Simplify Investing: How to Eliminate Stocks From Consideration

Source: Thinkstock

Source: Thinkstock

When we look at possible investment opportunities, we tend to be relatively optimistic and bullish. After all, not only is the market rising, but when we read company news releases, presentations, and annual reports, management is always bullish. What are they going to say otherwise, ‘Sell our stock?’ But this is really a lousy approach. There are thousands of stocks out there trading all over the world every single day, and you are going to construct a portfolio of 10 — maybe 15.

It follows that as a stock picker, you need to be more selective than a Yale admissions officer. But how do you eliminate stocks from consideration? After all nobody has time to analyze the various public documents and talk to the managements and corporate relations personnel from every single company. Therefore, you need to develop strategies for screening out stocks so that you can focus your energies on a few companies that are worth considering. Here are a few strategies to consider.

1. Using Computerized Stock Screeners

This can be a good first step. Many brokers allow you to put in certain inputs such as market capitalization, price-to-earnings multiple, growth rate, dividend yield, profit margin, and so forth. The program scans through each stock and spits out the few that meet your criteria. This is a great way to reduce your list from thousands to a few hundred or even a few dozen if your criteria are selective enough.

The issue is that stock screeners are perfunctory mechanisms and they may miss something. For instance, if you screen for companies with price-to-earnings multiples that are lower than 15 and a company misses the cut because it had a one-time tax-related expense that lowered its reported earnings, then you could be missing out on a great opportunity. You could also find that the opposite happens: you get a list containing several companies with one time earnings gains and thus you have wasted your time.

One way around this is to only filter things that aren’t easily manipulated by these outside events. For instance, filter for revenue growth; one time revenue items are less likely to impact revenue growth. Generally, these are useful tools, but you need to be careful.

Source: Thinkstock

Source: Thinkstock

2. Eliminate entire sectors

There are a lot of sectors in the economy that are simply not worth your time and effort from an investment standpoint. Of course, taking this attitude might mean you will miss out on some great opportunities, but you don’t need to own every great stock to be a successful investor. For instance, I eliminate sectors that I think are difficult to understand such as financials — especially those financials that deal in complex derivatives. I also eliminate sectors with a lot of competition, especially if they are in low-margin businesses such as grocery stores.

By eliminating sectors, you eliminate the headaches that come with owning stocks that face problems such as the ones I just mentioned. You also find it easier to understand the sectors you do invest in because you aren’t wasting time trying to understand everything about every sector.

Source: Thinkstock

Source: Thinkstock

3. Look for reasons not to own a company

There are many reasons not to own shares in a company that you can rationalize and then quickly apply to numerous companies without taking much time. It really depends on the sort of investor you are, but here are a few to consider:

  • The company has a lot of debt.
  • Executive compensation is too high.
  • The company buys back stock without incorporating a dividend as well.
  • The company didn’t buy back stock at a lower share price, but it is buying back a lot of stock at a higher share price.
  • Information about the company is too difficult to find and interpret.

Your reasons don’t even have to be fundamental in nature — they can be ethical.

Ultimately, there are simply too many investments out there, and a part of the selection process is eliminating these options. If you take a critical approach and find ways to eliminate investment options using broad strokes, you will have the time you need to perform in depth company analysis for the companies left standing.

Keep in mind, however, that you shouldn’t only take this negative approach. You need to combine it with a positive one that incorporates what you should look for in an investment, an issue I discuss in an earlier article.

Disclosure: None.

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