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Written and copyright © 2009-2010 by Thomas N. Bulkowski. All rights reserved.
One of the questions I am often asked is how do I select stocks when building a portfolio? The FAQ provides one answer, but this article discusses
how you can use fundamental analysis and value investing to improve your chances of success.
How to Pick Stocks Using Fundamental Analysis
When selecting stocks to build a portfolio, if you pick stocks with good fundamentals (the so called "value" investing approach), you give yourself a built-in edge because they tend to outperform stocks with poor fundamentals.
But what fundamentals lead to the best performance?
On the Fundamentals page, I provide answers using numbers from Value Line
(often available for free at large libraries). Here is a sample of what I found.
Price to book value.
Book value is what a company is worth. Many games can be played with book value by either inflating the value of assets or undervaluing them. Peter Lynch recounts a tale in
his book,
 
One Up on Wall Street by John Rothchild, that Warren Buffet had hoped to get $866,000 for the book value of machinery from a textile plant they were closing down.
They bought the machines for $5,000 a few years earlier but received only $26 each. The $866,000 book value turned into $163,000.
Price to book value can tell you whether or not you are overpaying for a stock. A low ratio is good. Testing reveals that stocks with a low price to book ratio
tend to outperform those with a high ratio 78% of the time.
Price to cash flow.
Analysts love cash flow, especially free cash flow. Free cash flow is what remains after removing capital spending (reinvesting in the company to build plants and buy equipment).
I found that stocks with a low price to cash flow outperformed those with a high ratio 78% of the time. A low ratio means the cash flow is high relative
to a stock’s price.
Price to earnings.
Many know what the p/e ratio means: it is price divided by earnings. The lower the ratio, the better. A low p/e means earnings are high compared to
the price of the stock. A low
p/e is especially good if it is half the growth rate of the company, and bad if it is twice the growth rate, according to Lynch. As in many of the ratios, you will want to compare the p/e for
a company against the ratios of other companies in the same industry. That will tell you at a quick glance which companies are over, under or fairly valued. My
testing showed that companies with a low p/e ratio outperformed those with a high one 71% of the time.
Price to sales.
You may not have heard of the price to sales ratio. I remember reading Forbes magazine in the late 70s when price to sales was in vogue, how values below 1.0 meant a good value.
Testing shows that they were right, and companies with a low price to sales ratio outperform those with a high one 71% of the time.
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No dividends.
I found that stocks without a dividend outperformed those with dividends 80% of the time. Having said that, a significant portion of my portfolio is
in utility or other stocks that pay a hefty dividend.
Stocks that keep their cash instead of paying a dividend reinvest the money in the company. That reinvestment often leads to a higher
stock price when the value of the company rises.
For people that enjoy current income, a dividend paying stock sure beats what you can earn at a bank, especially since the government
cut interest rates.
The Vanguard Prime money market fund, for example, currently yields 0.46% (as of July 16, 2009). Some of my utility stocks pay 8%. Of course, the utility stocks can and have cut their
dividends, with the stock price dropping 38% (see AEE which dropped from 32 to 20 in one month starting in Feb 2009) to 50% or more.
I show a chart of Great Plains Energy, GXP,
which dropped from 20 to 10, also in February, on news of a dividend cut. February was a popular month for utility stocks to pull the rug out from under investors.
Imagine if I told you about a company with a safe dividend that yielded 8%. Would you be interested in owning it? I have purchased stocks this past year for just that reason.
Thus, a stock paying a high dividend offers downside protection. If the stock drops too far, the yield will go up and that is attractive to people hunting for income. Just
be sure that the dividend is safe. That means the company is earning more than they are paying out as dividends and the prospect of their business growing (higher profits) is good.
If income is not important to you as capital gains, then buy stocks with little or no dividend for the best chance of capital appreciation.
If you hunt for companies with fundamental values as described in this article and then use technical analysis to time your entry and exit, you can make a lot of money.
Buying a value play gives you an extra cushion as you trade the stock. Good luck!
-- Thomas Bulkowski
Written and copyright © 2009-2010 by Thomas N. Bulkowski. All rights reserved. A mathematician is a machine for converting coffee into theorems.
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