Guide To Stock Picking Strategies: Personal Finance Stock Market

Guide to Stock Picking
Strategies
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Table of Contents
1) Introduction
2) Fundamental Analysis (Quantitative Factors)
3) Qualitative Analysis
4) Value Investing
5) Growth Investing
6) GARP Investing
7) Income Investing
8) CANSLIM
9) Dogs of the Dow
10) Technical Analysis
11) Conclusion and Resources
Introduction
When it comes to personal finance and the accumulation of wealth, few subjects are
more talked about than stocks. It's easy to understand why: the stock market is
thrilling. But on this financial rollercoaster ride, we all want to experience the ups
without the downs.
In this tutorial, we examine some of the most popular strategies for finding good
stocks (or at least avoiding bad ones). In other words, we'll explore the art of stock
picking--selecting stocks based on a certain set of criteria, with the aim of achieving
a rate of return that is greater than the market's overall average.
Before exploring the vast world of stock picking methodologies, we should address a
few misconceptions. Many investors new to the stock-picking scene believe that
there is some infallible strategy that, once followed, will guarantee success. There is
no foolproof system for picking stocks! If you are reading this tutorial in search of a
magic key to unlock instant wealth, we're sorry, but we know of no such key.
This doesn't mean you can't expand your wealth through the stock market. It's just
better to think of stock picking as an art rather than a science. There are a few
reasons for this:
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1. So many factors affect a company's health that it is nearly impossible to

construct a formula that will predict success. It is one thing to assemble data
that you can work with, but quite another to determine which numbers are
relevant.
2. A lot of information is intangible and cannot be measured. The quantifiable

aspects of a company, such as profits, are easy enough to find. But how do
you measure the qualitative factors, such as the company's staff, its
competitive advantages, its reputation, and so on? This combination of
tangible and intangible aspects makes picking stocks a highly subjective, even
intuitive process.
3. Because of the human (often irrational) element inherent in the forces that
move the stock market, stocks do not always do what you anticipate they'll
do. Emotions can change quickly and unpredictably. And unfortunately, when
confidence turns into fear, the stock market can be a dangerous place.
The bottom line is that there is no one way to pick stocks. Better to think of every
stock strategy as nothing more than an application of a theory--a "best guess" of
how to invest. And sometimes two seemingly opposed theories can be successful at
the same time. Perhaps just as important as considering theory, is determining how
well an investment strategy fits your personal outlook, time frame, risk tolerance,
and the amount of time you want to devote to investing and picking stocks.
At this point, you may be asking yourself why stock picking is so important. Why
worry so much about it? Why spend hours doing it? The answer is simple: wealth. If
you become a good stock picker, you can increase your personal wealth
exponentially. Take Microsoft, for example. Had you invested in Bill Gates' brainchild
at its IPO back in 1986 and simply held that investment, your return would have
been somewhere in the neighborhood of 35,000% by spring of 2004. In other words,
over 18 years, a $10,000 investment would have turned itself into a cool $3.5
million! (In fact, had you had this foresight in the bull market of the late '90s, your
return could have been even greater.) With returns like this, it's no wonder that
investors continue to hunt for "the next Microsoft."
Without further ado, let's start by delving into one of the most basic and crucial
aspects of stock picking: fundamental analysis, whose theory underlies all of the
strategies we explore in this tutorial (with the exception of the last section on
technical analysis. Although there are many differences between each strategy, they
all come down to finding the worth of a company. Keep this in mind as we move
forward.
Fundamental Analysis (Quantitative Factors)
Ever hear someone say that a company has "strong fundamentals"? The phrase is so
overused that it's become somewhat of a cliché. Any analyst can refer to a
company's fundamentals without actually saying anything meaningful. So here we
define exactly what fundamentals are, how and why they are analyzed, and why
fundamental analysis is often a great starting point to picking good companies.
This tutorial can be found at: http://www.investopedia.com/university/stockpicking/

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The Theory
Doing basic fundamental valuation is quite straightforward; all it takes is a little time
and energy. The goal of analyzing a company's fundamentals is to find a stock's
'intrinsic value', a fancy term for what you believe a stock is really worth--as
opposed to the value at which it is being traded in the marketplace. If the intrinsic
value is more than the current share price, your analysis is showing that the stock is
worth more than its price and that it makes sense to buy the stock.
Although there are many different methods of finding the intrinsic value, the premise
behind all the strategies is the same: a company is worth the sum of its discounted
cash flows. In plain English, this means that a company is worth all of its future
profits added together. And these future profits must be 'discounted' to account for
the time value of money, that is, the force by which the $1 you receive in a year's
time is worth less than $1 you receive today. (If you are new to this concept, not to
worry. Just check out the article "Understanding the Time Value of Money").
The idea behind intrinsic value equaling future profits makes sense if you think about
how a business provides value for its owner(s). If you have a small business, the
worth of that business is the money you can take from the company year after year
(not the growth of the stock). And you can take something out of the company only
if you have something left over after you pay for supplies and salaries, reinvest in
new equipment, and so on. A business is all about profits, plain old revenue minus
expenses, which is the basis of intrinsic value.
Greater Fool Theory

One of the assumptions of the discounted cash flow theory is that people are
rational, that nobody would buy a business for more than its future discounted cash
flows. Since a stock represents ownership in a company, this assumption applies to
the stock market. But why, then, do stocks exhibit such volatile movements? It
doesn't make sense for a stock's price to fluctuate so much when the intrinsic value
isn't changing by the minute.
The fact is that many people do not view stocks as a representation of discounted
cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell
the stock to somebody else for more than what you paid for it? Cynics of this
approach have labeled it the "greater fool theory," since the profit on a trade is not
determined by a company's value, but about speculating whether you can sell to
some other investor (the fool). On the other hand, a trader would say that investors
relying solely on fundamentals are leaving themselves at the mercy of the market
instead of observing its trends and tendencies.
This debate demonstrates the general difference between a technical and

fundamental investor. A follower of technical analysis is guided not by value, but by
the trends in the market often represented in charts. So, which is better:
fundamental or technical? The answer is neither. As we mentioned in the
introduction, every strategy has its own merits. In general, fundamental is thought
of as a long-term strategy, while technical is used more for short-term strategies.
(We'll talk more about technical analysis and how it works in a later section.)

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Putting Theory into Practice

The idea of discounting cash flows seems okay in theory, but implementing it in real
life is difficult. One of the most obvious challenges is determining how far into the
future we should forecast cash flows. It's hard enough to predict next year's profits,
so how can we predict the course of the next 10 years? What if a company goes out
of business? What if a company survives for hundreds of years? All of these
uncertainties and possibilities explain why there are many different models devised
for discounting cash flows, but none completely escapes the complications posed by
the uncertainty of the future.
Here we look at a sample of a model used to value a company. Because this is a

generalized example, don't worry if some details aren't clear. The purpose is to
demonstrate the bridging between theory and application. Take a look at how
valuation based on fundamentals would look:
The problem with projecting far into the future is that we have to account for the
different rates at which a company will grow as it enters different phases. To get
around this problem, this model has two parts: (1) determining the sum of the
discounted future cash flows from each of the next five years (years 1 to 5), and (2)
determining 'residual value', which is the sum of the future cash flows from the years
starting six years from now.
In this particular example, the company is assumed to grow at 15% per year for the
first five years and then 5% every year after that (year 6 and beyond). First, we add
together all the first five yearly cash flows-- each of which are discounted to year 0,
which is the present--in order to determine the present value (PV). So once the
present value of the company for the first five years is calculated, we must, in the

