How To Pick Great Stocks (part 3)

This is part 3 of a 3-part series, enjoy…

Following these principles will help you become successful at long-term investing in stocks.

Over the long term…

Stocks have provided the best
return compared with bonds,
Treasury bills, and gold and
other commodities. Wall Street
argues otherwise, but Pries
Capital
 believes Main Street
investors can meet these major
goals by investing in the stock
market
 without relying on a
financial adviser or a brokerage
firm to recommend specific stocks.

A commonsense analysis process can help you invest profitably in high-quality stocks.

The article Common Traits of the Best Stocks discussed what to look for when picking stocks. You want companies that have…

  • Above-average sales and earnings growth.
  • Stable or growing profitability.
  • A current price, as measured by the price-earnings ratio, that’s reasonable.

If you see that a company has above-average sales and earnings growth — the more consistent, the better — and stable or growing profitability, there’s a good chance it’s a well-managed, high-quality company. You’ll then want to see whether the current stock price offers an appropriate potential return.

Pries Capital has molded these concepts into an investment strategy and stock selection analysis process that will help you buy individual stocks. Anyone with the determination to remain focused on long-term results can build a portfolio of around 10 to 20 stocks that has to potential to outperform the S&P 500 or another index fund.

Our process focuses on finding quality growth stocks selling at reasonable P/E ratios for long-term gain. Pries Capital’s approach to stock analysis is that sales drive earnings, and earnings drive stock prices. Some people trade on short-term up and down ticks in stock prices, but over the long-term fundamental analysis — studying a company’s financial performance — is what works in building wealth.

Since 1998 Jason and Tina Pries have used this stock selection process to study stocks, and there’s some math involved. But our investment clubs and analysis tools automatically give you the critical data from company financial statements and we do the calculations for you. So, after reading the article, learn more about our investment clubs and analysis tools and sample our education and resources for free.

Step 1: Forecast Long-Term Sales Growth

In the short term, the stock market may not reward individual stocks for their excellence. But over the long term, stocks prices move upward with earnings growth. So, it’s the long-term projections — five years, very roughly enough for the company to go through a business cycle — you’ll care about.

You start by forecasting five-year annual sales growth, because as we said, sales drive earnings. You’ll use this estimate to build your earnings projection. You have several data points at your disposal, including

  • The company’s historical growth rate.
  • Company statements regarding growth goals.
  • Wall Street estimates.
  • The industry’s historical growth rate and estimates of future expansion.

Step 2: Forecast Long-Term Earnings Growth

You then estimate five-year annual earnings growth considering the sales projection. You can consider the company’s history of earnings growth and any goals it has stated. You can also access analyst reports and analysts’ consensus estimates, but these forecasts are usually optimistic. Often the best move is to use a similar rate as the sales growth forecast.

The earnings growth rate determines the estimate of earnings per share five years from now. If you’ve estimated earnings growth of 15 percent a year, and the EPS at the starting point is $1, five years from now EPS will be $2.

Step 3: Estimate the Future High and Low Stock Price

The EPS estimate is critical for the next stage: determining whether the stock is reasonably priced. Investors are good at discovering high-quality stocks but often buy stocks at the wrong price.

Using historical P/Es as a guide, you forecast the high and low P/Es over the next five years. At this point you’re ready to estimate a potential high price for the stock. It’s simple math: You multiply the estimated EPS in five years by the forecast high P/E. For example, if you predict EPS will be $2 in five years and the high P/E will be 30, the predicted high price will be $60.

For the low price, you multiply the projected low P/E by the expected low EPS to come up with a potential low price. For a quality growth company, you usually assume that the most recent year’s EPS is the low. Pries Capital’s stock analysis process has other options for the low price, but this is the most common one.

Step 4: Determine the Individual Stock’s Return Expectations

After you determine the stock’s potential range over the next five years, you’re ready to see whether this stock will provide a suitable return. Our analysis divides the range into three zones: Buy, Hold, and Sell. The lowest 25 percent of the range is the Buy zone, and the uppermost 25 percent is the Sell zone. Again, we will usually handle the math for you here.

