buyback should be an alarm that the company doesn't see many opportunities available.

On the other hand, larger companies can afford larger buybacks. If they have an established presence in their industry, they may simply want to return value in a form other than a dividend which is usually expected to continue perpetually.

Stock splits are generally benign as management simply wants to make the stock more amenable to a wider audience. A good rule of thumb here is to look at the company's historical stock price. If you see that it has risen in price over its competitors, then they probably want to bring the price back down to the sector’s average. You need to watch out for companies that haven't really appreciated that much and suddenly announce a stock split. That could be management's way of garnering new interest in a stock that hasn't been performing well.

While paying a dividend can hardly be considered a trick, unusually high yields should prompt you to do a little more research. Some sectors like utilities and MLP's (Master Limited Partnerships) naturally have higher yields, while tech companies rarely offer them.

Avoid stocks with high payout ratios as it could represent an unsustainable yield. A better way of finding solid dividend paying companies is by looking for companies with a history of solid dividend increases. If you see that a company has increased its dividend on a regular basis, chances are it will continue to do so into the future.

Don't get “tricked” into buying a stock that you shouldn't. Use due diligence when researching a stock and always look at why a company is engaging in an action instead of focusing on the action itself. Often times, that one distinction can be the difference between picking a winner and suffering with a loser.

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.