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second stage of the model, determine the value of the cash flows coming from the
sixth year and all the following years, when the company's growth rate is assumed to
be 5%. The cash flows from all these years are discounted back to year 5 and added
together, then discounted to year 0, and finally combined with the PV of the cash
flows from years 1 to 5 (which we calculated in the first part of the model). And
voila! We have an estimate (given our assumptions) of the intrinsic value of the
company. An estimate that is higher than the current market capitalization indicates
that the company may be a good one to buy. Below, we have gone through each
component of the model with specific notes:
1. Prior-year cash flow – The theoretical amount, or total profits, that the
shareholders could take from the company the previous year.
2. Growth rate - The rate at which owner's earnings are expected to grow for
the next five years.
3. Cash flow – The theoretical amount that shareholders would get if all the
company's earnings, or profits, were distributed to them.
4. Discount factor – The number that brings the future cash flows back to year
0. In other words, the factor used to determine the cash flows' present value
(PV).
5. Discount per year – The cash flow multiplied by the discount factor.
6. Cash flow in year 5– The amount the company could distribute to

shareholders in year 5.
7. Growth rate – The growth rate from year 6 into perpetuity.
8. Cash flow in year 6 – The amount available in year 6 to distribute to

shareholders.
9. Capitalization Rate – The discount rate (the denominator) in the formula for a
constantly growing perpetuity.
10. Value at the end of year 5 – The value of the company in five years.
11. Discount factor at the end of year 5 – The discount factor that converts the
value of the firm in year 5 into the present value.
12. PV of residual value – The present value of the firm in year 5.
So far, we've been very general on what a cash flow comprises, and unfortunately,
there is no easy way to measure it. The only natural cash flow from a public
company to its shareholders is a dividend, and the dividend discount model (DDM)
values a company based on its future dividends (read more in this article). However,
a company doesn't pay out all of its profits in dividends, and many profitable
companies don't pay dividends at all.

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What happens in these situations? Other valuation options include analyzing net
income, free cash flow, EBITDA, and many other financial measures. There are
advantages and disadvantages to using any of these metrics as glimpses into a
company's intrinsic value. The point is that what represents cash flow depends on
the situation. Regardless of what model is used, the theory behind all of them is the
same.
Qualitative Analysis
Fundamental analysis has a very wide scope. Valuing a company involves not only
crunching numbers and predicting cash flows but also looking at the general, more
subjective qualities of a company. Here we will look at how the analysis of qualitative
factors is used for picking a stock.
Management
The backbone of any successful company is strong management. The people at the
top ultimately make the strategic decisions and therefore serve as a crucial factor
determining the fate of the company. To assess the strength of management,
investors can simply ask the standard five W's: who, where, what, when, and why.
-Who? -
Do some research, and find out who is running the company. Among other things,
you should know who the company's CEO, CFO, COO, and CIO are. Then you can
move onto the next question.
-Where?-
You need to find out where these people come from, specifically, their educational
and employment backgrounds. Ask yourself if these backgrounds make the people
suitable for directing the company in its industry. A management team consisting of
people who come from completely unrelated industries should raise questions. If the
CEO of a newly-formed mining company previously worked in the healthcare
industry, ask yourself whether he or she has the necessary qualities to lead a mining
company to success.
-What and When? -

What is the management philosophy? In other words, in what style do these people
intend to manage the company? Some managers are more personable, promoting an
open, transparent, and flexible way of running the business. Other management
philosophies are more rigid and less adaptable, valuing policy and established logic
above all in the decision-making process. You can discern the style of management
by looking at its past actions or by reading the annual report's MD&A section. Ask
yourself if you agree with this philosophy, and if you can see it working for the
company, given its size and the nature of its business.
Once you know the style of the managers, find out when this team took over the
company. Jack Welch, for example, was CEO of General Electric for over 20 years.
His long tenure is a good indication that he was a successful and profitable manager;
otherwise, the shareholders and the board of directors wouldn't have kept him
around. If a company is doing poorly, one of the first actions taken is management

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restructuring, which is a nice way of saying "a change in management due to poor
results." If you see a company continually changing managers, it may be a sign to
invest elsewhere.
At the same time, although restructuring is often brought on by poor management, it

doesn't automatically mean the company is doomed. For example, Chrysler
Corporation was on the brink of bankruptcy when Lee Iacocca, the new CEO, came in
and installed a new management team that renewed Chrysler's status as a major
player in the auto industry. So, management restructuring may be a positive sign,
showing that a struggling company is making efforts to improve its outlook and is
about to see a change for the better.
-Why?-
A final factor to investigate is why these people have become managers. Look at the
manager's employment history, and try to see if these reasons are clear. Does this
person have the qualities you believe are needed to make someone a good manager
for this company? Has he or she been hired because of past successes and
achievements, or has he or she acquired the position through questionable means,
such as self-appointment after inheriting the company?
For more on assessing a company's mangagment, see these articles: "Get Tough on
Management 'Puff'" and "Evaluating a Company's Management."
Know What a Company Does and How it Makes Money

A second important factor to consider when analyzing a company's qualitative factors
is its product(s) or service(s). How does this company make money? In fancy MBA
parlance, the question would be "What is the company's business model?"
Knowing how a company's activities will be profitable is fundamental to determining

the worth of an investment. Often, people will boast about how profitable they think
their new stock will be, but when you ask them what the company does, it seems
their vision for the future is a little blurry: "Well they have this high-tech
thingamabob that does something with fiber-optic cables… ." If you aren't sure how
your company will make money, you can't really be sure that its stock will bring you
a return.
One of the biggest lessons taught by the dotcom bust of the late '90s is that not
understanding a business model can have dire consequences. Many people had no
idea how the dotcom companies were making money, or why they were trading so
high. In fact, these companies weren't making any money; it's just that their growth
potential was thought to be enormous. This led to overzealous buying based on a
herd mentality, which in turn led to a market crash. But not everyone lost money
when the bubble burst: Warren Buffett didn't invest in high-tech primarily because
he didn't understand it. Although he was ostracized for this during the bubble, it
saved him billions of dollars in the ensuing dotcom fallout. You need a solid
understanding of how a company actually generates revenue in order to evaluate
whether management is making the right decisions. For more on this, see the article
"Getting to Know Business Models."

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Industry/Competition
Aside from having a general understanding of what a company does, you should
analyze the characteristics of its industry, such as its growth potential. A mediocre
company in a great industry can provide a solid return, while a mediocre company in
a poor industry will likely take a bite out of your portfolio. Of course, discerning a
company's stage of growth will involve approximation, but common sense can go a
long way: it's not hard to see that the growth prospects of a high tech industry are
greater than those of the railway industry. It's just a matter of asking yourself if the
demand for the industry is growing.
Market share is another important factor. Look at how Microsoft thoroughly

dominates the market for operating systems. Anyone trying to enter this market
faces huge obstacles because Microsoft can take advantage of economies of scale.
This does not mean that a company in a near monopoly situation is guaranteed to
remain on top, but investing in a company that tries to take on the "500-pound
gorilla" is a risky venture.
Barriers against entry into a market can also give a company a significant qualitative
advantage. Compare, for instance, the restaurant industry to the automobile or
pharmaceuticals industries. Anybody can open up a restaurant because the skill level
and capital required are very low. The automobile and pharmaceuticals industries, on
the other hand, have massive barriers to entry: large capital expenditures, exclusive
distribution channels, government regulation, patents, and so on. The harder it is for
competition to enter an industry, the greater the advantage for existing firms.
Brand Name
A valuable brand reflects years of product development and marketing. Take for
example the most popular brand name in the world: Coca-Cola. Many estimate that
the intangible value of Coke's brand name is in the billions of dollars! Massive
corporations such as Proctor and Gamble rely on hundreds of popular brand names
like Tide, Pampers, and Head & Shoulders. Having a portfolio of brands diversifies
risk because the good performance of one brand can compensate for the lower
performance of another.
Keep in mind that some stock pickers steer clear of any company that is branded
around one person. They do so because, if a company is tied too closely to an
individual, any bad news regarding that person may hinder the company's share
performance even if the news has nothing to do with company operations. A perfect
example of this is the troubles faced by Martha Stewart Omnimedia as a result of
Martha Stewart's legal problems in early 2004.
Don't Overcomplicate
You don't need a PhD in finance to recognize a good company. In his book, One Up
on Wall Street, Peter Lynch discusses a time when his wife drew his attention to a
great product with phenomenal marketing. Hanes was test marketing a product
called L'eggs: women's pantyhose packaged in colorful plastic egg shells. Instead of
selling these in department or specialty stores, Hanes put the product next to the
candy bars, soda, and gum at the checkouts of supermarkets--a brilliant idea
because research showed that women frequented the supermarket on average about

