Apr 9, 2010

Choosing Quality Stocks - Step 1

In choosing good stocks to buy, begin with the end in mind.

I buy only those companies with stellar returns, a good history of consistent growth and earnings, strong but humble management, with an identifiable competitive advantage, at a good price.

Most folks recommend you start with products or companies you enjoy or ones you're familiar with.  Ones that have a special "meaning" to you.

Not a good idea.

Investing is for the mind, not the heart.  If you want to build a business, your heart better be in it.  If you're buying any type of investment however, your heart better be out of it, and your mind fully in it.

Plus, this "investing with your heart" mentality typically leads to a lot of dead-end roads.  Either because the products we like are owned by a conglomerate that owns a lot of other less-than-stellar companies or products, or because the company is overpriced due to its popularity in the marketplace, or the most common of all: the numbers indicate that while the products or services may be great, the company’s performance as a whole is anything but great.

Why not start with great performance and work our way backwards?

I use stockscreeners to weed out the potentially good from the potentially bad.  Perhaps the easiest one to use, when it works (sometimes it doesn’t), is google’s stock screener.  Another one I enjoy using is finviz.com.  These are both free tools anyone can use to get a preliminary list of good companies based upon predefined criteria.

The criteria I like to use for growth is the simple 15-rule:

10-year EPS growth of 15% min
10-year revenue growth rate of 15% min
5-year EPS growth rate of 15% min
5-year revenue growth rate of 15% min
5-year Net Income growth rate of 15% min

(note: you may want to leave off the 10-years as a criteria, as this weeds out more than half of the 3500-plus companies that google’s screener features, presumably because they don’t have a 10-year history just yet.)

For the operating metrics, we want:

ROI (TTM) of 15 min
ROI (5 yr) of 15 min
Return on Equity (TTM) of 15 min
Return on Equity (5 yr) of 15 min

As a general rule, I’m not going to be investing in any company priced 15 times or more its earnings, no matter how great the returns – call me old fashion, but I like to buy things when they’re priced at a discount - so I set the P/E ratio to 15 MAXIMUM.

Now the stocks we get as a result of this screen will be different for you, depending upon the day you run this search.  But for today, we get the following 8 stocks.  (If I take out the two 10-year rules as part of my search criteria, I get 32 stocks instead of the 8 listed here.)

ITT Educational Services, Inc.  ESI
Satyam Computer Services Limited(ADR)  SAY
VSE Corporation  VSEC
Garmin Ltd.  GRMN
Jinpan International Limited  JST
Noble Corporation  NE
China Mobile Ltd. (ADR)  CHL
Enstar Group Ltd.  ESGR

This gives us a menu of potentially good companies, for potentially low prices.  I say potentially because this is just step 1 of the research.  We have to dive quite a bit deeper to find out which companies are truly solid and good buys.

We’ll come to that in an upcoming post.

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