How To Find Good Stocks to Invest In
The Smart Profits Issue #491
By Marc Lichtenfeld
Senior Analyst, Smart Profits Report
Everyone loves a bargain. But the question is: How do you go about creating a list of good stocks worthy of your attention? I’ve got a few tips for you - and one great number you can look at to separate the good stocks from the bad stocks.
Finding Good Stocks To Invest In with One Ratio
Wouldn’t it be wonderful if there were a simple investment formula such as, “Buy any stock with a price-to-earnings ratio under X or a price-to-book under Y?”
Alas, nothing worthwhile in life is that easy.
But there is one number you can look at that will help you find good stocks selling at discount prices. It’s called the Price-to-Cash-Flow and it’s one of my favorite ratios to examine. And there’s a simple reason I like to use it.
While companies can manipulate and massage their earnings very easily through write-offs, channel-stuffing and other means, cash flow is much more difficult to alter as it represents the cash that the company actually generates.
Let me explain how it works…
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Take A 20% Tip From “The Father”
As I said, it’s not as simple as just assigning an arbitrary value to a stock and say that it’s a good stock to buy if it trades below that number. For example, David Dreman, considered by many financial minds to be the “father of contrarian investing,” recommends looking at the lowest 20% of any ratio (Price-to-Earnings, Price-to-Book, or Price-to-Cash-Flow, etc.) that you’re considering - and expanding that into specific industries to improve your chances of success finding good stocks to invest in.
For example, let’s say you’re looking at the major pharmaceutical companies. The two with the lowest Price-to-Cash-Flow (P/CF) are GlaxoSmithKline (NYSE: GSK) and Wyeth (NYSE: WYE).
But take a look at some of the other numbers and you’ll see that their P/Es are also low compared to their peers. In addition, Glaxo pays a healthy 4.2% dividend, has the highest return-on-equity of the group and a high net profit margin. Wyeth has a low Price-to-Book compared to the others in the sector.
If you’re a long-term investor, fundamentals like this reveal that it might be a good opportunity to pick up a solid drug manufacturer at a bargain price.
Let’s take a look at another healthcare-related sector…
Of the large companies that provide healthcare plans, WellCare (NYSE: WCG) stands out from a valuation perspective as a good stock to keep an eye on. No doubt, that’s because the stock was slashed in half (and more) after the Feds raided the company’s offices!
But aside from that negative press, the company is winning new contracts and is among the lowest in its peer group in terms of P/CF, P/E and Debt-to-Equity and is one of the highest in Return-on-Equity.
That’s a good start. But you still need to perform your due diligence to see if the balance sheet is healthy, whether cash flows are rising or falling, etc. Sometimes, a stock has a low valuation for a reason. Right now, investors are clearly concerned that WellCare is going to run into more problems with the federal government, otherwise it wouldn’t be so cheap. But after digging into your research, if you conclude that the company’s woes are behind it, WellCare looks like a tremendous bargain.
One More Sector Full of Good Stocks to Invest in…
Let’s say you wanted to stare down the recession and troll around in the industrials group. You might want to pay attention to Lincoln Electric Holdings (Nasdaq: LECO), a Cleveland based manufacturer of welding and cutting products.
The company’s P/CF is low compared to its peers and its cash flow from operations grew every quarter over the past year (in fact, on an annual basis, it’s grown for the past several years). Other positives include a below average P/E, little long-term debt, and a Price-to-Book ratio that is half the sector average.
Bottom line: When times are tough (like now), cash is king. And when companies trade at a discount to their peers, based on the cash they spin off, it pays to take a closer look.
Marc Lichtenfeld
Today’s Smart Profits Action Center:
- There are a host of fundamental numbers you can use to evaluate a stock’s power. But one of the best momentum indicators is cash flow. Harder for a company to spin, cash flow numbers give a truer gauge of how much cash it’s generating and takes various factors into account, such as net income, depreciation, and amortization. As Marc mentioned above, investing in stocks that not only have a healthy cash flow, but are also attractively valued relative to that cash flow can be a valuable addition to your portfolio.
- In the February Xcelerated Profits Report issue, sent to readers on Wednesday, the team recommended a new play on one of America’s biggest, cash-rich blue chip companies. With more $20 billion in the bank and cash flow around $14 billion, it’s no wonder the company can afford to pay out a very healthy dividend, too. Plus, it’s part of a sector that is one of the most resilient during an economic downturn.
Related Articles:
Investing In The Fear Effect: How To Buy Bargain Stocks When There’s Blood In The Streets
The Healthcare Sector: Recession-Proof Your Portfolio With This Robust Sector
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