Tuesday, August 14, 2007

What to Buy, When to Buy, and When to Sell

Probably the three most important questions a stock investor needs to answer is "What to Buy", "When to Buy", and "When to Sell". I'll try to address all three questions in this article from my perspective as a value investor. This is a long article, so you might want to grab a cup of coffee and a snack ;-)

What to Buy

Value investors look to buy companies with solid fundamentals. These are companies that generate positive Free Cash Flow (FCF), provide above average Cash Return on Invested Capital (CROIC), Return on Assets (ROA), and Return on Equity (ROE), have low or reasonable debt and are financially healthy (Debt/Equity Ratio, Current Ratio & Quick Ratio), have strong, and preferably shareholder friendly, management (Stewardship), and, last but not least, have a strong competitive advantage (Economic Moat). Let's briefly look at each of these criteria:

Free Cash Flow (FCF)

Companies that generate a lot of free cash flow can do all sorts of things with the money, like pay dividends, buy back shares, use it for acquisitions or expansion, etc. Free cash flow gives the company financial flexibility and allows it to survive during bad times. In a sense, free cash flow is money that could be extracted from the company without damaging the core business. Strong free cash flow is an excellent sign that the company has a competitive advantage (Economic Moat).

Companies that have negative free cash flow need to raise money, by taking out loans or selling additional shares, just to stay in business, which can lead to financial trouble and bankruptcy.

IMHO, free cash flow is more important than earnings. Here's a good article on earnings from F Wall Street.

The formula for FCF is:
Free Cash Flow = Cash Flow from Operations - Capital Expenditures

Cash Return On Invested Capital (CROIC)

Cash Return On Invested Capital (CROIC) measures how effectively a company uses the money (borrowed or owned) invested in its operations. Here's a good article about CROIC from F Wall Street.

The formula for CROIC is:
Cash Return on Invested Capital = Free Cash Flow / Shareholder Equity + Total Liabilities - Current Liabilities

Return on Assets (ROA)

Return on Assets (ROA) measures how efficient a company is on translating its assets into profits. If a company is able to consistently post high ROA's, it may have a competitive advantage over its peers.

The formula for ROA is:
Net Margin = Net Income / Sales
Asset Turnover = Sales / Assets
Return on Assets = Net Margin x Asset Turnover

Return on Equity (ROE)

Return on Equity (ROE) measures the profits per dollar of the capital shareholders have invested in the company. Like ROA, if a company is able to consistently post high ROE's, it may have a competitive advantage over its peers.

The formula for ROE is:
Financial Leverage = Assets / Shareholder Equity
Return on Equity = Return on Assets x Financial Leverage

Financial Health

Financial health relates to a company's indebtedness and it's ability to manage its debt. The following three ratios provide a means to measure a company's financial health.

Debt/Equity Ratio

Debt/Equity Ratio measures how much long-term debt the company has per dollar of equity.

The formula Debt/Equity is:
Debt/Equity Ratio = Long-term Debt / Shareholder Equity

Current Ratio

Current Ratio measures how much liquidity a company has (i.e. how much cash it could raise if it absolutely had to pay off its liabilities all at once). A low ratio means the company may not be able to source enough cash to meet near-term liabilities. As a general rule, a current ratio of 1.5 means the company should be able to meet operating needs without much trouble.

The formula for Current Ratio is:
Current Ratio = Current Assets / Current Liabilities

Quick Ratio

Quick Ratio is an even more conservative measure of a company's liquidity. This measure is especially useful for manufacturing companies and retailers, since both tend to have a lot of their cash tied up in inventories. In general, a quick ratio of 1.0 puts a company in fine shape.

The formula for Quick Ratio is:
Quick Ratio = Current Assets - Inventories / Current Liabilities

Management (Stewardship)

Management can make the difference between a mediocre company and an outstanding one. The goal is to find a management team that thinks like shareholders and treats the business as if they owned a piece of it, rather than as hired hands. I use Morningstar's Stewardship grade, which rates a companies management.

Competitive Advantage (Economic Moat)

Another important criteria is competitive advantage, otherwise know as an economic moat. Companies that have a strong competitive advantage (i.e. wide moat stocks) can usually weather most storms, either company/sector specific or market wide. If a company starts to lose it's competitive advantage the fundamentals will suffer (i.e. sales, revenue, profit margins, etc.).

When to Buy

Now that we know what to buy, the next question is when to buy it. Value investors always look to buy stocks when they're on sale, i.e when the company can be purchased with a "Margin of Safety" to its intrinsic value.

I use Morningstar ratings to determine when to buy. A 5 Star rated stock is a company that's selling at a discount to its intrinsic value, and at or below Morningstar's "Consider Buy" price. These are the ideal stocks to buy as long as they meet the "What to Buy" criteria.