The stock’s dividends — the cash payments of earnings to shareholders — is included in return calculations. So, there are three ways to achieve a return on a stock: through dividends, through the market increasing the stock’s price in concert with the earnings growth and through the stock’s price rising because the market believes the P/E should be higher.

When picking stocks, aim for return of 15% annually on average over the next five years, or a doubling of return. That’s an aggressive target, but don’t be disappointed if you don’t meet it. The idea is to maintain your focus on buying stocks of high-quality, growing companies. Achieving returns of, say, 10 percent yearly — about the historical return of the S&P 500 — is commendable.

In today’s unpredictable, volatile market, fundamental analysis is even more important than usual. But for an individual investor using a simple, straightforward methodology that focuses on the long term, these are also times of great opportunity.

Still interested in understanding more when it comes to successful stock investing? If so, contact our firm at 843-945-0051 and someone will be able to explain more in depth of what you need to know when it comes to becoming a consistently profitable individual stock investor! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Common Traits of the Best Stocks (part 2)

This is part 2 of a 3-part series, enjoy…

Following these principles will help you become successful at long-term investing in stocks.

Over the long term…

Stocks have provided the best
return compared with bonds,
Treasury bills, and gold and
other commodities. Wall Street
argues otherwise, but Pries
Capital
believes Main Street
investors can meet these major
goals by investing in the stock
market
without relying on a
financial adviser or a brokerage
firm to recommend specific stocks.

The best growth companies to invest in share a set of common characteristics.

You face a perplexing selection of choices when you pick stocks. When looking for stocks to buy to meet long-term financial goals, however, you can narrow the field quickly. For an individual investor who works full time and who wants to follow a consistent investing strategy to find stocks, growth stocks are the best ones to buy. These companies are easy to identify, and they share a set of common characteristics.

Seek Growth Stocks with Above-Average Sales and Earnings Growth

Growth stocks increase revenues and earnings at faster rates than that of the general economy and most competitors in the same industry. The best stocks to buy are those of companies that tend to continue growing even when business conditions are weak; their growth might soften during these times, but they do better than their competitors. They also can outlast their rivals in downturns and thrive when the economy bounces back. Stock prices tend to follow a company’s earnings growth.

Consistent growth is also a plus. Pries Capital’s Stock To Study and analysis includes a graph of sales and earnings growth. Graph lines that go up and are straight are generally preferred to those that are shaped liked roller coasters. The consistency of growth is a sign of quality performance by the management team.

It’s important to consider growth in context of company size. You should expect smaller companies to grow at faster rates than larger ones. Look for small companies of less than $1 billion in annual revenues to grow sales and earnings at 12% or more a year. Midsize companies, with $1 billion to $10 billion in annual revenues, should be growing between 7% and 12% a year. Expect large companies, those with annual revenues above $10 billion, to grow by at least 5% a year.

Pick Stocks with Stable or Growing Profitability

A company’s above-average sales and earnings growth indicates that its management is solid. Another test of management is stable or growing profitability. Eroding profit margins, the percentage the company gets to keep of what it makes in sales, can be a sign that the company is in trouble. Find stocks of well-managed companies that can find ways to keep this from happening, such as by increasing prices or lowering costs. (By the way, when considering profit margins, look for the profitability before taxes. Management has limited capability to control tax rates.)

Stable or steadily increasing pretax profit margins show that management can balance growing sales while containing or even decreasing costs.

Another test of management is the percent earned on equity, or return on equity, or ROE. That’s the return management achieves on investors’ money (including earnings retained in the business). ROE indicates how well management is employing a company’s resources contributed by shareholders’ money and earnings invested back into the company to create new assets that grow sales. The best stocks to buy are those of growth companies with stable or growing ROE.

Check a company’s pretax profitability and ROE histories against those of competitors. You want to find stocks that are the best in their industry for these management measures. Pries Capital subscribers get stock ideas from our online tools, education, and resources, which in some cases you can sample free.

