Empowered Investor

Glossary of Financial Terms

Introduction

This is an efficient, practical and complete system of instructions for successful, small-cap, growth investing. I provide a step-by-step recipe for stock selection, including criteria for buying and selling.

The question you may ask is - "Why would I take this burden of selecting the stocks, or make difficult decisions about buying and selling, myself, when I can rely upon my broker and the analysts?" The answer is - analysts are "dead wrong" most of the time. The failure of the analysts' recommendations is shown in the following Table.

Making the Primary List

It is a good idea to do a search with some broad criteria to identify about 25 companies. Whenever you are planning on adding new stocks to your portfolio, you should go through this procedure. Prepare a short list based on the following criteria (screens). Buy stocks only from this list. If you don't find a stock from this list, don't feel compelled to buy; wait for a few weeks to a month and update your list.

1st Set of Screens for Preparing Short List

The first six conditions can be employed in the Power-Screener software at Reuter's Investor. The use "Power-Screener" you need to go through the free registration process, the first time you enter. You will have your user-ID and "password" for future access of the screener.

What is "X" in the following conditions? You should select "X" between 15 and 25. In bear markets, 15 is reasonable; 25 in bull market. Select a value of "X" such that you get between 75 and 100 companies after the 1st set of screens.

• Companies can boost profit growth for a few quarters without increasing sales by laying off workers or selling off divisions. But after that is over, profits often stall. No business can generate superior earnings growth over the long term without sales growth. While picking the winners in the market, we look for companies with outstanding long-term and short-term sales growth rates. The resulting criteria are:
  • Sales Growth Rate over the last 5-years must be greater than X%.
  • Sales Growth Rate (TTM) must be greater than X%.
• Profits separate the winners from the short-term sparklers. We look for companies with outstanding long-term and short-term EPS growth rates. The resulting criteria are:
  • EPS Growth Rate over the last 5-years must be greater than X%.
  • EPS Growth Rate (TTM) must be greater than X%.
• The Profit Margin is a measure of how much a company is making for every dollar of sales. In a free-market economy, with competition, a company with high profit margin is winning over its competition. The criterion is:
  • Profit Margin must be greater than 7%.
• ROE is the return on the book value of all the shares of a company. The ROE measures how efficiently the management is using shareholders equity. The criterion on ROE is:
  • Return on Equity must be greater than 15%.
• Liquidity of a stock is the measure of how easily the shares of a company could be sold in the open market. Stocks with low average daily volume has low liquidity. We consider a stock to be fairly liquid if its average daily volume is 25,000 or more. The criterion is:
  • Monthly Average Volume must be greater than 0.5 million.
• You want the management of your company to do their best and the management should have confidence in the company's future. Management's confidence is demonstrated through insider holdings. Among all the stocks with one million shares outstanding and that were priced $12 or higher, 102 stocks at least doubled in price in the year 2000. On the average, 18% of their shares were held by the management (see IBD, 20 May 2001). The criterion we use is:
  • Insider Holdings must be greater than 15%.

After you have inserted these six criteria, the screener table should appear as the following diagram.

2nd Set of Screens for Preparing Short List

To apply the second set of screens, you need to collect some data from the Yahoo-Finance web-page.

In this web-page, enter the ticker symbol and click "Go".

In the stock data page, you will find a side-bar, on the left hand side, with numerous links. Click "Income Statement", "Balance Sheet", and "Key Statistics" for navigation and collect the following data.

Income Statement Data

• Total revenue from current quarter, one quarter ago, and two quarters ago.

Balance Sheet Data

• The net receivables from current quarter, one quarter ago, two quarters ago.
• The inventory from current quarter, one quarter ago, and two quarters ago.
• The long-term (LT) debt from current quarter, one quarter ago, and two quarters ago.
• The total stockholders equity from current quarter, one quarter ago, and two quarters ago.

Key Statistics Data

• The current ratio.

Enter these data in the following calculator. You will get a ranking of your stock as excellent/good/marginal/poor.

The ranking of your stock is obtained by using the following criteria.

