Friday, July 20, 2007

Evaluating stocks to buy

In the past few months I've been making two kinds of purchases: very long-term, and mid-term. As such, I've got two ways to evaluate which stocks to buy.

Very long-term

For very long-term buys, like the kind that I honestly don't plan on selling for 40 years or more (if ever), the first thing to decide is what industry to invest in. This depends mostly on what I think is going to happen in the world over the next 20 years or so. Here are a few of my speculations (some of which are pretty obvious):

  • BRIC (Brazil, Russia, India, China) is going to grow. A lot. And a lot of it is going to be growth in infrastructure, simply because they are relatively undeveloped.

  • The dollar is going to start recovering.

  • Chinese stocks are going to fall significantly sometime in the next few years, at which point they will make great investments.

Those are the three I feel pretty sure about. The first one has made me interested in infrastructure companies like GE and ABB. Before I graduated, I had an internship at ABB and was struck by an anecdote told by the vice president of R&D during a meeting. He said they weren't doing too well in India because their equipment was too expensive and complicated. The Chinese, on the other hand, absolutely loved how complex it was and bought it like crazy. I can totally picture that.

Anyway, the second point makes me kind of sad. I want to invest in overseas companies (like ABB) but if the dollar begins recovering, that will eat into my returns. So I want to focus mostly on American companies that do no more than half of their business overseas.

The third point has an obvious strategy -- wait until Chinese stocks fall (if they ever do) and then buy the nice ones.

Aside from those strategies, I currently am a big subscriber to the dividend growth theory: Companies that have a history of paying dividends and consistently increasing those dividends make great long term investments. This is a pretty well-researched area and I feel pretty confident in it. One source of ideas for such companies is Standard & Poor's "Dividend Aristocrat" list. Or you can just think of big companies that have been around for 100+ years and you'll pretty much be right on track.

Only when I've narrowed down my list to a few companies (that match the criteria above) do I start looking at the financial details. The first thing to look at, of course, is the stock chart. You can get a quick overview of how the market has "liked" the company over the past 5 to 10 years. Sudden drops or spikes always require investigation, but the best thing (to me) is a relatively flat graph. To me, a successful company whose stock price isn't going up is like a spring gathering potential energy. Eventually, it will make up those flat years with strong growth years.

The metric associated with this, of course, is the P/E ratio. If earnings have been growing and the price has stayed flat, the P/E ratio will decrease. Companies with P/E ratios below that of their peers, and below their own historical P/E ratio average, are definitely something to look into.

While normally I agree that timing the market is very difficult, I think this strategy is pretty realistic. Since there are so many good companies to invest in, the chances of a few of them being in one of these lull states is fairly good. I think of it as an opportunity to time-travel back a few years and invest. If a company is trading in the same range it was 5 years ago, investing today is equivalent to investing back then.

This option is primarily for new investors, like me, because half the risk of market timing is selling too early. In other words, if you start thinking "Oh GE isn't going to move for the next 5 years, I better sell" then you have a good chance of missing out. Only a new investor can look at the chart and say "Heh I'm glad my money hasn't been sitting idle for 5 years." But since investors typically add new money into their positions periodically, you can still look out for the same things. It's just not as comprehensive since this plan doesn't speak to your existing investments.


The other evaluation method is for mid-term investments. These, to me, are investments that you want to hold for an unknown amount of time, but typically less than a year. I see them more as price goal investments. The main source of these ideas comes from reading about sudden drops in stock prices. Earnings misses, natural disasters, war, anything can cause them. Your job is to do some research and guess at how much of the price drop is legitimate versus investor overreaction. I feel like most sudden drops in otherwise good companies are overreactions and the price will recover in the short term.

For instance, look at Duke Energy. They seem to have been affected by two things in the past few months. First, the recent interest rate hikes, which (I've read) send utility stocks down because of competition with their dividends. Apparently a lot of people invest in utilities for the dividend with the bonus of slow growth, which will probably out-perform bonds. When interest rates go up, people ditch the utilities and go to bonds. Sounds crazy to me but I believe it.

Second, Duke Energy wants to build new plants. Nuclear plants. Investors seem rather terrified of this idea -- whenever news comes out of some environmental group trying to stop them, the stock price goes up a bit. When more news comes out that they were unsuccessful, I think it's fair to say the price plummets a bit. Even Duke Energy's requests for rate hikes don't allay investors fears. I guess it's somewhat sensible for short-term thinkers, given that interest rates may be going up and Duke Energy is going to acquire lots of debt in the next 10 years... but still. Utilities have to expand eventually or what good are they?

I see both of those things as overreactions. I think that when all is said and done, new plants (not just nuclear but natural gas and coal) will give Duke Energy more customers, more revenue, and more profit. Then their price will go up. It's currently hovering around $18, down from $21 earlier in the year. The price drop has pushed up their dividend yield to almost 5%, and I suspect the price will recover as they A) keep raising their dividend and B) get some sweet incentives from the government. Anyway, that's what I hope will happen. :)


GoldnSilver said...

Thanks for sharing, I think I will write a post on this as well. Whatever I want to write will be too long to fit in this comment box.

MissGoldBug said...

Very interesting post. I think about this too as I choose where to put my money for the long haul. Its nice to see someone actually write about what they do in their own portfolios, thanks for sharing.

On an interesting side note-Netflix seems to make an effort in getting movies that you'd like to see. I've noticed that when I put something under the header of "Saved" they usually get them in a reasonable amount of time. Any kind of movies... Even older stuff from the '60s. Intriguing, no?

Best of Luck,