One of the more interesting things to consider when you hear someone spouting off a hot stock pick(s) is how he or she arrived at their conclusion. Everyone has had a company that they thought was going to be great, but not everyone has a sound rational as to how they arrived at their conviction.
What is even more important for investors to consider is how they determine whether a stock pick they hear about is worth following. How do you filter information to determine what’s worthwhile and what’s not? It’s not an easy question to answer. The variety of companies that are public make it impossible to have a single principle to accurately guide you in determining what company is worthy of your money. Different companies of different sizes in different industries at different stages of their lifecycle do not make for a one size fits all solution.
Here are a few areas that I look at when I’m told of certain types of stocks that might be good investments.
I receive a free newsletter every week by some investor that likes to invest in small companies. Some of the companies are very small. The vast majority of these companies are small start-ups and are going to look horrible on paper because they’re probably in debt up to their ears and have little or no income. Knowing this, I don’t look at their financials.
The first thing I look at is their chart. My main concern is the stock’s volume. If I see that the volume is so low that on an average day only a few thousand dollars worth of shares are traded, I’m not going to consider the company as a potential investment. Getting locked into an investment or having to buy/sell at a significant difference compared to the quoted price isn’t for me. One of the major draws of investing in stocks is the ability to move with relative is in and out as I need to.
A stock that has a significant dividend payment will be considered in light of its payout ratio, how consistent its payouts are and the dividend’s growth rate over 5 or more years. If things are looking bad based on these 3 factors, I probably will stop my research.
A company experiencing significant growth will likely lead me to first consider their operating cash flow (OCF). I’d say free cash flow (FCF), but companies growing fast often make significant capital investments that can throw free cash flow negative. OCF, as the name implies is the cash from the company’s operations…in other words, what does the company bring in from running its business. The major question is whether or not OCF is growing. If the company brags about earnings, but shows a sluggish or deteriorating OCF, then the company is probably not worth the time.
Lots of companies have good stories behind them. When a company has a good story and good quantifiable performance, then you have a dangerously good combination.
What do you use as a smell test for the stocks you consider investing in? Feel free to share. We can gain from each others grains of wisdom.