• You want your company's accounts receivable to be low. High accounts receivable can mean two things. Firstly, the company's products are sitting on the distributor's shelves. Secondly, the company is finding it difficult to sell its products and thus it is allowing generous terms of payment in installments. The criterion is: Receivables Turnover must be less than 30 days and from one quarter to the next, the receivables should be declining.
• You do not want your company to carry a lot of inventory. Your company should be able to sell its products quickly. The criterion is: The company should be able to sell all of its inventory in less than 15 days and from one quarter to the next, the inventory should be declining.
• You want your company to fund its growth and research from its cash reserve. Too much borrowing means that today's successes are weakening the future when these loans have to be paid back. We do not want the long-term debt to increase at a rate faster than the growth in shareholders' equity. The criterion is: the ratio (LT Debt/Equity) should have a downward trend.
• You want your company to have cash and assets convertible to cash to pay the bills that are due in a short period of time. The criterion is: Current Ratio must be greater than 1.

On October 26, 2006, four companies passed the two sets of screens. The tickers are: FRGB, FCFS, HANS, WIBC.

Here we calculate the fair price of the stock that has passed all the tests in the first two sets of screens. The questions you naturally ask are: "How is the upside potential of the stock price?" "How much could the gain be if I buy this stock now?"

We estimate a target price of the stock from an estimate of its future PE ratio. This estimate of PE is dependent upon the following factors.

• Earnings growth rate - higher growth rate justifies higher future PE.
• PE of the industry the company belongs to.
• The rate of inflation - higher rate of inflation results in a lower future PE
• The rate of return from a risk-free investment (fed-funds rate) - higher fed-funds rate results in lower future PE.
• Stocks current PE and its comparison with the historical average of the market PE.

After we obtain an estimate of future PE, we multiply that by the future earnings estimate to obtain the target price.

You will find these data in the Yahoo Finance page.

• The target price gives an estimate of the price one year from now. To help you make a better decision, the calculator also tells you whether the growthrate is accelerating or decelerating (based on currently available data).
• The difference between the target and present prices is an estimate of the gain, if the company matches the estimated earnings.
• You must recalculate the target price periodically as analysts often update the earnings estimates.

The Watch List

After applying the two sets of screens and the valuation test, you will have your final watch list. Now, you have tested the soundness of your company through a set of fundamental variables. These variables relate to your company's product, demand of the products in the market place, how efficiently the company is managing its finances, etc. But before you are going to make a purchase from this list, you must also analyze how the company's stock is performing at the stock exchange among the investors.

The results of target price calculation with our short list of stocks are shown in the Table below. Only the stocks with growth possibility are shown below.

At this point, you can improve your stock selection system if you consider a few secondary criteria. Your selected stocks need not absolutely satisfy these criteria. However, if they do, you will have an improved probability of price appreciation.

• Market cap is more than $30 million.
• Share price is between $25 and $50. Market's biggest winners begin their huge run from this price range.
• Institutional ownership has increased over the last three months.

There are five factors you must consider to gage the characteristics of a company. You can get this information by posting queries in the newsgroups or discussion/message boards on the internet, by studying the company web-page, or by directly calling the Investor's Relations department of the company. Another possible source is Zach's Investment Report which you will have to purchase by placing an order on the internet.

Pioneer or Follower

Check if the company has introduced new product, technology, or software in the market. Check if the company has introduced new service philosophy in its operation. You should prefer pioneers over followers.

Competitive Edge

Check if the company invests in maintaining or attaining leadership role in its business. See if it is working on innovation or resting on past accomplishments. You want strong companies that is striving to advance its role in product, service, and technology development.

Market Share

Market share is classified into three ranges: Large (more than 40%), medium (more than 25%), and small (less than 10%). You should invest in companies with large or medium market share. Avoid companies with small market share unless you have other compelling reasons.

Strategic Partnerships

Seek companies that have joint venture, technology sharing, joint advertising agreements, and parts or components supply agreements with large corporations. Isolated companies without strategic partnerships have a large probability of failure.

Management Qualification

Check if managers have appropriate expertise to head the departments of marketing, operations, finance, human resources, production, and research. Their previous experience should perfectly match their current responsibility within the cmpany.

