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Stock Selection

By Author: Brooks Richmond
Total Articles: 99

This is dedicated to those of you who want to invest in individual stocks. I would like to share with you the methods I have used over the years to select stocks that I have found to be consistently profitable in actual trading. I like to use a combination of fundamental and technical analysis for selecting stocks. My experience has shown that successful stock selection involves two steps:

1. Select a stock using the fundamental analysis presented then
2. Confirm that the stock is an uptrend as indicated by the 50-Day Exponential Moving Average Line (EMA) being above the 100-Day EMA

This two-step process increases the odds that the stock you select will be profitable. It also provides a signal to sell a stock that has not performed as expected if it’s 50-Day EMA drops below its 100-Day EMA. It is also a useful method for selecting stocks for covered call writing, a different type of strategy.

Fundamental Analysis

Fundamental analysis is the study of financial data such as earnings, dividends and cash flow, which influence the pricing of securities. I use fundamental analysis to help select securities for future price appreciation. Over the years I have used many methods for measuring a company’s growth rate in an attempt to predict its stock’s future price performance. I have used methods such as earnings growth and return on equity. I have found that these methods are not always reliable or predictive.

Earning Growth
For example, corporate net profits are subject to vague bookkeeping practices such as depreciation, cash flow, inventory adjustment and reserves. These are all subject to interpretation by accountants. Today more than ever, corporations are under increasing pressure to beat analyst’s earnings estimates which leads to more aggressive accounting interpretations. Some corporations take special “one time” write-offs on their balance sheet for such things as failed mergers or acquisitions, restructuring, unprofitable divisions, failed product development, etc. Many times these write-offs are not reflected as a drag on earnings growth but instead show up as a footnote on a financial report. These “one time” write-offs occur with more frequency than you might expect. Many companies that make up the Dow Jones Industrial Average have taken such write-offs.

Return on Equity
Another popular indicator, which I have found is not necessarily predictive of stock price appreciation, is return on equity (ROE). Conventional wisdom correlates a high return on equity with successful corporate management that is maximizing shareholder value (the higher the ROE the better).

Which company is more successful?
Coca-Cola (KO) with a Return on Equity of 46% or
Merrill Lynch (MER) with a Return on Equity of 18%

The answer is Merrill Lynch by any measure. But Coca-Cola has a much higher ROE. How is this possible?

Return on equity is calculated by dividing a company’s net income by stockholder’s equity. Coca-Cola is so over valued that its stockholder’s equity is only equal to about 5% of the total market value of the company. The stockholder equity is so small that almost any amount of net income will produce a favorable ROE.

Merrill Lynch on the other hand, has stockholder’s equity equal to 42% of the market value of the company and needs a much higher net income figure to produce a comparable ROE. My point is that ROE does not compare apples to apples so therefore is not a good relative indicator in comparing company performance.

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