You should also study company debt. High debt levels can be risky, because companies continue to pay debt obligations regardless of business conditions; conditions can become so severe that a company can no longer pay its debt and goes out of business. In general, look for stocks to buy of companies with a ratio of debt to total capital that’s less than 33%.

There are exceptions, though. Compare a company’s debt percentage to the industry average. Some industries, such as banks, financial institutions, and utilities, typically operate using higher levels of debt. Some successful companies in other industries have proven they can carry high debt over many years.

Buy Stocks with Reasonable Price-Earnings Ratios

Once you’ve determined you’re studying a quality company, you’ll need to make sure you’re selecting a stock to buy that’s selling at a reasonable price. We walk through Pries Capital’s stock analysis process, which helps you identify investments with suitable return potential, in How to Pick a Great Stock.

Paying too much for a great growth stock will hurt your long-term return. The cornerstone of stock price analysis is the price-earnings ratio. The P/E is the price you’ll pay for a dollar of a stock’s earnings and helps you compare stock prices.

Study the current price-earnings ratio — the earnings per share from the past four quarters divided by the share price — relative to the P/E history to help determine whether the stock is selling at price that will help you employ your investment strategy.

Stocks selling at wildly high P/Es — say, 50 and above — tend to provide poor returns. Stocks with P/Es above their historical range can also prove disappointing.

Pries Capital’s Investment Club courses for stock selection and analysis can help you make sense of this data and walk you through the two key questions to ask:

  1. Is this a well-managed growth company?
  2. Is the stock selling at a reasonable price?

Still interested in understanding more when it comes to successful stock investing? If so, contact our firm at 843-945-0051 and someone will be able to explain more in depth of what you need to know when it comes to becoming a consistently profitable individual stock investor! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

6 Steps for Successful Stock Investing (part 1)

This is part 1 of a 3-part series, enjoy…

Following these principles will help you become successful at long-term investing in stocks.

Over the long term…

Stocks have provided the best
return compared with bonds,
Treasury bills, and gold and
other commodities. Wall Street
argues otherwise, but Pries
Capital
believes Main Street
investors can meet these major
goals by investing in the stock
market
without relying on a
financial adviser or a brokerage
firm to recommend specific stocks.

Whatever your financial goals are — such as funding retirement, saving for your children’s college education, or buying a home — investing in stocks should play a critical role.

Though you can benefit from mutual funds and index funds composed of stocks, Pries Capital believes that ownership of individual stocks can lead to more profitable investing. Any investor willing to dedicate a few hours a month and a set amount monthly can buy stocks by applying commonsense principles and a consistent approach to identifying quality companies whose common stocks are selling at reasonable prices. The following are the main principles for successful long-term investing.

1. Buy Stocks Regularly, Regardless of the Market Outlook

Trying to guess the stock market’s direction so that you’re investing in stocks when share prices are low and selling stocks when prices are high has never worked. Despite the stock market’s gyrations, stock prices over the long term have continued to increase — about 10% a year, historically. So, investors are better off taking the long view and investing a set amount regularly, not matter what the market is doing, and Wall Street analysts are saying.

This method, called dollar-cost averaging, means you automatically buy more shares of a stock when the price is lower and fewer when the price is higher. The result is a lower average purchase price and a higher overall return.

Here’s an example of how you can benefit from regular investing. Say you buy $100 of a stock on the first day of the month over five months. The share prices on the day you buy the stocks are, in order, $10, $12.50, $8, $12, and $15. So, when you invest $100 to buy a stock when shares are at $10, you purchase 10 shares; when you invest $100 when shares are at $12.50, you purchase 8.33 shares; and so on.

At the end of five months, you have 45.82 shares of the stock, and the stock is currently selling at $15. The average price you paid for a share was $10.91, while shares now sell for $15. Not a bad profit — you didn’t buy all the shares at their lowest point, sure, but how could you possibly know what the low price would be?

2. Reinvest All Earnings to Meet Long-Term Financial Goals

Plowing the earnings, you receive from investing in individual stocks (from selling stocks at a profit or receiving dividends from current holdings) is a great way to charge up your portfolio. Over the years reinvesting those seemingly insignificant dividend payments as well as your gains from selling appreciated stock (the capital gains) can lead to tremendous growth in portfolio value via the magic of compounding.