When the media exposes the bad or good news within a company, it is actually too late for the investors to react profitably or defensively. Media information could be anywhere from three to six months old.

To obtain company information on a more timely fashion, check the company's 10-Q, 10-K, and 8-K filings at the SEC website. All companies are required to file a 10-Q within fortyfive days of the close of a quarter.

What would you find in 10-Q?

• Outlook for the next quarter or rest of the year.
• Growth rate of earnings per share.

What would you find in 10-K?

• Company's competitive advantage over its rivals.
• Company's financial, market, and product risks.

What would you find in 8-K?

• Hirings/resignations of key company executives.
• Loss/gain of major customers.
• Information on potential or on-going lawsuits.

When the Harvard MBA's of Wall Street were taken for a ride by Enron and its shenanigans, do small investors have any chance of catching the crooks that cook the books? Well, these are a few steps you can take to avoid the next company that will get caught for a bookkeeping scandal.

• Invest in companies that have low debt-to-equity ratio, compared to its competitors. A company with cash does not frequently get into trouble with the banks.
• Do not trust earnings reported on a pro-forma ( meaning "as a matter of form" ) basis. Pro-forma earnings show how the company "would have done" if they had not paid income taxes, payroll taxes, reserach and development costs, etc. In summary, pro-forma earnigs is the "earnings before the bad stuff".
• Examine the 10-k for cash-flow statement. If the statement shows that cash-flow from operations is less than the cash-flow from investment, then avoid the company.
• Read the footnotes in the 10-k statement. Companies must reveal the cost of stock options, which expenses are "one-time-charges", which expenses should be deducted from the earnings, in these footnotes.

Technical analysis pertains to the performance of the stock among the investors. This analysis deals with the price movement and volume. Numerous statistical quantities are drived and investors usually have their favorite quantities that they follow, depending on their investing style. It is very easy to get lost in the forest of technical indicators, waves, Fibonacci, and Phi. My advice is to keep technical analysis very simple. My favorites are shown and classified in the following diagram. I find these suitable for intermediate and long term investing.

Technical analysis is broadly classified into two parts - price momentum indicators and price pattern. Price pattern is further classified into reversals and continuations. These are used for buy and sell signals acording to the following list.

• Momentum indicators are used for buy and sell signals.
• Reversal price patterns are used to make buy or sell decisions.
• Continuation price patterns are used to make hold or buy decisions.

The best web-site to do technical analysis is bigcharts.com. In the figure below, the buttons and the settings in the "bigchart" page are shown.

A majority of the DMA and oscillator conditions, given below, should be satisfied. We do not eliminate any stock if it does not satisfy any of the conditions, because none of the conditions is individually very significant. When several of these conditions give the same positive indication then the price appraisal is highly probable.

DMA and Oscillators Conditions

• Price just crossed or about to cross 50 DMA in uptrend.
• RSI is between 40 and 60.
• MACD is increasing from a bottom.
• OBV has positive divergence with price or at least sloping upward.
• MFI has positive divergence with price or at least sloping upward.
• Valley below Bollinger Band followed by second valley inside the band.

The Price and Volume Patterns

• Bottoms or Bases

  The bottoms or bases must be at least eight weeks long and show a decline of 20% to 50% from the most recent high.

