How I Choose a Stock to Buy or Sell

This week I subbed in for Charles Rotblut on the weekly radio show MoneyLife with Chuck Jaffe. Each week Charles chooses a “buy of the week” and a “sell of the week” and provides some editorial guidance on his reasoning.

In order to prepare for the interview, I had to think, “what qualities do I look for in a stock and, subsequently, what would prompt me to sell it?”

I started off by brainstorming what the qualities of a “good stock” are in hopes that I could reverse these metrics to create a list of sell metrics. By no means is this a static list, and the metrics mentioned below represent my personal views. Additionally, the analysis described here focuses primarily on fundamental metrics and “bottom up” analysis (focusing on individual attributes and fundamental factors of a particular company or stock) as opposed to “top down” analysis (which focuses on macroeconomic factors to determine which sectors and industries will outperform or underperform the market).

Generally speaking, among the qualities that I look for in stocks are positive estimated earnings growth, estimate revisions upward, increasing return on equity (ROE), positive and growing free cash flow and an attractive valuation as compared to its historical levels. I use AAII’s Stock Investor Pro, our fundamental stock screening and analysis tool, to find my initial candidates and track their fundamentals over time.

By taking the opposites of those rules, a stock that could be considered a sell may have slowing or negative earnings growth, estimate revisions downward, declining return on equity, negative or declining free cash flow and a high valuation compared to its historical levels.

Your personal preferences will dictate which metrics you feel are important when choosing stocks. This could be based on historical research you have read or behavioral biases that influence your actions. Metrics will also change depending on what strategy you are following, such as growth versus value.

To begin this analysis, I created a stock screen using Stock Investor Pro by implementing the metrics that I desired in a stock. Creating a more manageable list through a stock screen allows you to identify stocks that meet your minimum criteria that may warrant further analysis. The stricter the criteria you choose, the fewer number of stocks will pass the screen.

Why did I choose the metrics mentioned above?

Positive estimated earnings growth: Growth in the company is ultimately what will drive future share price increases. When choosing stocks, I want to make sure that analysts at least expect its earnings to increase in the future. You have to be careful here to note how many analysts are estimating the earnings growth and what the variability is among analysts’ estimates. But don’t seek out too high of a growth level, as research shows that extreme growth can’t be sustained.

Estimate revisions upward: This means that analysts have recently revised their expectations of future earnings upward. This is one of the metrics we have identified as being helpful in highlighting stocks that tend to exhibit strong future price performance. When an analyst raises an estimate, it is a signal that things look brighter for a company’s future than originally expected. Since a stock’s price reflects the overall expectations and risk of a company, higher expectations tend to translate into higher stock prices. The greatest bump in stock prices occurs at the time of the estimate revision, but there is a measured persistence to the positive effects of a revision. For more information on estimate revisions, check out “How to Profit From Revisions in Analysts’ Earnings Estimates.”

This metric isn’t always essential to my analysis, because sometimes a stock is “over-punished” when earnings are revised down slightly, which could present a buying opportunity. Sometimes earnings are revised down because the company is selling off some of its assets or divesting a segment, which lowers earnings in the near term but can increase the company’s overall efficiency and profitability in the future.

Increasing ROE: Return on equity reflects management’s ability to allocate capital efficiently and effectively. It measures how much return is generated for every dollar of shareholder equity. As a common stock shareholder, you should be concerned about the company’s ability to increase the return on your investment over time. I prefer to see a positive trend in the ROE rather than just a high level of it, as it points to improvement.

Positive and increasing free cash flow: I’m sure many of you have heard the phrase “cash is king.” Free cash flow represents the cash that a company is able to generate from day-to-day operations after spending the money required to maintain or expand its asset base. Increasing free cash flow means the company has positive cash flow from operations and has the ability to expand production or develop new products, reduce debt, make acquisitions and pay dividends, among other things. It’s often mentioned that earnings are more easily manipulated compared to free cash flow; it’s more difficult for management to “fake” free cash flow growth.

Attractive valuation compared to historical levels: By analyzing a stock’s current value compared to its historical value, I am attempting to purchase the stock at a “discount” to its normal valuation level. There are many ways to measure value, but the price-earnings (P/E) ratio is a common value that is readily available and has a proven history. if the company pays a dividend, I often take the dividend yield into consideration. If a stock’s P/E is below its historical average, it could signal undervaluation provided the company’s risk or prospects have not changed. You would be paying less for a given level of earnings.

Alternatively, if a stock’s dividend yield is above its historical average, it could signal undervaluation provided the dividend is secure and expected to grow. You would be paying less for a given dividend payment. One has to be careful though; sometimes a stock deserves a lower valuation because of its future growth prospects and uncertainty of its growth.

In regard to the MoneyLife show with Chuck Jaffe: For the buy, I chose CVS Health (CVS), which you can hear more about by clicking here. For the sell I chose Chipotle Mexican Grill (CMG), which you can hear more about by clicking here.

(I hope you like my drawing, although I know my artistic capabilities are not nearly as in tune as Charles’!)