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12 times more often than the traditional outlets of pantyhose. The product was a
huge success and became the second highest-selling consumer product of the 1970s.
Most women at the time would have easily seen the popularity of this product, and
Peter Lynch's wife was one of them. Thanks to her advice, he researched the
company a little deeper and turned his investment in Hanes into a solid six bagger
for Fidelity, while most of the male managers on Wall Street missed out. The point is
that it's not only Wall Street analysts who are privy to information about companies;
average everyday people can see such wonders too. If you see a local company
expanding and doing well, dig a little deeper, ask around. Who knows, it may be the
next Hanes.
Conclusion
Assessing a company from a qualitative standpoint and determining whether you
should invest in it are as important as looking at sales and earnings. This strategy
may be one of the simplest, but it is also one of the most effective ways to evaluate
a potential investment.
Value Investing
Value investing is one of the best known stock picking methods. In the 1930s,
Benjamin Graham and David Dodd, finance professors at Columbia University, laid
out what many consider to be the framework for value investing. The concept is
actually very simple: find companies trading below their inherent worth.
The value investor looks for stocks with strong fundamentals--including earnings,
dividends, book value, and cash flow--that are selling at a bargain price, given their
quality. The value investor seeks companies that seem to be incorrectly valued
(undervalued) by the market and therefore have the potential to increase in share
price when the market corrects its error in valuation.
Value, Not Junk!

Before we get too far into the discussion of value investing let's get one thing
straight. Value investing doesn't mean just buying any stock that declines and
therefore seems "cheap" in price. Value investors have to do their homework and be
confident that they are picking a company that is cheap given its high quality.
It's important to distinguish the difference between a value company and a company
that simply has a declining price. Say for the past year Company A has been trading
at about $25 per share but suddenly drops to $10 per share. This does not
automatically mean that the company is selling at a bargain. All we know is that the
company is less expensive now than it was last year. The drop in price could be a
result of the market responding to a fundamental problem in the company. To be a
real bargain, this company must have fundamentals healthy enough to imply it is
worth more than $10--value investing always compares current share price to
intrinsic value not to historic share prices.
Value Investing at Work

One of the greatest investors of all time, Warren Buffett, has proven that value

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investing can work: his value strategy took the stock of Berkshire Hathaway, his
holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat
the S&P 500's performance by about 13.02% on average annually! Although Buffett
does not strictly categorize himself as a value investor, many of his most successful
investments were made on the basis of value investing principles. (See the following
article on Warren Buffett.)
Buying a Business, not a Stock

We should emphasize that the value investing mentality sees a stock as the vehicle
by which a person becomes an owner of a company--to a value investor profits are
made by investing in quality companies, not by trading. Because their method is
about determining the worth of the underlying asset, value investors pay no mind to
the external factors affecting a company, such as market volatility or day-to-day
price fluctuations. These factors are not inherent to the company, and therefore are
not seen to have any effect on the value of the business in the long run.
Contradictions
While the Efficient Market Hypothesis (EMH) claims that prices are always reflecting
all relevant information, and therefore are already showing the intrinsic worth of
companies, value investing relies on a premise that opposes that theory. Value
investors bank on the EMH being true only in some academic wonderland. They look
for times of inefficiency, when the market assigns an incorrect price to a stock.
Value investors also disagree with the principle that high beta (also known as
volatility, or standard deviation) necessarily translates into a risky investment. A
company that has an intrinsic value of $20 per share but is trading at $15 would be,
as we know, an attractive investment to value investors. If the share price dropped
to $10 per share, the company would experience an increase in beta, which
conventionally represents an increase in risk. If, however, the value investor still
maintained that the intrinsic value was $20 per share, he or she would see this
declining price as an even better bargain. And the better the bargain, the lesser the
risk. A high beta does not scare off value investors. As long as they are confident in
their intrinsic valuation, an increase in downside volatility may be a good thing.
Screening for Value Stocks

Now that we have a solid understanding of what value investing is and what it is not,
let's get into some of the qualities of value stocks.
Qualitative aspects of value stocks:
1. Where are value stocks found? - Everywhere. Value stocks can be found
trading on the NYSE, the Nasdaq, the AMEX, over the counter, on the FTSE,
the Nikkei, and so on.
2. a) In what industries are value stocks located? - Value stocks can be

located in any industry, including energy, finance, and even technology
(contrary to popular belief).
b) In what industries are value stocks most often located? - Although

value stocks can be located anywhere, they are often located in industries

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that have recently fallen on hard times, or are currently facing market
overreaction to a piece of news affecting the industry in the short term. For
example, the auto industry's cyclical nature allows for periods of
undervaluation of companies such as Ford or GM.
3. Can value companies be those that have just reached new lows? -
Definitely, although we must re-emphasize that the "cheapness" of a
company is relative to intrinsic value. A company that has just hit a new 12-
month low or is at the half of a 12-month high may warrant further
investigation.
Here is a breakdown of some of the numbers value investors use as rough guides for
picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:
1. Share price should be no more than 2/3 of intrinsic worth.

2. Look at companies with P/E ratios at the lowest 10% of all equity securities.
3. PEG should be less than 1.
4. Stock price should be no more than tangible book value.
5. There should be no more debt than equity (ie D/E ratio < 1).
6. Current assets should be two times current liabilities.
7. Dividend yield should be at least 2/3 of the long-term AAA bond yield.
8. Earnings growth should be at least 7% per annum compounded over the last
10 years.
The P/E and PEG Ratios

Contrary to popular belief, value investing is not simply about investing in low P/E
stocks. It's just that stocks that are undervalued will often reflect this undervaluation
through a low P/E ratio, which should simply provide a way to compare companies
within the same industry. For example, if the average P/E of the technology
consulting industry is 20, a company trading in that industry at 15 times earnings
should sound some bells in the heads of value investors.
Another popular metric for valuing a company's intrinsic value is the PEG ratio,
calculated as a stock's P/E ratio divided by its projected year-over-year earnings
growth rate. In other words, the ratio measures how cheap the stock is while taking
into account its earnings growth. If the company's PEG ratio is less than one, it is
considered to be undervalued.
Narrowing It Down Even Further

One well-known and accepted method of picking value stocks is the net-net method.
This method states that if a company is trading at two-thirds of its current assets, no
other gauge of worth is necessary. The reasoning behind this is simple: if a company
is trading at this level, the buyer is essentially getting all the permanent assets of
the company (including property, equipment, etc.) and the company's intangible
assets (mainly goodwill, in most cases) for free! Unfortunately, companies trading
this low are few and far between.

