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Chuck Hughes - Stock Selection (The Fail Safe Financial Program pgs. 155-158)
This really is dedicated to those of you who wish to purchase individual stocks. I would like to share along with you the techniques I have tried personally through the years to select stocks that I have discovered to become consistently profitable in actual trading. I prefer to make use of a mixture 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 the stock is definitely an uptrend as indicated by the 50-Day Exponential Moving Average Line (EMA) being over the 100-Day EMA
This two-step process boosts the odds the stock you decide on will be profitable. It offers 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 another useful method for selecting stocks for covered call writing, a different type of strategy.
Fundamental analysis is the study of financial data for example earnings, dividends and funds flow, which influence the pricing of securities. I use fundamental analysis to assist select securities for future price appreciation. Over time 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 discovered these methods aren't always reliable or predictive.
For example, corporate net earnings are subject to vague bookkeeping practices such as depreciation, cash flow, inventory adjustment and reserves. These are all susceptible to interpretation by accountants. Today more than ever before, corporations they are under increasing pressure to beat analyst�s earnings estimates which results in more aggressive accounting interpretations. Some corporations take special �one time� write-offs on their own balance sheet for things like failed mergers or acquisitions, restructuring, unprofitable divisions, failed product, etc. Many times these write-offs are not reflected like a continue earnings growth but rather appear as a footnote on the financial report. These �one time� write-offs occur with increased frequency than you might expect. Many companies that make up the Dow Jones Industrial Average took 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 larger the ROE the greater).
Recognise the business is more successful?
Coca-Cola (KO) having a Return on Equity of 46% or
Merrill Lynch (MER) with a Return on Equity of 18%
The reply is Merrill Lynch by any measure. But Coca-Cola includes a much higher ROE. How is that this possible?
Return on equity is calculated by dividing a company�s net gain by stockholder�s equity. Coca-Cola is really over valued that it is stockholder�s equity is only equal to about 5% from the total market price from the company. The stockholder equity is so small that nearly any amount of net income will create a favorable ROE.
Merrill Lynch however, has stockholder�s equity equal to 42% from the market value of the company and requires a greater net income figure to produce a comparable ROE. My point is that ROE doesn't compare apples to apples therefore is not a good relative indicator in comparing company performance.
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