My CC strategy looks at 3-5 Star rated stocks. Since I'm selling covered calls on these stocks I don't need such a large discount on the stock price because the call premium will lower my cost basis.

When to Sell

Probably the hardest question of all is when to sell. There are many opinions on this depending on your perspective. A value investor would only sell a stock when the company fundamentals start to deteriorate or when the stock price reaches or surpasses the company's intrinsic value. A CC trader would allow the stock to be called away if it meets the annualized return requirement.

As a value investor, as soon as you notice that the fundamentals of a company are beginning to deteriorate, you may want to consider getting out of the stock. A good place to look for deteriorating fundamentals is the balance sheet. Things to look for include rising debt levels, rising inventory levels, and accounts receivable that are rising faster than revenues. These are three common warning signs that a company's efficiency is deteriorating. Here are some other warning signs that the fundamentals of a company are deteriorating:

  • Shrinking return on equity
  • Declining profit margins
  • Market share losses
  • Unwise acquisitions
  • Unexpected management shakeups
Since fundamentals usually take a long time to change, I take a long term view and don't worry to much about the short-term fluctuations. In fact, I profit from the short-term fluctuations by selling calls on the stocks I own. I'm also willing to let my CC stocks get called away, since I've already pre-determined that the annualized return if called meets my requirements.

There's a good article at Morningstar which further describes some of the criteria I use when deciding when to sell.

When Not to Sell

Probably just as important as "When to Sell" is "When Not to Sell".

Assuming you followed the guidelines in "What to Buy", you don't want to sell just because the stock price has declined and don't want to use stop losses blindly (a stop loss is a order or mental note to sell the stock once it declines to a certain price). This is typically done by technical traders to cut their losses in case they're wrong (e.g. they picked the wrong direction). Price action is short term and usually unrelated to a company's fundamentals. Value investors don't judge a company solely by its stock price. Stock prices fluctuate for a variety of reasons that don't necessarily reflect a change in company fundamentals. So, selling a stock just because its stock price has declined, without regard to the company fundamentals, is like throwing the baby out with the bath water.

As someone on the Yahoo Group so eloquently said "Value investors have an entirely different perspective on companies whose stock price is less than what they paid for them. They are more likely to buy more of those companies than sell them. While it's wise to occasionally take a loss on a position and admit that a mistake may have been made, the mistake in question is not simply because the stock price has gone down. In that case it is the market that has made the mistake -- an error in valuation. A value investor would and should only sell a losing position because something has fundamentally changed in the valuation of a company. When that happens, and only then, the value investor would sell."


I use this same approach for both my buy & hold portfolio and my covered call portfolio. The differences are slight.

For my B&H portfolio, I only buy 5 Star Wide Moat stocks, since the only way I profit is from capital appreciation, and dividends. These stocks are usually held long-term and sold once they reach or surpass the company's intrinsic value.

For my CC portfolio, I'm not so rigid, since I'm able to generate income on my stocks from selling call options. Although the intent is to have these positions called away in the short-term, since they meet my annualized return requirement, I select the stocks as if I was going to hold them for the long-term. About 72% of my initial positions get called away, leaving about 28% that have declined and need to be managed. Currently, about 60% of my positions are "management" positions.

While this strategy appears to sell the winners and keep the losers, it all depends on your definition of a loser? For me, a loser is not a company whose stock price has gone down just because some irrational investors decided to sell their stocks when the company missed EPS by a penny. I judge a company by its fundamentals not by its stock price. So for me a loser is a company that's losing money (e.g. negative free cash flow), has high debt, and is in financial trouble (sounds like many of the old Dot.com stocks). None of my "management" positions fall into this category. So, while some people might call these losers, just because their stock price has declined, I don't.

There's a big difference between a losing stock and a losing company. Here's a perfect example:

Last week: "Wal-Mart Stores Inc. posted a 1.9 percent same-store sales gain, beating the 1.5 percent estimate of analysts surveyed by Thomson Financial."

The day of that announcement, WMT stock dropped 4%.

Today: "Wal-Mart's earnings rose to $3.1 billion, or 76 cents per share, in the second quarter ended July 31, from $2.08 billion, or 50 cents per share, a year earlier. Earnings per share from continuing operations were 72 cents per share before a gain of 4 cents. Analysts on average were expecting 76 cents. Sales rose nearly 9 percent to $91.99 billion. U.S. sales at stores open at least a year, a key retail gauge known as same-store sales, rose 1.9 percent. Same-store sales increased 1.2 percent at Wal-Mart stores."

As of this writing, WMT stock is currently down about 5%. A losing stock, YES, a losing company, NO. Here's a look at WMT from F Wall Street.

So there you have it. Now you know the thought process I go through when deciding "What to Buy", "When to Buy", and "When to Sell". I hope you found this useful.