The Investment Methodology of Researching Stocks

By: Steve Rubis

On Saturday, we discussed the current investment climate and what direction the market is going to take going forward. Today the market continued it’s down swing to a tune of 20 points. We believe that investors should stand pat and utilize this downturn as a time to do investment research. Recently, we ran screens on the Oil industry, as well as the Retail Apparel industry. The results of which were quite telling; suggesting that there are numerous deals in these industries. Our results prompted us to conclude that we should provide our readers with an outline of our actual investment process. A major blunder that most investor’s make is not having a plan. Here at Researching Stocks, we utilize different equity valuation methods to create sign posts for our investment positions.

Our goal today is to outline the investment process that we follow at Researching Stocks. The reason is not only to educate our readers and help them to find good investments, but also to codify our efforts and give some organization to our efforts. As Benjamin Graham pointed out, those who purchase stocks often blur the line between investment and speculation – they believe they are investing but actually speculating. Codifying our research methods helps keep us out of the speculation game. At the same time, having a distinct research method serves as a shock absorber when the market begins to soften. In our minds this is the true meaning of diversification; researching a position and knowing enough about it that you are correct in purchasing. Once again, Benjamin Graham summarizes this thinking in the following quote, “Have the Courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ.”

So remember it is not a matter of having x number of stocks, rather diversification is about knowledge. As an investor, you must do the necessary homework in order to develop a strong thesis about a stock. At that point you should be able to develop a simple sketch of where that stock might go. In developing this thesis, you should use both fundamental and technical analysis to accumulate facts which validate your thinking. The following explains some statistics that we use to develop our facts.

Macro Economic Indicators

It must be said that here at Researching Stocks, that we follow a bottom-up approach to investing. Therefore, we look for interesting stocks regardless of the market. At the same time, we believe that there are two strong indicators investors can use to get a sense of where the overall market is and will go. First, one must pay strong attention to the Broker Call Rates. We have written numerous articles on this indicator. It serves as a proxy for how much money is available for speculation. The lower the interest rate the more money is available; when rates go higher less money is available. This is important because there comes a point in every bull market where the gain switch from being investment to speculatively oriented.

Secondly, we place a lot of faith in what seems to be a little used metric called earnings yield. We state that this metric seems little used, because we have noticed very few references to this metric in the plethora of investment books we have read. Earnings yield is very simply EPS (Earnings Per Share) / Price, it is the inverse of P/E. The importance of this metric is that you have now calculated the initial return on your equity investment. Since you have a yield, it can be compared to the yield on Treasury Bonds or any Corporate Bond for that matter. As long as the equity yield is higher than a bond, equity investments are undervalued. Once bonds provide the better deal it is time to re-allocate your funds; currently bonds seem to offer a better yield than stocks.

Microeconomic Indicators

Our stock picking criteria is simple, although time consuming. First, we use the screening tool at Yahoo Finance to generate possible investments. Final selections are based on the following criteria

1.) EBITDA Value also known as Take Out Value
2.) P/E Value: using the EPS (ttm) and multiplying by the industry P/E
3.) P/S Value: using the Sales (ttm) and multiplying by the industry P/S
4.) Intrinsic Value: created by Benjamin Graham, EPS((2*Growth rate)+8.5)*(4.4/10 Yr Treasury Yield)
5.) The simple average of these values gives us our target or fair value price
6.) NCAV: Net Current Asset Value. Does the stock have one?

While this is the end product, there are important aspects to this process that do not necessarily have to do with valuation. The balance sheet is the base for our investment analysis. Value investing is our inclination and therefore we wish to pay for assets while getting a growth component at a discount. First, we look for a Net Current Asset Value in order to determine the financial viability of the firm in question. Secondly, we look at Current Asset Value in order to determine the short-term financial viability of the firm. Next, we look at the debt to equity ratio; stocks with an equity value greater than all liabilities usually make it to the next step. Fourth, we examine the current assets in order to determine their quality. Cash and investments should make up the bulk of current assets, if this is not the case there is usually something wrong. Lastly, depending on industry, we look at property values and other items such as reserves.

Our final decisions are usually based on technical indicators. While most value investors are not chartists, we here at Researching Stocks are. Many feel that stock charts offer no real insight into equity values. We believe that much like doctor uses an EKG to analyze the heart, an investor should utilize stock charts to determine entry and exit points. Remember the more things change the more they stay the same. That is why it pays immense dividends to develop an investment strategy and stick with it.