My Computer Ninja

Welcome to another edition of “Stock Picking 101” at mycomputerninja.com. My second lesson in the series is going to cover a stock picking method that helps in selecting small market capitalization stocks. As I mentioned in Lesson 1, these stock picking methods can be found as a part of the set of preset screens in the free yahoo.com stock screener application.

The aim of this series of lessons is to give speculators some interesting criteria with which to find new stocks, hopefully before everyone else finds them. Not only will I provide the criteria for picking the stocks, but I will also explain why these methods may or may not work.

The Criteria for picking a small market capitalization stock are as follows:

• Market capitalization between $250 million and $1 billion dollars
• Price to earnings ratio of less than or equal to 10
• Quick ratio greater than or equal to 1.0

The first criteria, market capitalization, is defined by Wikipedia as “A measurement of corporate or economic size equal to the stock price times the number of shares outstanding of a public company. ” Market capitalization is easy to calculate by hand, and in most cases, is provided for you as part of a summary of the stock. Market capitalization numbers contain information on the overall worth of the company in investors eyes. This provides a number with which analysts could value the company. An interesting way to explain it is to look at Google’s market capitalization, currently hovering around $162 billion dollars. Not a small cap stock, but its interesting to see. You can ask yourself, “is search, and the advertising Google does with search, worth $162 Billion dollars.” Of course, this is a very subjective question, and I leave it to you to decide.

The second criteria, price to earnings ratio, is again defined by Wikipedia as “a measure of the price paid for a share relative to the income or profit earned by the firm per share. ” Price to earnings, or P/E is calculated by taking the price per share and dividing it by the earnings per share of the stock. Effectively, this calculation defines how many dollars you have to spend to receive $1 in profit. It is easy to see why a lower P/E is more attractive. A stock with a P/E of 20 means you have to spend $20 to realize $1 in income, or that it will take 20 years to earn back your original investment. It is not so easily cut and dried, as the P/E is generally a trailing ratio, and as we all know, “Past performance is no indication of future returns”. There are criteria to define a “Forward P/E”, which use estimates of future earnings, but these can be wildly inaccurate and subject to manipulation.

The last criteria to discuss in using these criteria is the “quick ratio”. Once again, I return to Wikipedia for a concise definition. “Quick ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish its current liabilities.” Effectively, this criteria defines if a company has enough cash on hand to extinguish all of its outstanding debt. This criteria is set at 1.0 or greater because at lower than 1, a company would have difficulty paying back its outstanding debt with liquid assets. This criteria can be calculated by finding a number representing current assets, and dividing it by current liabilities. Using my favorite whipping boy, Google, a quick run through the Yahoo Stock Screener reveals a quick ratio of 10.693. This is good, because it means that Google has plenty of extra cash on hand.

With that, I conclude Lesson #2 on picking stocks. Stay tuned, Lesson #3 is coming up soon.

The admin of this site and writer of this post, Jon Steege, is not a financial analyst or a stock broker. He is a Computer Scientist with a knack for data analysis. He does not own Google stock, and does not make any recommendation as to the stability, or lack there of, of any stock mentioned. Buy smart, but buy at your own risk.

See other posts in this series by visiting the investing section on mycomputerninja.com

Over the next few weeks, I will be doing a series on how to pick stocks. This is not a lesson on how to throw darts at newspaper; on the contrary, it is about paying attention to the data, and filtering it to find stocks you (and others!) may not have seen before. Many casual speculators do not use hard data to make their stock choices, much to their detriment. A lot of investors fall prey to word of mouth or stocks that end up as media darlings because of their amazing gains in the past. This causes people to be reactive instead of proactive to possible opportunity. In this series, I will be going over different criteria that can be entered into a stock screener to filter out potential winners. I will then describe the criteria as best I can, so as to explain why the technique demonstrated in the lesson may (or may not) work. All of the stock picking techniques I will be going over can be found the the free Yahoo stock screener as built in screens, so for those of you keen to do your own research in to picking criteria, take a look at the built in screens in the Yahoo stock screener.

Our first stock picking technique attempts to find stocks that represent the ability for “Strong Forecasted Growth”. The criteria for these stocks is that top analysts and money managers predict earnings growth of 50% for the next year, as well as 30% earnings growth for the next 5 years. These criterion describe a stock that a well educated financial person or institution doing analysis on the stock projects that a company will somehow manage to grow earnings at this pretty high rate, and maintain a large portion of that growth for 5 years. This particular method is well suited to finding those “diamond in the rough” stocks, but it is obviously not fool proof. As a last criteria, you may enter a maximum price for such a stock. Total stock price should not be a deterrent, as Warren Buffet’s Berkshire Hathaway class A stock shows great returns year over year, but lets face it, not all of us can afford a single share of a $110,000 stock, or even a single share of a $550 share of Google. The last price criteria is my own addition, so as to keep our heads out of the clouds.

The problem with this method is that these earnings numbers are not derived from anything more than projections from the company and in some cases, an educated investor’s analysis of the company. Clearly the danger is there for inflated earnings growth numbers, so the educated speculator must pick up the slack when weeding out candidates from within the pool of stocks that fit the criteria. Background information is needed before you can make an educated pick.

To pick a stock, the last step you should always do before buying is to read up on that company. See who leads the company. Take a look at previous news stories involving that company. Take a look at the major downturns (if any!) in the stock’s historical price and read up on what caused those downturns. Ask yourself if you are familiar with the company or what it does. A company could tout great earnings projections, but if the product they will be makeing that money from looks like a red herring (or a musical fish wall clock), you may want to think twice before investing.

In this game, it is extremely important to know that stock speculation should be done with money that you can afford to lose. Despite my attempt at educating on how to avert loss, it invariably happens to all of us from time to time. Remember to diversify, and that one of the safest places to invest your money is in an Index Fund, or a savings account if you like.

The admin of this site and writer of this post, Jon Steege, is not a financial analyst or a stock broker. He is a Computer Scientist with a knack for data analysis. He does not own Berkshire Hathaway or Google stock, and does not make any recommendation as to the stability, or lack there of, of any stock mentioned. Buy smart, but buy at your own risk.

See other posts in this series by visiting the investing section on mycomputerninja.com