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The Margin of Safety

A discussion of value investing would not be complete without mentioning the use of
a margin of safety, a technique which is simple yet very effective. Consider a real-life
example of a margin of safety. Say you are planning a pyrotechnics show, which will
include flames and explosions. You have concluded with a high degree of certainty
that it's perfectly safe to stand 100 ft from the center of the explosions. But to be
absolutely sure no one gets hurt, you implement a margin of safety by setting up
barriers 125 ft from the explosions.
This use of a margin of safety works similarly in value investing. It's simply the
practice of leaving room for error in your calculations of intrinsic value. A value
investor may be fairly confident that a company has an intrinsic value of $30 per
share. But in case his or her calculations are a little too optimistic, he or she creates
a margin of safety/error by using the figure $26 per share in his or her scenario
analysis. The investor may find that at $15 the company is still an attractive
investment, or he or she may find that at $24, the company is not attractive enough.
If the stock's intrinsic value is lower than the investor estimated, the margin of
safety would help prevent this investor from paying too much for the stock.
Conclusion
Value investing is not as sexy as some other styles of investing; it relies on a strict
screening process. But just remember, there's nothing boring about outperforming
the S&P by 13% over a 40 year span!
Growth Investing
In the late 1990s, when technology companies were flourishing, growth investing
techniques yielded unprecedented returns for investors. But before any investor
jumps onto the growth investing bandwagon, he or she should realize that this
strategy comes with substantial risks and is not for everyone.
Value versus Growth

The best way to define growth investing is to contrast it to value investing. Value
investors are strictly concerned with the here and now; they look for stocks that, at
this moment, are trading for less than their apparent worth. Growth investors, on the
other hand, focus on the future potential of a company, with much less emphasis on
its present price. Unlike value investors, growth investors buy companies that are
trading higher than their current intrinsic worth--but this is done with the belief that
the companies' intrinsic worth will grow and therefore exceed their current
valuations.
As the name suggests, growth stocks are companies that grow substantially faster
than others. Growth investors are therefore primarily concerned with young
companies. The theory is that growth in earnings and/or revenues will directly
translate into an increase in the stock price. Typically a growth investor looks for
investments in rapidly expanding industries especially those related to new
technology. Profits are realized through capital gains and not dividends as nearly all
growth companies reinvest their earnings and do not pay a dividend.

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No Automatic Formula
Growth investors are concerned with a company's future growth potential, but there
is no absolute formula for evaluating this potential. Every method of picking growth
stocks (or any other type of stock) requires some individual interpretation and
judgment. Growth investors use certain methods--or sets of guidelines or criteria--as
a framework for their analysis, but these methods must be applied with a company's
particular situation in mind. More specifically, the investor must consider the
company in relation to its past performance and its industry's performance. The
application of any one guideline or criterion may therefore change from company to
company and from industry to industry.
The NAIC
The National Association of Investors Corporation (NAIC) is one of the best known
organizations using and teaching the growth investing strategy. It is, as it says on its
website, "one big investment club" whose goal is to teach investors how to invest
wisely. The NAIC has developed some basic "universal" guidelines for finding possible
growth companies--here's a look at some of the questions the NAIC suggests you
should ask when considering stocks.
1. Strong Historical Earnings Growth?

According to the NAIC, the first question a growth investor should ask is
whether the company, based on annual revenue, has been growing in the
past. Below are rough guidelines for the rate of EPS growth an investor
should look for in companies of differing sizes, which would indicate their
growth investing potential:
Although the NAIC suggests that companies display this type of EPS growth in
at least the last five years, a 10-year period of this growth is even more
attractive. The basic idea is that if a company has displayed good growth (as
defined by the above chart) over the last five- or 10-year period, the
company is likely to continue doing so in the next five to 10 years.
2. Strong Forward Earnings Growth?

The second criterion set out by the NAIC is a projected five-year growth rate
of at least 10-12%, although 15% or more is more ideal. These projections
are made by analysts, the company, or other credible sources.
The big problem with forward estimates is that, by nature, they are
estimates. When a growth investor sees an ideal growth projection, he or she,
before trusting this projection, must evaluate its credibility. This requires
knowledge of the typical growth rates for different sizes of companies. For
example, an established large cap will not be able to grow as quickly as a
younger small-cap tech company. Also, when evaluating analyst consensus
estimates, an investor should learn about the company's industry--

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specifically, what its prospects are and what stage of growth it is at. (See the
article "The Stages of Industry Growth.")
3. Is Management Controlling Costs and Revenues?

The third guideline set out by the NAIC focuses specifically on pre-tax profit
margins. There are many examples of companies with astounding growth in
sales but less than outstanding gains in earnings. High annual revenue growth
is good, but if EPS has not increased proportionately, it's likely due to a
decrease in profit margin.
By comparing a company's present profit margins to its past margins and its
competition's profit margins, a growth investor is able to gauge fairly
accurately whether or not management is controlling costs and revenues and
maintaining margins. A good rule of thumb is that if company exceeds its
previous five-year average of pre-tax profit margins as well as those of its
industry, the company may be a good growth candidate.
4. Can Management Operate the Business Efficiently?

Efficiency can be quantified by using return on equity (ROE). Efficient use of
assets should be reflected in a stable or increasing ROE. Again, analysis of
this metric should be relative: a company's present ROE is best compared to
the five-year average ROE of the company and the industry.
5. Can the Stock Price Double in Five Years?

If a stock cannot realistically double in five years, it's probably not a growth
stock. That's the general consensus. This may seem like an overly high,
unrealistic standard, but remember that with a growth rate of 10%, a stock's
price would double in seven years. So the rate growth investors are seeking is
15% per annum, which yields a doubling in price in five years.
An Example
Now that we've outlined the NAIC's basic criteria for evaluating growth stocks, let's
demonstrate how these criteria are used to analyze a company, using Microsoft's
2003 figures as our example. For the sake of this demonstration, we'll discuss these
numbers as though they were Microsoft's most current figures (that is, "today's
figures").

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1. Five-Year Earnings Figures
• Five-year average annual sales growth is

15.94%.
• Five-year average annual EPS growth is
10.91%.
Both of these are strong figures. The annual EPS growth is well above the 5%
standard the NAIC sets out for firms of Microsoft's size.
2. Strong Projected Earnings Growth
• Five-year projected average annual earnings growth

is 11.03%.
The projected growth figures are strong, but not exceptional.
3. Costs and Revenue Control

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• Pre-Tax margin in most recent fiscal year is

45.80%.
• Five-year average fiscal pre-tax margin is
50.88%.
• Industry's five-year average pre-tax margin
is 26.7%.
There are two ways to look at this. The trend is down 5.08% (50.88% - 45.80%)
from the 5 year average, which is negative. But notice that the industry's
average margin is only 26.7%. So even though Microsoft's margins have
dropped, they're still a great deal higher than those of its industry.
4. ROE
• Most recent fiscal year end is ROE

16.40%.
• Five-year average ROE is 19.80%.
• Industry average five-year ROE is
13.60%.
Again, it's a point of concern that the ROE figure is a little lower than the average
over the past five years. However, like Microsoft's profit margin, the ROE is not

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drastically reduced--it's only down a few points and still well above the industry
average.
5. Potential to Double in Five Years
• Stock is projected to appreciate by

254.7%
The average analyst projections for Microsoft suggest that in five years the stock
will not merely double in value, but it'll be worth 254.7% its current value.
Is Microsoft a Growth Stock?

On paper, Microsoft meets many NAIC's criteria for a growth stock. But it also falls
short of others. If, for instance, we were to dismiss Microsoft because of its
decreased margins and not compare them to the industry's margins, we would be
ignoring the industry conditions within which Microsoft functions. On the other hand,
when comparing Microsoft to its industry, we must still decide how telling it is that
Microsoft has higher-than-average margins. Is Microsoft a good growth stock even
though its industry may be maturing and facing declining margins? Can a company
of its size find enough new markets to keep expanding?
Clearly there are arguments on both sides and there is no "right" answer. What
these criteria do, however, is open up doorways of analysis through which we can dig
deeper into a company's condition. Because no single set of criteria is infallible, the
growth investor may want to adjust a set of guidelines by adding (or omitting)
criteria. So, although we've provided five basic questions, it's important to note that
the purpose of the example is to provide a starting point from which you can build
your own growth screens.
Conclusion
It's not too complicated: growth investors are concerned with growth. The guiding
principle of growth investing is to look for companies that keep reinvesting into
themselves to produce new products and technology. Even though the stocks might
be expensive in the present, growth investors believe that expanding top and bottom
lines will ensure an investment pays off in the long run.

