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Chuck Hughes - Stock Selection (The Fail Safe Financial Program pgs. 155-158)


Stock Selection

This is dedicated to people who want to invest in individual stocks. I wants to share with you the methods I have used over the years to select stocks which i have discovered to be consistently profitable in actual trading. I like to use a mixture of fundamental and technical analysis for selecting stocks. My experience has shown that successful stock selection involves two steps:

1.    Select a regular using the fundamental analysis presented then
2.    Confirm that the stock is an uptrend as shown by the 50-Day Exponential Moving Average Line (EMA) being above the 100-Day EMA

This two-step process boosts the odds that the stock you select is going to be profitable. It offers a signal to sell a regular that has not performed not surprisingly if it�s 50-Day EMA drops below its 100-Day EMA. It is another useful method for selecting stocks for covered call writing, a different type of strategy.

Fundamental Analysis

Fundamental analysis is the study of financial data such as earnings, dividends and cash flow, which influence the pricing of securities. I use fundamental analysis to help select securities for future price appreciation. Over the years I have tried personally many methods for measuring a company�s rate of growth so that they can predict its stock�s future price performance. I used methods such as earnings growth and return on equity. I have discovered these methods aren't always reliable or predictive.

Earning Growth
For instance, corporate net earnings are susceptible to vague bookkeeping practices for example depreciation, cash flow, inventory adjustment and reserves. These are all subject to interpretation by accountants. Today more than ever before, corporations they are under increasing pressure to beat analyst�s earnings estimates which leads to more aggressive accounting interpretations. Some corporations take special �one time� write-offs on their own balance sheet for such things as failed mergers or acquisitions, restructuring, unprofitable divisions, failed product, etc. Many times these write-offs are not reflected as a drag on earnings growth but rather appear as a footnote on the financial report. These �one time� write-offs occur with increased frequency than you may expect. Many companies that make up the Dow Jones Industrial Average took such write-offs.
Return on Equity
One other popular indicator, which I have found is not necessarily predictive of stock price appreciation, is return on equity (ROE). Conventional wisdom correlates a higher return on equity with successful corporate management that is maximizing shareholder value (the larger the ROE the better).

Which company is much more successful?
Coca-Cola (KO) having a Return on Equity of 46% or
Merrill Lynch (MER) with a Return on Equity of 18%

The answer is Merrill Lynch by any measure. But Coca-Cola has a much higher ROE. How is that this possible?

Return on equity is calculated by dividing a company�s net gain by stockholder�s equity. Coca-Cola is really over valued that it is stockholder�s equity is only comparable to about 5% from the total market value from the company. The stockholder equity is so small that almost any amount of net gain will create a favorable ROE.

Merrill Lynch on the other hand, has stockholder�s equity comparable to 42% from the market value of the company and needs a greater net gain figure to make a comparable ROE. My point is the fact that ROE does not compare apples to apples so therefore isn't a good relative indicator in comparing company performance.

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