Here’s an example of the compounding’s power. If you invested $1,000 in the S&P 500 index on Jan. 1, 1978, and spent all the dividends you received, you would have amassed $26,360 by Dec. 31, 2018. But if you had reinvested those dividends, you would have had $61,639. And if you would have invested $50 a month over that time, your total would have been $349,553.

3. Invest in Stocks of Quality Growth Companies

Pries Capital’s principles work best when applied to quality growth companies. Growth companies generally increase their revenues and earnings faster than the combined rates of growth for the overall economy and inflation. The ones to focus on also grow faster than other companies in their industry.

With quality growth companies, sales growth leads to earnings growth. And earnings growth leads to growth in share prices. Pries Capital can help you identify quality growth stocks, and we discuss the hallmarks of these stocks in the article Common Traits of the Best Stocks.

4. Diversify Your Investments in the Stock Market to Reduce Risk

Investing is a humbling activity: We all make mistakes. Even if you buy stocks only after a thorough study, be prepared for one out of every five stocks you buy to perform worse than expected. (Also expect three to do about as you expected, and one to do much better than you forecast.)

So, diversify your investments to limit the damage an underperforming stock can do. You’ll want to own stocks not only in different industries but also of different company sizes. Don’t buy so many stocks, however, that your portfolio looks like an S&P 500 index fund. Pries Capital suggests that you need only around 10 to maybe 20 companies of different sizes from at least 10 to 12 unrelated industries to reduce the risk in your portfolio. A good rule of thumb is not to own more stocks than you can follow.

5. Follow a Consistent Approach to Analysis of Common Stocks

Warren Buffett has always studied potential investments the same way. So has legendary mutual fund manager Peter Lynch. The great investors all might have different ways to find stocks, but they all maintain a consistent philosophy, no matter what the market is doing.

Pries Capital’s approach to stock analysis hasn’t changed since Jason and Tina’s development in 1998. We ask ourselves two questions when studying a stock: Is this a quality company? and Is the stock selling at a reasonable price? Our stock selection process helps you answer these two questions. You can learn more about how we identify stocks to buy in How to Pick Great Stocks — or try out our free resources, tools, and education.

6. Shut Out the Noise from Wall Street

With financial news channels, websites and social media platforms, you can follow the stock market’s and your individual stocks’ daily movements. But we don’t recommend doing so. When the market’s down, the financial news networks tend to specialize in negative stories that create a mood of fear. When the market’s up, the ebullience can convince you that any stock is worth buying at any price.

Very little of this conversation helps you invest for retirement or meet other long-term financial goals. Stay focused on company fundamentals — sales, earnings, and profitability.

Still interested in understanding more when it comes to successful stock investing? If so, contact our firm at 843-945-0051 and someone will be able to explain more in depth of what you need to know when it comes to becoming a consistently profitable individual stock investor! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Trading Defining “R”

This week’s article, I want to focus on Van Tharp’s “R” from his investment book, Trade Your Way to Financial Freedom. Thanks to understanding “R”, I can honestly say I’ve been more profitable and on the path to becoming a far more consistent day trader.

What is “R” and How is it Used?

R is simply the dollar $ risk per trade. It is another way of looking at a profit vs loss ratio.

Example 1

Let’s say for example you buy 100 shares of stock at $100 per share, so total investment $10,000. If you define your cut off point at $97 and set a stop loss order accordingly, 1R is $3 and your total Risk $ is then $300 (100 shares x $3 per share).

If the stock trades down to $97 and you are subsequently stopped out of the position, your net loss is -1R (-$300). Alternatively, let’s say the stock moves up to $106 and then you sell for a +$600 profit, that would be a +2R winner.

Example 2

Now, let’s say you bought 10,000 shares of the same stocks at $100 per share. Using the same $97 Stop, your risk is $30,000 instead of $300, however it is still 1R.

By translating each trade into R terms, you open yourself to a new state of mind and your ability to manage positions becomes far more effective.