• In a rounding or U-bottom, volume is decreasing at the left wall, low along the base, and increasing along the right wall. A sharp increase in volume at the rim of the U indicates breakout. Quite often, a handle forms at the right end of the U-pattern. The handle is a slight drop in price with decreasing volume. Price rise at the end of the handle with sharp rise in volume indicates breakout.
• Look for spike reversal with a V-bottom. Volume is low at the left wall of the V. Peak volume is associated with the lowest point of the V. RSI is largely neutral through this formation. A sharp increase in volume at the rim of the V indicates breakout.
• Look for the double bottom pattern. Sometimes, this is called a W-bottom. When the center of the W is higher than than the tops of either side, it usually signals an ill-formed and erratic base.
• Look for triple bottom. Volume peaks at the first bottom and then tapers off after the second bottom. Volume peaks at the end of the third bottom.
• Look for inverted head and shoulders. The left shoulder and the head usually has largest volume. Volume drops at the right shoulder. Volume increases along the right side of the right shoulder. Break-out is at the end of the right shoulder accompanied by heavy volume. RSI remains flat through most of the pattern.
• Triangles
  • Symmetrical triangular pattern is bounded by two lines - one sloping down and the other sloping up. Drawing any conclusion from this pattern is highly unreliable.
  • In a converging pattern, the price is bounded by a horizontal line and an inclined line. If the inclined line is a rising trendline, then an up-side breakout is likely. If price penetrates the horizontal line with increase in volume, an up-side breakout is detected.
• Rectangles
  • the price pattern is bounded by two horizontal parallel lines. When the upper line is penetrated with increase in volume, an up-side breakout is detected.

The phrase "increase in volume" generally means that the volume is more than the 30-day average volume.

The sell criteria are divide into two groups. The first group consists of the "absolute sell conditions". Any one of the absolute sell conditions should trigger a sell signal. The second group consists of the "collective sell conditions". When you get a signal from a majority of the collective sell conditions, consider selling.

Absolute Sell Conditions

Any one of these conditions should trigger a sell.

• Drop of 10% in price from buy point.
• 50 DMA should provide a good support for your stock and the stock may bounce off the 50 DMA line and zoom higher. Although a stock may, sometimes, nudge slightly below 50 DMA, but when the stock slices through 50 DMA with heavy volume, sell the stock.
• After a run-up, if the stock falls with heaviest single-day volume in months.
• Identify trendlines. For uptrends, connect two valleys in a series. For downtrends, connect two peaks. You need two points for a tentative trend and three to confirm it. An uptrend consists of rising crests and troughs. A trend reversal is hinted at when the bottom of a price trough is lower than the bottom of the previous trough AND the top of a price crest is lower than the top of the previous crest. You can adopt the strategy of selling at the first sign of trend reversal, but this condition can be somewhat relaxed. In the relaxed condition, you can allow the price to retrace one-third of the way from the beginning of the uptrend. (Example: Stock begins uptrend at $25 and reaches $40. One-third of this $15 rise is $5. Thus, you can allow the stock to retrace $5 from $40 to $35.) If the retracement is more than one-third, then it is time to sell.
• Temporary reversal of price trend is very common. After any such temporary reversal, you should draw a new trendline. Sequence of trendlines form a fan of trendlines. Consider selling when price crosses the third trendline in a downward movement.
• Price churning is a sell signal. Churning is identified by the three following conditions - (i)above average volume, (ii)big, intra-day high low spread, (iii)closing price is in the bottom half of the price-spread. Two consecutive days of churning is a definite sell signal.
• Price rising to new highs with below average volume for a period of more than two weeks.
• Sell when price hits climax. The identification of climax is explained in the following boxed-text.

Collective Sell Conditions

When majority of the following eight conditions are satisfied, sell the stock.

• Price reached 40% above the 50 DMA.
• Price reached 120% above the 200 DMA.
• RSI peaks close to 80.
• MACD reaches a peak and begins downward slope.
• Negative divergence in OBV.
• Negative divergence in MFI.
• Price reached the "Target Price" (use the calculator available on this page).
• Peak above Bollinger Band followed by peak inside the band.

A rapid movement, up or down, in the price of your stock can push you into a panic mode. When it is moving up too rapidly, you may be worried that it is reaching a climax and you are unsure if you would sell and lock the profit. When it is falling rapidly, you may be worried that a bad news is brewing inside the company and you are unsure if you would sell to minimize the loss. In both of these situations, it is a good idea to get a feel for what the brokers and dealers of the stock are thinking.

The intention of the brokers and dealers are hidden in the Interest Messages and the Super Messages. An Interest Message is an indicator of the broker's interest to buy or sell a security. Interest Message is not binding, which means that the broker is inclined toward a buy or sell, but may not actually execute the trade. In a Super Message, the broker actually specify the price and volume they want to trade.

