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, 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 percent for the recently completed fiscal first quarter. This followed declines of 5.0 percent and 5.5 percent 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. Although I am a member of the company's customer loyalty program, Best Buy Rewards, I bought a TV from Costco, accessories for my cell phone from Amazon and an external hard drive from Target within the past 12 months.
In addition to competition, reliance on a single customer can increase risk. Amtech Systems, 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 oil-field 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 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.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors (http://www.aaii.com) and editor of the AAII Journal.