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GARP Investing
Do you feel that you now have a firm grasp of the principles of both value and
growth investing? If you're comfortable with these two stock picking methodologies,
then you're ready to learn about a newer, hybrid system of stock selection. Here we
take a look at growth at a reasonable price, otherwise known as GARP
What Is GARP?
The GARP strategy is a combination of both value and growth investing: it looks for
companies that are somewhat undervalued and have solid sustainable growth
potential. The criteria which GARPers look for in a company fall right in between
those sought by the value and growth investors. Below is a diagram illustrating how
the GARP-preferred levels of price and growth compare to the levels sought by value
growth investors:
What GARP Is NOT

Because GARP borrows principles from both value and growth investing, some
misconceptions about the style persist. Critics of GARP claim it is a wishy-washy,
fence-sitting method that fails to establish meaningful standards for distinguishing
good stock picks. However, GARP doesn't deem just any stock a worthy investment.
Like most respectable methodologies, it aims to identify companies that display very
specific characteristics.
Another misconception is that GARP investors simply hold a portfolio with equal
amounts of both value and growth stocks. Again, this is not the case: because each
of their stock picks must meet a set of strict criteria, GARPers identify stocks on an
individual basis, selecting stocks that have neither purely value nor purely growth
characteristics, but a combination of the two.
Who Uses GARP?

One of the biggest supporters of GARP is Peter Lynch, whose philosophies we have
already touched on in the section on qualitative analysis. Lynch has written several
popular books, including One Up on Wall Street and Learn to Earn, and in the late
1990s and early 2000s he starred in the Fidelity Investment commercials. Many

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consider Lynch the world's best fund manager, partly due to his 29% average annual
return over a 13-year stretch from 1977-1990. (To learn more about Peter Lynch,
check out this feature.)
The Hybrid Characteristics

Like growth investors, GARP investors are concerned with the growth prospects of a
company: they like to see positive earnings numbers over the past few years,
coupled with positive earnings projections for upcoming years. But unlike their
growth-investing cousins, GARP investors are skeptical of extremely high growth
estimations, such as those in the 25-50% range. Companies within this range carry
too much risk and unpredictability for GARPers. To them, a safer and more realistic
earnings growth rate lies somewhere between 10 to 20%.
Something else that GARPers and growth investors share is their attention to the
ROE figure. For both investing types, a high and increasing ROE relative to the
industry average is an indication of a superior company.
GARPers and growth investors share other metrics to determine growth potential.
They do, however, have different ideas about what the ideal levels exhibited by the
different metrics should be, and both types of investors have varying tastes in what
they like to see in a company. An example of what many GARPers like to see is
positive cash flow or, in some cases, positive earnings momentum.
Because a variety of additional criteria can be used to evaluate growth, GARP

investors can customize their stock picking system to their personal style. Exercising
subjectivity is an inherent part of using GARP. So if you use this strategy, you must
analyze companies in relation to their unique contexts (just as you would with
growth investing). Since there is no magic formula for confirming growth prospects,
investors must rely on their own interpretation of company performance and
operating conditions.
It would be hard to discuss any stock picking strategy without mentioning its use of
the P/E ratio. Although they look for higher P/E ratios than value investors do,
GARPers are wary of the high P/E ratios favored by growth investors. A growth
investor may invest in a company trading at 50 or 60 times earnings, but the GARP
investor sees this type of investing as paying too much money for too much
uncertainty. The GARPer is more likely to pick companies with P/E ratios in the 15-25
range--however, this is a rough estimate, not an inflexible rule GARPers follow
without any regard for a company's context.
In addition to a preference for a lower P/E ratio, the GARP investor shares the value
investor's attraction to a low price-to-book ratio (P/B) ratio, specifically a P/B of
below the industry average. A low P/E and P/B are the two more prominent criteria
with which GARPers in part mirror value investing. They may use other similar or
differing criteria, but the main idea is that a GARP investor is concerned about
present valuations.
By the Numbers
Now that we know what GARP investing is, let's delve into some of the numbers that
GARPers look for in potential companies.

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The PEG Ratio

The PEG ratio may very well be the most important metric to any GARP investor, as
it basically gauges the balance between a stock's growth potential and its value. If
you are unfamiliar with the PEG ratio, check out this article: "How the PEG Ratio Can
Help Investors."
GARP investors require a PEG no higher than 1 and, in most cases, closer to 0.5. A
PEG less then 1 implies that, at present, the stock's price is lower than it should be
given its earnings growth. To the GARP investor, a PEG below 1 indicates that a
stock is undervalued and warrants further analysis.
PEG at Work
Say the TSJ Sports Conglomerate, a fictional company, is trading at 19 times
earnings (P/E = 19) and has earnings growing at 30%. From this you can calculate
that the TSJ has a PEG of 0.63 (19/30=0.63), which is pretty good by GARP
standards.
Now let's compare the TSJ to Cory's Tequila Co. (CTC), which is trading at 11 times
earnings (P/E = 11) and has earnings growth of 20%. Its PEG equals 0.55. The
GARPer's interest would be aroused by the TSJ, but Cory's Tequila Co. would look
even more attractive. Although it has slower growth compared to TSJ, CTC currently
has a better price given the growth potential it offers. In other words, CTC has
slower growth, but TSJ's faster growth is more overpriced. As you can see, the GARP
investor seeks solid growth, but also demands that this growth be valued at a
reasonable price. Hey, the name does make sense!
GARP at Work
Because a GARP strategy employs principles from both value and growth investing,
the returns that GARPers see during certain market phases are often different than
the returns strictly value or growth investors would see at those times. For instance,
in a raging bull market the returns from a growth strategy are often unbeatable: in
the Internet boom of the mid- to late-1990s, for example, neither the value investor
nor the GARPer could compete. However, when the market does turn, a GARPer is
less likely to suffer than the growth investor.
Therefore, the GARP strategy not only fuses growth and value stock-picking criteria,
but also experiences a combination of their types of returns: a value investor will do
better in bearish conditions; a growth investor will do exceptionally well in a raging
bull market; and a GARPer will be rewarded with more consistent and predictable
returns.
Conclusion
GARP might sound like the perfect strategy, but combining growth and value

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investing isn't as easy as it sounds. If you don't master both strategies, you could
find yourself buying mediocre rather than good GARP stocks. But as many great
investors such as Peter Lynch himself have proven, the returns are definitely worth
the time it takes to learn the GARP techniques.
Income Investing
Income investing, which aims to pick companies that provide a steady stream of
income, is perhaps one of the most straightforward stock picking strategies. When
investors think of steady income they commonly think of fixed-income securities
such as bonds. However, stocks can also provide a steady income by paying a solid
dividend. Here we look at the strategy that focuses on finding these kinds of stocks.
(For more on fixed-income securities, check out these links: "Bond Basics" and
"Advanced Bond Tutorial.")
Who Pays Dividends?