Position Sizing Magic Using R

By thinking in terms of R and calculating it with each trade, you can quickly and easily define risk for each trade. Furthermore, you will realize that despite trading roughly the same amount each time, your trades have been terribly inconsistent.

Let me explain.

Let’s assume you put roughly the same amount of money in each trade. For these examples, we will use $10,000 to keep things simple.

As an example, Apple (AAPL) trading at $467.68, which would buy us a nice even 20 shares with our $10k. If we determine our stop to be $460, our total risk would be $153.60 (20 shares x $7.68). $7.68 is our initial 1R.

At the same time, we also determine Netflix (NFLX) to be a strong buy candidate, which is trading at $302 even. Trading the same $10,000, we can buy an even 30 shares (avoid odd sizes, ie 43 or 67, whenever possible). Let’s say we feel $300 is key support, so we set our stop at $299, thus our total risk is $90 (30 shares x $3). $3 is our initial 1R.

This is where it gets interesting.

Let’s say both stocks run 5% higher and we sell to lock in a profit. Our Apple trade would yield us $467.68 in profit (20 x $23.38), and our Netflix trade would return us $453 (30 * $15.1) in profit.

$467.68 (AAPL) and $453 (NFLX), both roughly 5% profits off each initial $10,000 investment. Great right? No problems here.

Wrong.

The difference is that with Apple we risked $153.60 to make $467.68, so using R our return is +3R, whereas with Netflix, since we took less risk ($90), our return is actually +5R. A huge difference of 60%+!

Now imagine making 100s of trades over xx years without using R vs using R. You can quickly figure out that your returns would differ dramatically.

By defining risk using R, a completely different story is told under the surface. Not only can you manage positions equally (risking the same amount $ on each trade), but you can tweak your strategies to focus on higher Risk / Reward trades moving forward.

“R” is a Tool to Limit Risk

Many, many, many successful traders over the years talk about limiting risk as one of the critical keys to long term success with day trading:

“At the end of the day, the most important thing is how good you are at risk control. Ninety-percent of any great trader is going to be the risk control.” – Paul Tudor Jones

“The elements of good trading are: 1. Cutting losses, 2. Cutting losses, and 3. Cutting losses. If you can follow these three rules, you may have a chance.” – Ed Seykota

“The golden rule of trading is to keep losses at a level of 1 R as often as possible and to make profits that are high-R multiples.” Van Tharp

By defining R with each trade, you have the power to quickly determine not only what your R value is for winners, but also losers.

Look at your losers and see if you have ever lost more than -1R (your original risk). More than likely you have. The question is how much more and why.

It is common to experience slippage and have orders executed lower than the preset stop. This is especially true for those trading larger position sizes. So, a -1.1R might be common. But, if you are seeing -2R, -3R, or heaven forbid -4R losses or more, you have identified a serious flaw in your trading. You can’t cut your losses!

Create a new column in your excel sheet Trader Worksheet right next to your % return column so you can see the R result to quickly analyze past R values. Then, average them together to determine your average R.

It is inevitable that you will have losses over -1R or less than -1R. But they should never average out to anything below -1R. If they do, you have one big hole in your trading, which is a good thing, because it means you have room for improvement.

Just like the most successful day traders of our time, you too can cut your losses short, and by using R, you can quickly determine how well your efforts have panned out. Do it!

Determining Strategy Success Using “R”

The last piece of calculating R is determining the overall success or failure of any given trading strategy.

With all your trades logged away and organized by strategy, you can quickly determine the real results. Take all your R returns, sum them up, and you will have your net R return for that given strategy or group of trades.

If it is positive, congratulations. If it is negative, congratulations as well, you have an opportunity to make a change right now today and improve as a day trader.

Whether you are a day trader or a long-term investor, the end goal is always the same: return maximum R in the shortest amount of time.

You might think that your long-term strategy that yields a 100% return, a +10R winner, is your best. However, if each +10R winner takes you on average 3 three years to achieve, you may find that your shorter term trading strategy which yields one +30%, +3R winner every 6 months is more successful and a better place to focus your energy.

