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Author: Larry01Gott Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 3431  
Subject: How I select my stocks Date: 8/13/2003 12:28 AM
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The question one should always ask regularly is this, “Is my hard-earned money in the very best possible place that it can be?”

Here's my story, unpublished until now (except on the Quality Systems board), about how my money came to be where it is (as seen a few posts ago):

In the early 80's, I was a stockbroker who wanted to be a stock analyst. The firm wanted me to peddle their new-issue stocks door-to-door, but I wanted to analyze stocks -- those that already had a track record. We parted over a difference in philosophies. Soon afterwards, in 1985, I built my first spreadsheet analyzer of stocks. (call it ver 1.0).

By early 1999, I was monitoring 240 stocks using 45 different criteria, and spent eight months back-testing my results, still refining and eliminating many highly-touted factors as virtually worthless, and ranking and weighting those that had relevance.
I wanting my personal stocks to have both 1) excellent market appreciation potential for market updrafts, and 2) as much safety as possible for market downdrafts.

And now, having seen both the highs and lows of the market, I have full confidence in my system to use it for my own investing (call it ver 6.0). As a rule, the stocks that I have the largest position in are generally the stocks with the highest numerical rating in my system.

Here are the 15 factors I use to grade and rank stocks, but the factors are not shown in order of importance. After this list, I will give guidelines for their relative importance.

*Sales momentum – last 10 quarters
*Earnings momentum – last 10 quarters
*Profit Margin momentum – last 10 quarters
*Profit Margin %age
*Operating Margin %age (aka Oper Income)
*ROE (Return on Equity)
*Current Ratio (Curr Assets vs Curr Liabilities)
*Sales R.O.G. (growth rate), Next Qtr estimate and Curr Qtr actual
*Earnings R.O.G., Next Qtr estimate and Curr Qtr actual
*P/E Ratio, Next Qtr estimate
*PEG (PE/Growth rate), Next Qtr estimate
*Price/Sales Ratio, Next Qtr estimate
*Volatility/consistency/predictability of Sales and Earnings (not of stock price)
*Free Cash Flow margin
*Equity/Liability ratio

Noticeably absent are 1) beta; 2) Foolish Flow; 3) anything having to do with stock price – past, present, or future; 4) any attempt to numerically represent technical analysis (although I may use T.A. sparingly outside the ranking system).

There are four broad classes of criteria, or factors:
1. Rate of Growth factors
2. Momentum factors (a way of measuring consistency and stability of growth)
3. Valuation factors (looking for potentially undervalued stocks)
4. Financial factors (looking for safe stocks in the financial reports)

I have listed these broad classes in order of importance,
and my credo is:

“Look for fast-growing stocks, with consistent and stable growth, at the lowest possible price, with good financials.”


There are some major presuppositions in these statements:
A. The best financials in the world will not help a slow-growing company.
example: a fast-growing company with no free cash flow (FCF) will beat a company with great FCF but no growth.
B. In the long run, the R.O.G. of fast-growing companies acts BOTH as a price appreciation factor, and as a safety factor.
C. Using OPM (other people's money) is very late-90's'ish. That's why so many of the high-flyers are mired in deep trouble. Using IMW (incoming money wisely) is very 00's'ish, and most of the high-flyers now have that philosophy.
example: Foolish Flow is a 90's philosophy, and is counterintuitive to having safe financials. High Foolish Flow = potential danger ahead.
D. And based on C, Receivables are now better than Payables, and Receivables are better than Inventory. (To put it very simply in the terms of this decade, “Would you rather owe, or be owed?”)
E. The ROG of revenues is somewhat more important than the ROG of earnings – but the ROG of earnings should be the higher %age of the two.
(Why is the revenue R.O.G. more important than the earnings R.O.G. ??!)
Because future earnings growth comes from one place only -- future revenue growth. You show me a company that has stopped increasing revenue, and I'll show you a company that will stop having earnings growth within a year, if not immediately.


So, in order of priority,
1. Growth rate of Revenues.
2. Growth rate of Earnings.
3. Momentum of revenues and earnings.

Example: I monitor 60 fast-growing companies on a spreadsheet using the very factors listed here. But only nine of them have had increased revenues and earnings in every one of the last 10 quarters: NTES, JCOM, MRVL, ERES, ANSI, ARTI, PKTR, SINA, & SOHU. (although a few others missed only one quarter)
4. Momentum of profit margin percentage.
Only 4 of my 60 companies have increased their profit margin percentage in every one of the last 10 quarters: MRVL, ERES, SINA, and SOHU.
Just for example, ERES (eResearch Tech)'s growth of profit margin looks like this quarter-by-quarter (beginning in 6/30/01 and ending with my 9/30/03 estimate:
1.43%=>4.11%=>6.41%=>8.43%=>11.88%=>12.84%=>14.88%=>18.38%=> 18.92%=>20.00%(est next qtr)) WOW! What a record!
And notice: the four companies here are on both lists!

5. Potentially undervalued, as indicated in PE, PEG, and Price/Sales ratios
6. Financially sound, as shown in margins, current ratio, ROE, FCF etc. (although as Fool writers have pointed out, it's not easy to have a high FCF when you're growing at 80% a year)
Disclosure: long in all mentioned except PKTR (Packeteer).

That's about it for now.

If you are interested in printing this, remember the “Format for Printing” icon right below here. That makes it look much cleaner with no ads.

Best wishes to all you investors, and I hope this helps.
Lets discuss anything that you question or need more info on.
Larry
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