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INVESTING


Stock Analysis And Investing For The Small Investor

08/21/06 02:43:57 PM PST
by Daniel Subach

Here's some advice and wisdom for small investors seeking to invest in the stock market for the first time.

Many people spend a great deal of time earning money, but very little time figuring out how to manage their finances. It takes time to manage a securities portfolio and to analyze investments, and most people are too busy with making a living to attend properly to their investments. But in that case, how can investors make a good investment in the stock market? This is a good question, as it is unwise to buy securities and then forget about them. But that is exactly what the small investor is asking: How do I invest in the stock market to grow my funds and not have to attend to details? Small investors generally deal with $25,000 to $50,000, and have minimal funds for discretionary investment.

Since economic conditions, technology, consumer sentiment, politics, and governments change, an investor must review his or her investment portfolio periodically. The process of analyzing and selecting investments takes time and requires some knowledge about investing. Since the effort takes time and know-how, some investors elect to retain professional investment advisors. This is not an option for the small investor, seeking to maximize return with minimal cost.

MINIMUM EFFORT, MAXIMUM RETURN
What factors can small investors who desire to make investments and manage their portfolios personally focus on to minimize time and effort and maximize investment return over a one- to two-year investment time frame? I have been investing for more than 20 years, and a few select factors, it is clear to me, may be utilized as a minimal set of conditions for selecting investments. These factors may include, but are not limited to, beta, diversification, and dividends. Understanding complexities such as volatility, trend, structure of averages in the stock market, and so on, is more appropriate to high-level, advanced trading. Formula plans based on such factors as price/earnings ratios,and other statistics can yield decisions such as selling or buying under specified conditions, such as buying at 10 times earnings and selling at 20. For the small investor, this type of data must be simplified based on the constraints of time allowed for portfolio review and management.

THE FUNDAMENTALS
  • The market capitalization rate (defined as the number of shares outstanding times the stock price) compared to annual revenue is a first consideration. If the value of outstanding shares times price exceeds corporate annual sales, the stock is expensive and should be avoided.
  • Example: 30 million shares outstanding x a price of $13 = $390 million compared to annual revenues of $575 million. The stock is a potential buy.

  • A company's net worth (shareholders' equity) divided by the number of shares is defined as book value. A stock worth buying should sell around book value or about 1.5–1.7 times book value. A higher value incurs too much risk.
  • Example: The recent price of a stock is $20. The book value is 31 or 1.55 x the stock price of $20. The stock is a potential buy.

  • The value of the P/E ratio versus rate of earnings growth should be determined. If the P/E is not more than a third to half of the projected five-year earnings growth rate, the stock can be considered safe. You should not pay more than 20–25 times earnings for a stock. This is a difficult scenario in an overvalued stock market and requires diligence in finding the right company's stock. In today's market, it may be necessary to go to 30, but not over, for a small investor.
  • Example: EPS is 1.55 in the year 2005. The EPS in 2000 is 1.14. (1.55 - 1.14)/1.14 = 0.36 or 36%. The P/E of the stock is 12, a third of the EPS growth, and the stock looks promising.

    Other considerations might include the following:

  • P/E ratios should be less than or equal to the average highs over the last three years.
  • The stock price should be less than or equal to three-quarters of book value per share.
  • The ratio of current assets to current liabilities should be greater than or equal to 2.0.
  • The ratio of total debt to stockholders equity should be less than or equal to 1.0.
  • The EPS growth should be 10% of compound annual growth for the last 10 years.
  • Some industry groups have run into subtle issues, the first example of which was the steel industry in the late 1970s, and now the automotive companies. The impact of pension costs has a significant impact on stock performance. While certain automotive companies are recommended, such investments would be out of the question for a small investor due to unusually high pension costs that will affect company performance overall.

  • A last consideration that might be employed is to ascertain the value of the firm using the Gordon model (VB) defined as:
  • VB = (Next year's dividend)/((required rate of return) - (estimated long-run dividend growth))

    VB should be approximately equal to EPS.

  • Always look for a company stock that pays a dividend.
  • Diversification is inherent in this model, as the industry is not analyzed directly. Only the data for a selected company in an industry group is analyzed. Obviously, you would not build an investment portfolio with stock selected from only one industry.


  • A HYPOTHETICAL SCENARIO
    As an example, say you have selected a stock with a recent price of 13, a P/E of 11.5, and a dividend yield of 0.9%. The market capitalization is $360 million and the revenue is $3.2 billion. The book value is 21.5 and the recent price is 13. The P/E ratio vs. rate of earnings growth is 38%, close to our specification of a third of the P/E.

    The stock does pay a dividend. You will find there is no merger or acquisitions that would add an element of risk. Pension costs are not prohibitive. You decide to purchase 200 shares of the stock through an Internet low-cost broker. Since there is little additional time, you ascertain that the current assets/current liabilities are less than 2.0; the ratio of debt to stockholders equity is less than 1.0; and the stock price of 13 is less than three-quarters of the book value per share of 22.

    The small investor's portfolio will not include Treasury bills, government bonds, or no-load investments. The typical small-investor portfolio might include the following composition:

     
  • High-yield utility stocks 20%
  • Corporate bonds 20%
  • Non-utility high-yield stocks 10%
  • Stocks 40%
  • Money market instruments 10%
  • The investment strategy is to drive growth with a small investment outlay. Select the high-yield stocks for dividend return. If a drop in price occurs that is 1.5 times the annual dividend return, consider selling the stock. Some high-yield stocks may have cyclic variations, particularly in oil, gas, petroleum, and foreign stocks in telephone, communications, and energy, but they may still be valuable investments.

    Utilize the money market instrument for investment in stocks. You should consider selling stocks that rise above 10–15% of the original price to take profit and reinvest. Set your stock alerts at the 10–15% level so you get a timely notification on your computer. Review the stock and ascertain the investment trendline. Does this stock appear to be rising or leveling out? If the stock is rising, sell a portion of the shares. Sell the residual in the next few days as the stock rises. If the stock appears to be leveling out and the price decreasing, compare the price chart over the last year to determine the actual trend. If it appears that you will begin losing what you have gained, sell the stock and look for another investment, following the same procedure. This model has validity for investments from $25,000 to $100,000, although we have used it at the $200,000 level successfully.

    DYNAMIC AND PROFITABLE
    As you begin to build the total value of your investment, remember that investing is dynamic, and different levels of investment call for different strategies and models, including highly sophisticated mathematical modeling such as the Klinger oscillator (KVO) for determining whether a stock is under accumulation or in distribution. As your experience in investing develops, models like the KVO can help you in your decisions concerning trendline actions. As the KVO reaches an extreme reading above or below the center line and reverses direction, an impending reversal in price is quite likely.

    The approach outlined provides a convenient, rapid, and analytical model that has demonstrated success over a period of 20 years and may be useful to help the small investor judiciously invest precious funds with minimal time and effort.

    SUGGESTED READING
    Klinger, Stephen J. [1997]. "Identifying Trends With Volume Analysis," Technical Analysis of STOCKS & COMMODITIES, Volume 15: December.



    Daniel Subach

    Daniel Subach has a master's degree in physics, a doctorate in chemistry, and an MBA in marketing and strategic planning. He is CEO of Proteome Diagnostics and president of InPro Technologies. He provides stock analyses, strategic planning marketing research, and business development services for asset investment, private equity, and securities evaluation for individuals and corporations. His primary research interests are in the areas of risk minimization and oscillating models to describe stock performance and as predictors of future stock performance. Contact him at db17976@att.net.

    E-mail address: db17976@att.net


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