Choosing an Investment Strategy
You’re interested in investing, you
want to get started, but how do you choose which stocks to buy? There’s the American
Stock Exchange, the New York Stock Exchange and the Nasdaq, plus foreign stocks. Tens of
thousands of companies to choose from, so how do you distinguish the good ones from the
bad?
Everyone has a theory or strategy. Some
share their strategies such as Peter Lynch, Warren Buffet, and the Gardner brothers.
Others follow principles such as the Dogs of the Dow. I’m going to cover two
strategies I like. The first is from the Gardner brothers, they run The Motley Fool and have several different strategies,
including the Rule Maker. The second theory is the Chicks Dozen, a strategy used by a
womans investment club at Chicks Laying Nest
Eggs. The Chicks Dozen is a combination of Peter Lynch, Warren Buffet and the Gardner
brothers philosophies. How you choose stocks is ultimately up to you, but learning from
other people’s strategies will help you along the way, especially if you are starting
out not knowing anything. The other great way to learn is to start an
investment club of your own.
Motley Fool’s Rule Maker
- The company must have at least one sustainable competitive advantage.
A competitive advantage is something that staves off competition such as patents, trade
names, or well known brands.
- Great management with a track record of excellence. You want
to know who is running the company and that they will do the right things.
- Expanding possibilities. A company that can create new
products or services has room to grow.
- Annual sales growth of at least 10%.
- Gross margins greater than 50%. Gross margins is the amount
of profit that a company makes when selling an item. So if an item costs $10 to make and
they can sell it for $20, they make 50%.
- Net profit margin of at least 10%. Net profit is the amount
the company makes after all of it’s expenses, including marketing, salaries, etc.
- Cash king margin
greater than 10%. This is similar to net profit margin, but rather than using net
income from the balance sheet, you use free cash flow from the cash flow statement and
divide it by sales.
- Cash no less than 1.5
times the company’s total debt.
- Foolish flow
rate no greater than 1.25. The flow rate shows how efficiently a company uses
it’s cash and is determined by taking the current assets minus the company’s
cash and dividing that number by current liabilities minus the company’s short term
debt.
- Reasonable purchase price for clear possibility of 2x/5y.
The stock price has to be reasonable enough to expect you to be able to earn twice that
amount in 5 years.
Chicks Dozen
- Buy what you know. Understanding the industry in which you
are buying stock is important. By understanding the industry you will have an edge in
seeing what may happen in the future and be able to understand press releases and news
stories about the company.
- Keep It Simple Sister. You should be able to explain the
company and industry to a ten year old.
- Industry. Know the industry, if it’s emerging or
declining. You wouldn’t buy stock in a buggy company now that cars run the roads.
- Leader in it’s field. Is the company the first or
second name you think of when the industry is mentioned?
- Repeat profitability. Do customers
need the service or product over and over again?
- Gross margins at least
50%. Gross margins is the amount of profit that a company makes when selling an
item. So if an item costs $10 to make and they can sell it for $20, they make 50%.
- Cash no less than 1.5 times the company’s total debt.
- Net profit margins at least 8%. Net profit is the amount the
company makes after all of it’s expenses, including marketing, salaries, etc.
- Flow ratio no great than 1.5. See explanation above.
- Increasing growth. The chicks don’t have a set
percentage like the Motley Fool’s do.
- Strong management.
- On sale. Is the stock price lower than the 52 week average?
While the Chicks don’t like to watch the market, they are long term holders, if you
are trying to choose between stocks and the last factor is price, go with the sale!
We’re women after all!
You can see that the strategies are very
similar, which is probably why I like both of them. They may not work for everyone, but
it’s a starting point to see how other people are evaluating stocks. So where do you
find all of this information? You can find any company’s stock price, history and
news at http://momsbudget.master.com. For a
company’s financial information, for determining things like gross margins you can
research at FreeEdgar.com. Once you start
researching some companies, take advantage of our portfolio
tracker, you can “buy” stocks and test different strategies before you start investing actual money!
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