Income investors usually end up focusing on older, more established firms, that have
reached a certain size and are no longer able to sustain higher levels of growth.
These companies generally no longer are in rapidly expanding industries and so
instead of reinvesting retained earnings into themselves (as many high-flying growth
companies do), mature firms tend to pay out retained earnings as dividends as a
way to provide a return to their shareholders.
Thus, dividends are more prominent in certain industries. Utility companies, for
example, have historically paid a fairly decent dividend, and this trend should
continue in the future. For more on the resurgence of dividends following the tech
boom, check out this article: "Dividends: Back in Vogue."
Dividend Yield
Income investing is not simply about investing in companies with the highest
dividends (in dollar figures). The gauge that is more important is the dividend yield,
calculated by dividing the annual dividend per share by share price. This measures
the actual return that a dividend gives the owner of the stock. For example, a
company with a share price of $100 and a dividend of $6 per share has a 6%
dividend yield, or 6% return from dividends. The average dividend yield for
companies in the S&P 500 is 2-3%.
But income investors demand a much higher yield than 2-3%. Most are looking for a
minimum 5-6% yield, which on a $1 million investment would produce an income
(before taxes) of $50,000-$60,000. The driving principle behind this strategy is
probably becoming pretty clear: find good companies with sustainable high dividend
yields to receive a steady and predictable stream of money over the long term.
Another factor to consider with the dividend yield is a company's past dividend
policy. Income investors must determine whether a prospective company can
continue with its dividends. If a company has recently increased its dividend, be sure
to analyze that decision. A large increase, say from 1.5% to 6%, over a short period
such as a year or two, may turn out to be over-optimistic and unsustainable into the
future. The longer the company has been paying a good dividend, the more likely it

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will continue to do so in the future. Companies that have had steady dividends over
the past five, 10, 15, or even 50 years are likely to continue the trend.
An Example
There are many good companies that pay great dividends and also grow at a
respectable rate. Perhaps the best example of this is Johnson & Johnson (ticker
symbol: JNJ). From 1963 to 2004, Johnson & Johnson has increased its dividend
every year. In fact, if you bought the stock in 1963 the dividend yield on your initial
shares would have grown approximately 12% annually. Thirty years later, your
earnings from dividends alone would have rendered a 48% annual return on your
initial shares!
Here is a chart of Johnson & Johnson's share price (adjusted for splits and dividend
payments), which demonstrates the power of the combination of dividend yield and
company appreciation:
This chart should address the concerns of those who simply dismiss income investing
as an extremely defensive and conservative investment style. When an initial
investment appreciates over 225 times--including dividends--in about 20 years, that
may be about as "sexy" as it gets.
Dividends Are Not Everything

You should never invest solely on the basis of dividends. Keep in mind that high
dividends don't automatically indicate a good company. Because they are paid out of
a company's net income, higher dividends will result in a lower retained earnings.
Problems arise when the income that would have been better re-invested into the
company goes to high dividends instead.

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The income investing strategy is about more than using a stock screener to find the
companies with the highest dividend yield. Because these yields are only worth
something if they are sustainable, income investors must be sure to analyze their
companies carefully, buying only ones that have good fundamentals. Like all other
strategies discussed in this tutorial, the income investing strategy has no set formula
for finding a good company. To determine the sustainability of dividends by means of
fundamental analysis, each individual investor must use his or her own interpretive
skills and personal judgment--for this reason, we won't get into what defines a "good
company."
Stock Picking, not Fixed Income

Something to remember is that dividends do not equal lower risk. The risk associated
with any equity security still applies to those with high dividend yields, although the
risk can be minimized by picking solid companies.
Taxes Taxes Taxes

One final important note: in most countries and states, dividend payments are taxed
at the same rate as your wages. As such, these payments tend to be taxed higher
than capital gains, which is a factor that reduces your overall return.
CANSLIM
CANSLIM is a philosophy of screening, purchasing, and selling common stock.

Developed by William O'Neil, the co-founder of Investor's Business Daily, it is
described in his highly recommended book How to Make Money in Stocks.
The name may suggest some boring government agency, but this acronym actually
stands for a very successful investment strategy. What makes CANSLIM different is
its attention to tangibles such as earnings, as well as intangibles, such as overall
strength and ideas in the company. The best thing about this strategy is that there's
evidence that it works: there are countless examples of companies that, over the last
half of the twentieth century, met CANSLIM criteria before increasing enormously in
price. In this section we explore each of the seven components of the CANSLIM
system.
C= Current Earnings
O’Neil emphasizes the importance of choosing stocks whose earnings per share
(EPS) in the most recent quarter have grown in relation to the EPS of last year’s
same quarter. For example, a company’s EPS figures reported in this year’s quarter
from April to June should have grown relative to the EPS figures for that same three-
month period one year ago. If you're unfamiliar with EPS, check out the article
"Types of EPS."
How Much Growth?

The percentage of growth a company’s EPS should show is somewhat debatable, but
the CANSLIM system suggests no less than 18-20%. O’Neil found that in the period
from 1953 to 1993, three-quarters of the 500 top-performing equity securities in the
U.S. showed quarterly earnings gains of at least 70% prior to a major price increase.
The other one quarter of these securities showed price increases in two quarters

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after the earnings increases. This suggests that basically all of the high performing
stocks showed outstanding quarter-over-quarter growth. Although 18-20% growth is
a rule of thumb, the truly spectacular earners usually demonstrate growth of 50% or
more.
Earnings Must Be Examined Carefully

The system strongly asserts that investors should know how to recognize low-quality
earnings figures--that is, figures that are not accurate representations of company
performance. Because companies may attempt to manipulate earnings, the CANSLIM
system maintains that investors must dig deep and look past the superficial numbers
companies often put forth as earnings figures. For more on how to assess the quality
of earnings, check out this article: "How to Evaluate the Quality of EPS."
O’Neil says that, once you confirm that a company's earnings are of fairly good
quality, it's a good idea to check others in the same industry. Solid earnings growth
in the industry confirms the industry is thriving and the company is ready to break
out.
A= Annual Earnings
CANSLIM also acknowledges the importance of annual earnings growth. The system
indicates that a company should have shown good annual growth (annual EPS) in
each of the last five years.
How Much Annual Earnings Growth?

It's important that the CANSLIM investor, like the value investor, adopt the mindset
that investing is the act of buying a piece of a business, becoming an owner of it.
This mindset is the logic behind choosing companies with annual earnings growth
within the 25-50% range. As O’Neil puts it, "who wants to own part of an
establishment showing no growth?"
Wal-Mart?
O’Neil points to Wal-Mart as an example of a company whose strong annual growth
preceded a large run-up in share price. Between 1977 and 1990, Wal-Mart displayed
an average annual earnings growth of 43%. The graph below demonstrates how
successful Wal-Mart was after its remarkable annual growth.

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A Quick Re-Cap
The first two parts of the CANSLIM system are fairly logical steps employing
quantitative analysis. By identifying a company that has demonstrated strong
earnings both quarterly and annually, you have a good basis for a solid stock pick.
However, the beauty of the system is that it applies five more criteria to stocks
before they are selected.
N= New
O’Neil’s third criterion for a good company is that it has recently undergone a
change, which is often necessary for a company to become successful. Whether it is
a new management team, a new product, a new market, or a new high in stock
price, O’Neil found that 95% of the companies he studied had experienced something
new.
McDonald’s
A perfect example of how newness spawns success can be seen in McDonald’s past.
With the introduction of its new fast food franchises, it grew over 1100% in four
years from 1967 to 1971! And this is just one of many compelling examples of
companies that, through doing or acquiring something new, achieved great things
and rewarded their shareholders along the way.
New Stock Price Highs

O’Neil discusses how it is human nature to steer away from stocks with new price
highs--people often fear that a company at new highs will have to trade down from
this level. But O’Neil uses compelling historical data to show that stocks that have
just reached new highs often continue on an upward trend to even higher levels.
S= Supply and Demand

The S in the CANSLIM system stands for supply and demand, which refers to the
laws that govern all market activities. If you are unfamiliar with how supply and
demand determine price, you can learn more in the "Economics Basics Tutorial."