You can see the Super Messages and the Interest Messages at the Thomson Invest web site. Enter the ticker of your stock, select the radio-button labeled as I-Warch, and click "Go". The buy messages are shown in blue; the sell messages in red.

The Thomson Invest site also shows you buy/sell indicator arrows. The size of the indicator arrow tells you the volume of shares that the broker is advertising to trade. The position of the arrow, on the price chart, tells you the weighted average price that the broker is advertising to trade. Red arrows indicate an intention of selling; blue arrows buying.

In summary, red indicator arrows or many red Messages tell you that the market is in a selling mood for your stock.

Stop-Loss Orders

You can tell your broker to buy or sell a stock at a target price by issuing a "Stop Order". Many investors try to minimize the risk of loss by issuing a stop-loss order at a price 5% to 8% below the purchase price of the stock. Some investors try to maximize the gain by inching the stop-loss order upward as the stock price appreciates. These investors are attempting to replace the good habit of disciplined trading with an automatic process. This is a bad practice. You may use stop orders when you are on vacation or a business trip and will not be able to follow your stocks over a period of time. But do not use stop-loss as a regular practice.

Using stop-loss is equivalent to playing a card game with your hand exposed to your opponents. Market makers can see all the stop-loss orders that are existing with all the brokers and dealers. Thus, a market maker can force the price to go down to trigger your stop-loss order and buy your shares at a cheap price and consequently knocking you off the market. It is said that, if there are a lot of stop-loss orders in existence at a price, the market has a tendency to seek that price.

There are other pit-falls in stop-loss orders. If a stock gaps below your stop-loss order, your shares will be sold at a price well below what you intended. Stocks often go through retracements as large as 10% to 25% during an uptrend. A stop-loss order kicks you out of the stock at the low point of the retracement and you miss the chance of truly big gains.

Hedging with Put Options

Stock prices do not go straight up, but oscillate around an upward sloping trendline. Sometimes, prices retrace and tumble by as much as 25%, before resuming the uptrend. Many investors buy option puts to protect themselves from losses during the downward correction of stock prices. This strategy is utterly flawed.

Before we state the flaw in this strategy, let us briefly define what option puts are. Buying put options is buying the right to sell a stock at a pre-determined price called the striking price. If the stock declines to a price below the strike, then the investor buys the stock in the open market at a lower price and sells at the higher striking price.

Buying a stock and buying option puts for the same stock is like mixing oil and water. You are buying the stock with the hope that it will appreciate and you are buying the puts hoping that it would depreciate. Some investors do mix oil and water and call it hedging. This is how their logic works. If the stock depreciates, the loss in the stock price is somewhat reduced when the option put is exercised. Thus, buying puts is a loss reduction technique. However, you do not need another loss reduction technique, because you already had one - "sell a declining stock so that your loss is never more than 10%".

On the other hand, if your stock really appreciates, you will make money in trading the stock, but at the same time you will lose money in exercising the option put. Thus, holding the put option effectively reduces your gain

Hedging with option puts is a two-edged sword that will hurt you - (i) it gives you false security which you do not need, because you already have a disciplined sell strategy; (ii) it cuts into your gains from appreciating stocks.

Buy and Hold Strategy

Starting in 1995 with "The warren Buffett Way: Investment Strategies of the World's Greatest Investor", many popular books worshipped the "buy and hold" strategy. The Genius from Omaha recommends buying large chunks of "high quality stocks" and holding them for a long long period of time and rope in outstanding return. A word of wisdom indeed. However, only a few have the ability to identify "high quality stcks". Most investors, ruled by the emotions of hope and greed, end up hoarding under-performing stocks.

Often, investors refuse to admit their incorrect buy decisions and remain attached to the losers. Why not get guided by a stock's current price, company's quarterly reports, revenue growth rate, earnings growth rate, and the perception of the company among other investors? Instead of relying upon poorly conceived expectations.

Investors should develop good "buy and sell rules" and should not just "buy and hold".

Here, I take the bold step of putting my money where my advice is. In the previous paragraphs, I have outlined a system for investing in stocks. I follow this system in buying and selling of stocks for my own portfolio.

Performance Compared to Russell 2000