Remember, the R $ dollar value is ultimately irrelevant once it is equalized for each trade. If your R is $100 for every trade you make, then you can use R to quickly calculate success. +30R over 20 trades means a +$3,000 return, and so on.

Day Trading is about long term sustainability. Learning to always calculate and think in terms of R is a great step towards getting there.

Conclusion

In conclusion, “R” can be broken down as follows:

  • R is total $ risk. If you buy 100 shares of a $100 stock and your stop is $99, then your initial risk is $100 (100 shares x $1) and 1R equals $1 ($100 purchase – $99 stop).
  • By calculating R for each trade, you will learn that the total $ amount invested in each trade does not matter, it is total amount $ risked (initial R) that matters.
  • No two trades are equal unless they have the same initial R value. A +$500, +5% profit as a +5R return is far better than a +$500, +5% profit as a +1R return simply because there was far less risk required to achieve the result.
  • To determine success of a strategy or group of trades, determine the net R for each trade then sum them together. Average your losers together to ensure you are always cutting losses short.
  • Using R is one big key towards long term sustainable, successful day trading.

Still interested in understanding more when it comes to successful day trading defining risk as “R”? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to becoming a consistently profitable trader! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Keep an Eye on Inflation

In October 1968, with the United States fighting wars against poverty at home and perceived communist threats abroad, the S&P 500 Index climbed on the back of an overheated economy to record highs in both real and nominal terms. The boom times were not to last. Adjusted for inflation, stocks would not return to their late 1968 levels until mid-1992 (chart data). In nominal terms, full recovery took about seven years from a January 1973 peak.

I offer this cautionary tale by way of explaining why recent decades have differed so dramatically for equity market investors from those generally unprofitable years a generation or two ago. Unlike current conditions, what characterized the period beginning in the late 1960’s were cost of living increases that compelled President Richard Nixon to impose wage and price controls and the Federal Reserve to raise interest rates to levels that today would seem unfathomable.

At the vanguard of the Fed’s anti-inflation effort was the late Paul Volcker, the central bank’s chairman from 1979-1987. Volcker allowed benchmark rates to reach nearly 20%, but his tough love approach to price stability is widely credited with subduing inflationary expectations and thus sowing the seeds for the long economic expansions and bull markets to follow.

So, while recessions are the most obvious and direct causes of severe market declines, it’s rising inflation that triggers economic downturns by motivating the Fed to take away the monetary punchbowl. Of course, recessions cause corporate profits to fall as well, but earnings are only half the story. The other half concerns the impact of rates on valuations.

Historically, the equity market’s price-earnings ratio has moved inversely to bond yields as money flowed out of stocks and into higher-yielding assets. Viewed another way, the equity market’s earnings yield – its P/E ratio expressed as a percent – closely tracked the yield on Treasury bonds. (A P/E ratio of 20 equals an earning yield of 5%, or 1.00/20=0.05)

Which brings our story to the outlook for stocks in the months ahead.

Among the enduring mysteries of what’s become the longest expansion on record is the breakdown in the relationship between unemployment and inflation, also known as the Phillips Curve. In the past, tight labor markets have fueled fast-rising wages and benefits, which in turn fed through to consumer prices and finally to higher interest rates. This time, not so much. Despite the lowest jobless rate since the boom days of the late 1960’s, inflation has consistently undershot the Fed’s 2% target, as measured by the central bank’s preferred metric, the Core Personal Consumption Expenditures Price Index. That’s allowed rates to stay low by historical standards, thus extending the bull market in stocks.

Some economists believe the recent failure of the Phillips Curve to explain inflation can be attributed to a changed definition of full employment while others think a myriad of complex global factors are at work.

Conclusion

What matters most for investors, however, is that inflation expectations remain anchored and that core inflation stays at or below the Fed’s 2% target. Until that changes, we aren’t likely to find the Fed’s fingerprints on whatever weapon eventually brings about the demise of the longest bull market in U.S. history.

Still interested in understanding more when it comes to inflation? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to what’s ahead for stocks and inflation! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Bonus websites of interest…