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The analysis of supply and demand in the CANSLIM method maintains that, all other
things being equal, it is easier for a smaller firm, with a smaller number of shares
outstanding, to show outstanding gains. The reasoning behind this is that a large-cap
company requires much more demand than a smaller cap company to demonstrate
the same gains.
O’Neil explores this further and explains how the lack of liquidity of large institutional
investors restricts them to buying only large-cap, blue-chip companies, leaving these
large investors at a serious disadvantage that small individual investors can
capitalize on. Because of supply and demand, the large transactions that institutional
investors make can inadvertently affect share price, especially if the stock's market
capitalization is smaller. Because individual investors invest a relatively small
amount, they can get in or out of a smaller company without pushing share price in
an unfavorable direction.
In his study, O’Neil found that 95% of the companies displaying the largest gains in
share price had fewer than 25 million shares outstanding when the gains were
realized.
L= Leader or Laggard
In this part of CANSLIM analysis, distinguishing between market leaders and market
laggards is of key importance. In each industry, there are always those that lead,
providing great gains to shareholders, and those that lag behind, providing returns
that are mediocre at best. The idea is to separate the contenders from the
pretenders.
Relative Price Strength

The relative price strength of a stock can range from 1 to 99, where a rank of 75
means the company, over a given period of time, has outperformed 75% of the
stocks in its market group. CANSLIM requires a stock to have a relative price
strength of at least 70. However, O’Neil states that stocks with relative price
strength in the 80–90 range are more likely to be the major gainers.
Sympathy and Laggards

Do not let your emotions pick stocks. A company may seem to have the same
product and business model as others in its industry, but do not invest in that
company simply because it appears cheap or evokes your sympathy. Cheap stocks
are cheap for a reason, usually because they are market laggards. You may pay
more now for a market leader, but it will be worth it in the end.
I= Institutional Sponsorship
CANSLIM recognizes the importance of companies having some institutional
sponsorship. Basically, this criterion is based on the idea that if a company has no
institutional sponsorship, all of the thousands of institutional money managers have
passed over the company. CANSLIM suggests that a stock worth investing in has at
least 3-10 institutional owners.
However, be wary if a very large portion of the company’s stock is owned by

institutions. CANSLIM acknowledges that a company can be institutionally over-
owned and, when this happens, it is too late to buy into the company. If a stock has

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too much institutional ownership, any kind of bad news could spark a spiraling sell-
off.
O’Neil also explores all the factors that should be considered when determining
whether a company’s institutional ownership is of high quality. Even though
institutions are labeled "smart money," some are a lot smarter than others.
M= Market Direction
The final CANSLIM criterion is market direction. When picking stocks, it is important
to recognize what kind of a market you are in, whether it is a bear or a bull.
Although O’Neil is not a market timer, he argues that if investors don’t understand
market direction, they may end up investing against the trend and thus compromise
gains or even lose significantly.
Daily Prices and Volumes

CANSLIM maintains that the best way to keep track of market conditions is to watch
the daily volumes and movements of the markets. This component of CANSLIM may
require the use of some technical analysis tools, which are designed to help
investors/traders discern trends.
Conclusion
Here’s a recap of the seven CANSLIM criteria:
1. C = Current quarterly earnings per share - Earnings must be up at least

18-20%.
2. A = Annual earnings per share – These figures should show meaningful

growth for the last five years.
3. N = New things - Buy companies with new products, new management, or
significant new changes in industry conditions. Most importantly, buy stocks
when they start to make new highs in price. Forget cheap stocks; they are
that way for a reason.
4. S = Shares outstanding - This should be a small and reasonable number.

CANSLIM investors are not looking for older companies with a large
capitalization.
5. L = Leaders - Buy market leaders, avoid laggards.
6. I = Institutional sponsorship - Buy stocks with at least a few institutional

sponsors who have better than average recent performance records.
7. M = General market - The market will determine whether you win or lose,
so learn how to discern the market's overall current direction, and interpret
the general market indexes (price and volume changes) and action of the
individual market leaders.
CANSLIM is great because it provides solid guidelines, keeping subjectivity to a

minimum. Best of all, it incorporates tactics from virtually all major investment

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strategies. Think of it as a combination of value, growth, fundamental, and even a

little technical analysis.
Remember, this is only a brief introduction to the CANSLIM strategy; this overview
covers only a fraction of the valuable information in O’Neil’s book, How to Make
Money in Stocks. We recommend you read the book to fully understand the
underlying concepts of CANSLIM.
Dogs of the Dow
The investing strategy which focuses on 'Dogs of the Dow' was popularized by
Michael Higgins in his book, Beating the Dow. The strategy's simplicity is one of its
most attractive attributes. The Dogs of the Dow are the 10 of the 30 companies in
the Dow Jones Industrial Average (DJIA) that have the highest dividend yield. In the
Dogs of the Dow strategy, the investor shuffles around his or her portfolio, adjusting
it so that it is always equally allocated in each of these 10 stocks.
Typically, such an investor would need to completely rid his or her portfolio of about
three to four stocks every year and replace them with different ones. The stocks are
usually replaced because their dividend yields have fallen out of the top 10, or
occasionally, because they have been removed from the DJIA altogether.
Is It Really that Simple?

Yes, this strategy really is as simple as it sounds. Every year, at the end of the year,
you reassess the 30 components of the DJIA, determine which ones have the highest
dividend yield, and ask your broker to make your portfolio as equally weighted in
each of these 10 stocks as possible. Hold onto these 10 stocks for one calendar year,
until the following January 1st, and repeat the process. This is a long-term strategy,
requiring a long time period to see results. There have been a few years in which the
Dow has outperformed the Dogs, so it is the long-term averages that proponents of
the strategy rely on.
The Premise
The premise of this investment style is that the Dow laggards, which are temporarily
out-of-favor stocks, are still good companies because they are still included in the
DJIA; therefore, holding on to them is a smart idea, in theory. Once these companies
rebound and the market has revalued them properly (or so you hope), you can sell
them and replenish your portfolio with other good companies that are temporarily
out of favor. Companies in the Dow have historically been very stable companies
that can weather any market decline with their solid balance sheets and strong
fundamentals. Furthermore, because there is a committee perpetually tinkering with
the DJIA's components, you can rest assured that the DJIA is made up of good, solid
companies.
By the Numbers
As mentioned earlier, one of the big attractions of the Dogs of the Dow strategy is its
simplicity; the other is its performance. From 1957 to 2003, the Dogs outperformed
the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dows
averaged 11%. The performance between 1973 and 1996 was even more

(Page 28 of 33)
impressive, as the Dogs returned 20.3% annually whereas the Dows averaged
15.8%.
Variations of the Dogs

Because of this strategy's simplicity and its returns, many have tried to alter it in an
attempt to refine it, making it both simpler and higher yielding. There is the Dow 5,
which includes the five Dogs of the Dow that have the lowest per share price. Then
there is the Dow 4, which includes the 4 highest priced stocks of the Dow 5. Finally,
there is the Foolish 4, made famous by the Motley Fool, which chooses the same
stocks as the Dow 4, but allocates 40% of the portfolio to the lowest priced of these
four stocks and 20% to the other three stocks.
These variations of the Dogs of the Dow were all developed using back testing, or
testing strategies on old data. The likelihood of these strategies outperforming the
Dogs of the Dow or the DJIA in the future is very uncertain; however, the results of
the back testing are interesting. The table below is based on data from 1973-1996.
Before you go out and start applying one of these strategies, consider this: picking
the highest yielding stocks makes some intuitive sense, but picking stocks based
strictly on price seems odd. Share price is a fairly relative thing; a company could
split its shares but still be worth the same, simply having twice as many shares with
half the share price. When it comes to the variations on the Dogs of the Dow, there
are many more questions than there are answers.
Dogs Not Fool Proof

As is the case with the other strategies we've looked at, the Dogs of the Dow
strategy is not foolproof. The theory puts a lot of faith in the assumption that the
time period from the mid-20th century to the turn of the 21st century will repeat
itself over the long run. If this assumption is accurate, the Dogs will provide about a
3% greater return than the Dow, but this is by no means guaranteed.
Conclusion
The Dogs of the Dow is a simple and effective strategy based on the results of the
last 50 years. Pick the 10 highest yielding stocks of the 30 Dow stocks, and weigh
your portfolio equally among them, adjusting the portfolio annually, and you can
expect about a 3% out performance of the Dow. That is, if history repeats itself.

