The secret to successful stock picking

While most investors lost money on Facebook’s initial public offering John Schwinghamer came out ahead. “I had bets in the office on where Facebook would trade,” he says with a laugh. Some of his colleagues, all seasoned brokers, expected the tech stock to trade at $60; Schwinghamer picked $38. “I won $20.”

Given the way Facebook has traded most investors would have been better off sticking to office pools instead of buying into the IPO. Still, Schwinghamer, a portfolio manager with ScotiaMcLeod and author of Purple Chips: Winning in the Stock Market with the Very Best of the Blue Chip Stocks, isn’t surprised that both institutional and retail investors got caught up in the Facebook hype. “Investing is all about discipline but people make the same mistakes over and over,” he says. “They get caught up in the excitement even though it doesn’t make sense.”

The Facebook fiasco is just another example of how little people know about stock picking. Many investors will buy a company simply because a friend told them to; they rarely take the time to look at the underlying fundamentals to see, if in fact, the businesses is in good shape.

Stock picking takes time and a lot of due diligence. There are many metrics that you can, and should, look at, but here are three of the most important things to consider when looking for a good buy.

PEG Ratio

Schwinghamer likes to look at a company’s price-to-earnings growth ratio because it helps him determine whether a company is undervalued or over priced. A PEG that’s below one means the business is below value. Looking at price-to-earnings ratio alone, which many people do, isn’t enough, he says. You need to make sure that the company’s earnings are growing.

Typically the higher the P/E the more expensive the company; Facebook had a P/E above 100 before it listed on the Nasdaq. Still, high growth startups like the social network typically have higher P/E ratios because investors will pay more if they think the company’s earnings will grow dramatically in the future. If that growth materializes then the stock price should soar, of course the opposite is true if something goes awry.

Low P/E companies typically grow their earnings at a slower rate. People know what to expect so it’s easier to put a value on it.

The one way to figure out if a company like Facebook is properly valued is by determining future earnings growth. If you think the business’ earnings will grow by 100% a year, and it’s trading a 100 times earnings, then the PEG ratio would be 1. That means the company is fairly priced, says Schwinghamer.

In the case of Facebook its growth rate in the first quarter was 45%, although that was down from 55% the quarter before.

Earnings record

Determining the growth rate, especially for a new, unproven company like Facebook, is difficult. For that reason, Schwinghamer only invests in businesses that have an earnings track record. If a company has consistently grown 20% a year, every year, for five years, then it would be reasonable to expect that the growth to continue, he says.

Eric Kirzner, a professor of finance at the Rotman School of Management at the University of Toronto, says that while earnings growth is significant, it’s also important to strip out positive and negative non-recurring revenue, such the sale of an asset or having to pay penalties in a lawsuit. An unusual one time charge or windfall could affect earnings numbers, he says.

In addition to figuring out earnings per share you also need to determine the discount rate, which is an interest rate that helps determine the current value of future cash flows. It’s all very subjective, says Kirzner, but if you say a company is worth $5 of earnings per share and has a discount rate of 10%, then the value of the company’s shares should be $50.

Predictability

If you don’t have the time to work out a discount rate or project earnings growth there is still one fairly easy way to find a good stock, says Schwinghamer: own companies that have smooth and predictable growth in earnings. Look at the growth in a company’s earnings per share over the last 20 years and plot it on a chart. If the line goes up, then you have a winner, he says.

There aren’t a lot of companies with that type of growth trajectory, but many of the ones that do are household names, like Johnson & Johnson, McDonalds and Shoppers Drug Mart. Schwinghamer identifies 10 Canadian companies that follow this steady growth path. In the past five years, which has been a particularly turbulent time for equities, these companies have outperformed the S&P/TSX Composite. But it’s worth noting that these companies often lag when volatility drops and investors are willing to take on more risk.

These types of companies also typically pay dividends, have high cash flow and low debt. “Predictable businesses are often the ones in the best financial state,” he explains.

If Facebook investors took the time to consider these three things then maybe more people would have taken a pass on the IPO. So will we learn from this debacle? Probably not, says Kirzner, who prefers investing in ETFs or mutual funds. “People want easy and fast money,” he says. “It’s about greed.”