Investors are told to look for a combination of growth, profitability, fiscal strength and low valuation. A stock possessing all of these characteristics should be an attractive candidate. In theory, this holds true. In practice, you need to take your analysis a step further and consider qualitative factors.

Some of these qualitative risks are easy to identify; for example intensifying competition. Others require an understanding of the broad trends that impact an industry’s revenues. Many qualitative factors are subjective; for instance, you may not understand what a company does or you might find something in a company’s SEC filings that just does not sound right.

This type of analysis does not adhere to strict rules, but it does play an important role in determining whether a stock is merely cheap or a bargain. To help you apply the analysis, I’m going to give you a few examples.

A good place to start is with Best Buy (BBY), which does have some appealing characteristics:

• Revenues have increased for several years
• The company has a history of profits and positive cash flow
• The balance sheet is strong, with a very manageable level of debt
• Dividends have been rising, and the company recently announced plans to further increase its dividend
• The price-earnings (P/E) ratio is 10.2 and the price-to-book (P/B) ratio is 1.8

What is not included in the numbers above is the decline in same-store sales, a key metric for retailers. Sales at domestic stores open for more than a year fell 2.4% for the recently completed fiscal first quarter. This followed declines of 5.0% and 5.5% for the third and fourth quarters of fiscal 2011, respectively.

Though the sluggish economy is not helping, the bigger threat is competition. Even the demise of Circuit City has not stopped competition from intensifying. My experience is typical of what is occurring. Though I’m a member of the company’s customer loyalty program, Best Buy Rewards, I bought a TV from Costco (COST), accessories for my cell phone from Amazon.com (AMZN) and an external hard drive from Target (TGT) within the past 12 months.

In addition to competition, reliance on a single customer can increase risk. Amtech Systems (ASYS), a semiconductor stock that is currently passing my Risk/Reward stock screen, is highly dependant on a Chinese solar company for revenues. The screen did its job of finding stocks with low quantitative risk. However, because it does not consider qualitative risk, a company with higher levels of business risk can still pass. (No stock screen considers factors outside of its specific filtering criteria.)

Being able to step back and assess the industry itself is also important. Oil rig operators and oilfield equipment companies are significantly impacted by the price of oil—a factor over which they have no control. Thus, while a stock such as ENSCO (ESV) may have a low valuation (a P/B ratio of 1.3), it is also at risk of large revenue declines should oil prices fall.

In SEC filings, what may appear as a risk varies by company. It can be the way a company records revenues or handles costs. (An example would be a firm that constantly claims extraordinary or one-time write-downs.) It could be that you are just not comfortable with the amount of money a company paid for an acquisition relative to the size of its balance sheet. You are mostly looking for something that appears to be unusual or, more importantly, just does not seem right.

These are subjective criteria, but risk is ultimately risk. If you don’t feel comfortable investing in a certain company, don’t buy the stock (or bond).

Realize that some risk factors will not be apparent when basic quantitative analysis is performed. Rather, you need to perform qualitative analysis as well, including reading a company’s SEC filings. It’s an extra step, but one that can help you differentiate the true bargain stocks and bonds from those that are merely cheap.

What subjective risk factors do you look for? Tell us on the AAII Discussion Boards.

July AAII Journal Now Online

The July AAII Journal has been posted to AAII.com. (Print copies are in the mail.)

This month’s feature story discusses alternative investments. A new set of mutual funds and exchange-traded funds (ETFs) uses strategies intended to produce return characteristics different from those of stocks or bonds. To help investors understand how these funds fit into an individual investor’s portfolio strategy, I interviewed Phil DeMuth. Phil is a co-author of “The Little Book of Alternative Investments” and he says these funds can help lower portfolio risk.

Other articles in this month’s issue include, but are not limited to:

• Delaying Retirement, But Not Your Retirement Dreams by Christine Fahlund
• Chasing Dividend Yield for Income: Three Reasons to Be Wary by Rod Greenshields
• The Truth About Top-Performing Mutual Fund Managers by Aaron Reynolds
• Shadow Stock Gains Limited by Pause in Small-Cap Stocks by James Cloonan

The Week Ahead

The U.S. financial markets will be closed on Monday, July 4.

No members of the S&P 500 are scheduled to report earnings next week. Second-quarter earnings season will “officially” start on July 11, when Alcoa (AA) reports.

The week’s first economic report will be May factory orders on Tuesday. Wednesday will feature the June ISM services index and the June ADP employment report. June jobs data, including the unemployment rate and change in nonfarm payrolls, will be published on Friday. May wholesale trade data will also be published on Friday.

No Federal Reserve officials are currently scheduled to speak.

AAII Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 38.3%, up 0.9 points
  Neutral: 31.5%, up 4.7 points
  Bearish: 30.2%, down 5.5 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment edged up 0.9 percentage points to 38.3% in the latest AAII Sentiment Survey. This is the highest level of optimism that stock prices will rise over the next six months since April 14, 2011. Nevertheless, bullish sentiment remained below its historical average of 39% for the 11th consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, jumped 4.7 percentage points to 31.5%. This is a four-week high. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped 5.5 percentage points to 30.2%. This is the lowest level of pessimism since April 7, 2011. This drop puts bearish sentiment essentially even with its historical average of 30%.

Pessimism over the direction of stock prices has dropped for three consecutive weeks after setting a 2011 high of 47.7%. The stabilization and recent rebound in stock prices has helped to lower the level of worry. Even with this week’s improvement, bearish sentiment has been at or above its historical average of 30% for 18 out of the last 19 weeks. This is a sign that individual investors remain cautious, which is not surprising given the ongoing lack of resolution to the debt ceiling problem and the slower pace of economic growth.

This week’s special question asked AAII members how much impact the debt problems in Greece were affecting their sentiment toward stocks. The responses were mixed. Many said the situation was either somewhat or significantly negatively affecting their sentiment. A nearly equal number said their attitudes either weren’t affected or were only slightly affected. A few thought the worries were creating buying opportunities in stocks. Several noted that the lack of agreement on the U.S. debt ceiling concerned them more.

Here is a sampling of the responses:

• “It makes me bearish on the fringes, but I am much more concerned with the games in Washington, D.C.”
• “My stock portfolio is steady, but the market is going like a yo-yo with every twist and turn in Greece.”
• “I’m more cautious because of the uncertainty in Europe and elsewhere.”
• “If Greece defaults, there will be a double-dip recession.”
• “The fear of the Greek situation has made stocks more of a bargain.”
• “Not at all. Of course, if the malady spreads, then I’ll head for the basement.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.