(Page 29 of 33)
Technical Analysis
Technical analysis is the polar opposite of fundamental analysis, which is the basis of
every method explored so far in this tutorial. Technical analysts, or technicians,
select stocks by analyzing statistics generated by past market activity, prices, and
volumes. Sometimes also known as chartists, technical analysts look at the past
charts of prices and different indicators to make inferences about the future
movement of a stock's price.
Philosophy of Technical Analysis

In his book, Charting Made Easy, technical analysis guru John Murphy introduces
readers to the study of technical analysis, explaining its basic premises and tools.
Here he explains the underlying theories of technical analysis:
Chart analysis (also called technical analysis) is the study of market action, using
price charts, to forecast future price direction. The cornerstone of the technical
philosophy is the belief that all factors that influence market price--fundamental
information, political events, natural disasters, and psychological factors--are quickly
discounted in market activity. In other words, the impact of these external factors
will quickly show up in some form of price movement, either up or down.
The most important assumptions that all technical analysis techniques are based
upon can be summarized as follows:
1. Prices already reflect, or 'discount', relevant information. In other words,

markets are efficient.
2. Prices move in trends.
3. History repeats itself.
If you're already lost, or have no idea what technical analysis is, take a look at this
technical analysis tutorial for a more detailed overview of the subject. Here we will
look at how stocks are chosen by means of technical analysis.
What Technical Analysts Don't Care About

Pure technical analysts couldn't care less about the elusive intrinsic value of a
company or any other factors that preoccupy fundamental analysts, such as
managements, business models, or competition. Technicians are concerned with the
trends implied by past data, charts, and indicators, and they often make a lot of
money trading companies they know almost nothing about.
Is Technical Analysis a Long-Term Strategy?

The answer to the question above is no. Definitely not. Technical analysts are usually
very active in their trades, holding positions for short periods in order to capitalize on
fluctuations in price, whether up or down. A technical analyst may go short or long
on a stock, depending on what direction the data is saying the price will move. If you
would like to learn more about active trading and why technical analysis is
appropriate for a short-term strategy, see "Defining Active Trading."

(Page 30 of 33)
If a stock does not perform the way a technician thought it would, he or she wastes
little time deciding whether to exit his or her position, using stop loss orders to
mitigate losses. Whereas a value investor must exercise a lot of patience and wait for
the market to correct its undervaluation of a company, the technician must possess a
great deal of trading agility and know how to get in and out of positions with speed.
Support and Resistance

Among the most important concepts in technical analysis are support and resistance.
These are the levels at which technicians expect a stock to start increasing after a
decline (support), or to begin decreasing after an increase (resistance). Trades are
generally entered around these important levels because they indicate the way in
which a stock will bounce. They will enter into a long position if they feel a support
level has been hit, or enter into a short position if they feel a resistance level has
been struck.
Here is an illustration of where technicians might set support and resistance levels:
Picking Stocks with Technical Analysis

Technicians have a very full toolbox. They literally have hundreds of indicators and
chart patterns to use for picking stocks. However, it is important to note that no one
indicator or chart pattern is infallible or absolute; the technician must interpret
indicators and patterns, and this process is more subjective than formulaic. Let's
briefly examine a couple of the most popular chart patterns (of price) that
technicians analyze.
Cup and Handle

This is a bullish pattern that looks like a pot with a handle. The stock price is
expected to break out at the end of the handle, so by buying here, investors are able
to make a lot of money. Another reason for this pattern's popularity is how easy it is
to spot. Here is an example of a great cup and handle pattern:

(Page 31 of 33)
Head and Shoulders

This pattern resembles, well, a head with two shoulders. Technicians usually consider
this a bearish pattern. Below is a great example of this particular chart pattern:
Remember, these two examples are mere glimpses into the vast world of technical
analysis and its techniques. We couldn't have a complete stock picking tutorial
without mentioning technical analysis, but this brief intro barely scratches the
surface. If you would like to learn more, take a look at this archive of technical
analysis articles, each explaining a specific indicator or strategy.
Conclusion
Technical analysis is unlike any other stock picking strategy--it has its own set of
concepts, and it relies on a completely different set of criteria than any strategy
employing fundamental analysis. However, regardless of its analytical approach,
mastering technical analysis requires discipline and savvy, just like any other
strategy.
Conclusion and Resources
Let's run through a quick recap of the foundational concepts that we covered in our
look at the most well-known stock-picking strategies and techniques:
• Most of the strategies discussed in this tutorial use the tools and techniques
of fundamental analysis, whose main objective is to find the worth of a
company, or its intrinsic value.

(Page 32 of 33)
• In quantitative analysis, a company is worth the sum of its discounted cash

flows. In other words, it is worth all of its future profits added together.
• Some qualitative factors affecting the value of a company are its

management, business model, industry, and brand name.
• Value investors, concerned with the present, look for stocks selling at a price
that is lower than the estimated worth of the company, as reflected by its
fundamentals.
• Growth investors are concerned with the future, buying companies that may
be trading higher than their intrinsic worth but show the potential to grow and
one day exceed their current valuations.
• The GARP strategy is a combination of both growth and value: investors

concerned with 'growth at a reasonable price' look for companies that are
somewhat undervalued given their growth potential.
• Income investors, seeking a steady stream of income from their stocks, look
for solid companies that pay a high but sustainable dividend yield.
• CANSLIM analyzes these factors of companies: current earnings, annual

earnings, new changes, supply and demand, leadership in industry,
institutional sponsorship, and market direction.
• Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial
Average (DJIA) that have the highest dividend yield.
• Technical analysis, the polar opposite of fundamental analysis, is not

concerned with a stock's intrinsic value, but instead looks at past market
activity to determine future price movements.
Related Tutorials and Links

Stock Basics Tutorial - If you're new to the stock market and want the basics,
this is the tutorial for you!
Introduction to Fundamental Analysis - Here's an easy to understand tutorial

on the techniques of analyzing a company's financial statements, including the
annual and quarterly reports, the auditor's report, and much more.
Introduction to Technical Analysis - Here is an easy to understand tutorial on

the various tools used in technical analysis, including moving averages, RSI,
Bollinger bands, stock chart patterns, and much more.
Index Investing Tutorial - Get to know the most important market indexes and
the advantages and disadvantages of investing in them.

(Page 33 of 33)

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Guide to Stock Picking

As always, we welcome any feedback or suggestions.

1. So many factors affect a company's health that it is nearly impossible to

2. A lot of information is intangible and cannot be measured. The quantifiable

Fundamental Analysis (Quantitative Factors)

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Greater Fool Theory

This debate demonstrates the general difference between a technical and

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Putting Theory into Practice

Here we look at a sample of a model used to value a company. Because this is a

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6. Cash flow in year 5– The amount the company could distribute to

7. Growth rate – The growth rate from year 6 into perpetuity.

8. Cash flow in year 6 – The amount available in year 6 to distribute to

12. PV of residual value – The present value of the firm in year 5.

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-What and When? -

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At the same time, although restructuring is often brought on by poor management, it

Know What a Company Does and How it Makes Money

Knowing how a company's activities will be profitable is fundamental to determining

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Market share is another important factor. Look at how Microsoft thoroughly

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Value, Not Junk!

Value Investing at Work

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Buying a Business, not a Stock

Screening for Value Stocks

Qualitative aspects of value stocks:

2. a) In what industries are value stocks located? - Value stocks can be

b) In what industries are value stocks most often located? - Although

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1. Share price should be no more than 2/3 of intrinsic worth.

The P/E and PEG Ratios

Narrowing It Down Even Further

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The Margin of Safety

Value versus Growth

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1. Strong Historical Earnings Growth?

2. Strong Forward Earnings Growth?

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3. Is Management Controlling Costs and Revenues?

4. Can Management Operate the Business Efficiently?

5. Can the Stock Price Double in Five Years?

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1. Five-Year Earnings Figures

• Five-year average annual sales growth is

2. Strong Projected Earnings Growth

• Five-year projected average annual earnings growth

The projected growth figures are strong, but not exceptional.

3. Costs and Revenue Control

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• Pre-Tax margin in most recent fiscal year is

• Most recent fiscal year end is ROE

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5. Potential to Double in Five Years