Tuesday, July 28, 2009

Building Your Prospect List

Step 1 – Build Your Prospect List

Selecting the right stock is the most important and critical aspect of investing. If there is one thing that you want to get right above everything else – this is it! That is why I believe in only trading options against the best and safest stocks for generating option income. After all we need to be okay with purchasing and owning the stock. Also, the biggest risk to the option income system (and to investing in the stock market in general) is that your stock(s) suddenly plunges in price. In the option income case where you have sold Puts, we don’t want the stock to drop way below our strike price and have the stock assigned to us at a significant loss. However, if it does we are okay with owning the stock and will employ our stock ownership strategies, but the less it drops below our strike price the better and easier for us manage and profit on the ownership side.

But, our first objective is to have our stock stay above the strike price and expire so we get to repeat our income generation strategy again the next month.

The first step to select a high quality stock is to use a stock screening tool to build a prospect list of about 20 strong, stable, high quality companies to choose from. I prefer using Morningstar’s premium stock screener which is a paid service, but there are other free stock screening tools on the internet that you can query for similar criteria. For example, MSN has a powerful stock screener in its MoneyCentral investing section.

Using Morningstar’s premium stock screener build your prospect list using the following search criteria:

Fundamental Analysis
• Market Cap > 1B
• Morningstar Economic Moat = Wide
• Morningstar Fair Value Uncertainty <= Medium • 3-Yr Revenue growth rate > 8%
• Consecutive Years of Dividend Growth Increases > 10 years (longer the better)
• Dividend Payout Ratio (DPR) <>= four stars

Here’s a brief explanation of each criteria:

Large Cap Companies

This is the value (or “capitalization”) of the company’s stock (stock price multiplied by the # of shares). Large companies with a value of more than $1 Billion are more stable than smaller companies due to competitive advantages, deeper pockets, track record, economies of scale, etc.. They usually have multiple if not hundreds of different revenue streams that balance out their overall revenue and sustainability; unlike a smaller business where there may only be a few shoes and when one drops it sends their stock reeling.

Wide Economic Moat

According to Morningstar this is the strength and sustainability of a firm's competitive advantage over other companies. Here are some of the attributes that can give companies economic moats: huge market share, low-cost producer, patents, copyrights, or governmental approvals and licenses, unique corporate culture, and high customer-switching costs. Again this provides stability, on-going profit potential and the likelihood of the company staying in business and growing its dividend.

Fair Value Uncertainty

To generate Morningstar Fair Value Uncertainty, analysts consider factors such as: How predictable are the firm's sales? Does the company's operating profit vary widely with changes in sales? How strong is the company's balance sheet? Is there a nonfinancial issue that could materially affect the company's fortunes? Analysts then classify stocks into one of several uncertainty levels: Low, Medium, High, Very High, or Extreme. I look at this as the quality of the company’s financials. We only want to accept companies that have medium or lower uncertainty rating on them so we have more trust and confidence in the overall rating of the company.

History of increasing revenues

High quality large companies are supported by consistently producing moderate revenue (sales) growth over long periods of time. For earning to continue to grow they must be supported by sales growth and not just cost cutting measures. I like a minimum of 8% sales growth because for large companies it is the “just right” amount; high enough to keep earning positive, but not too high so that it is sustainable. High growth rates cannot be maintained and when they drop the company’s stock takes a nose dive.

Currently pays a minimum 2% dividend yield

This helps in two areas: one as a stock price falls the dividend yield goes up which helps create what I call a soft floor. The rising yield attracts income investors who come into the market and purchase the stock. This provides a floor to form where the higher the yield (price falls) the stronger the support (new buyers) to keep the stock from falling further. This helps reduce the downside risk of the stock. This is based on the assumption that the dividend is not at risk of being cut. Secondly, it shows current commitment by management to distribute some of the profits to its shareholders in the form of cash dividends.

History of increasing dividends

Most people look at dividends for their income, but what most don’t consider is that a company’s ability (and willingness) to pay dividends and especially their history of growing their dividend is probably the best single indicator of a company’s financial health. Dividend growth that continues to increase year after year is a sign of future growth prospects and a signal that management has confidence in the company’s continued earnings power.

Safe dividend payout ratio

Payout ratio is calculated by dividing dividends declared for the indicated 12 month period by net income for the same period of time. This helps ensure that the company is making enough profit to continue to pay their regular dividend and not be forced to cut them. Safe payout ratios can vary depending on what industry the company is in, but a good rule of thumb is less than 60% of their net income is distributed in the form of dividends.

Morningstar rating

The final criterion that I use is Morningstar’s 1-5 Star rating where 1=Low, 3=Medium, 5=High, which they describe as follows: “The Morningstar Rating for Stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value.”. The higher the star rating the better the value of the stock and the higher the expected return. We are looking for 4 to 5 star ratings which indicate price of the stock undervalued compared to fundamental fair value of the company. I use this as a broad technical or timing indicator, because when the stock price is undervalued it is “more likely” to trend sideway or up rather than to trend down.

In Morningstar’s stock screener the criteria looks like this:

Market Capitalization (mil $) >= 1000
Morningstar Economic Moat >= Wide
Fair Value Uncertainty <= Medium Revenue Growth % - 3 Year >= 8
Dividend Yield % >= 2
Dividend Growth % Past 5 Years >= 8
Payout Ratio - Year 5 <= 60 Morningstar Rating >= Four Stars

Is this the end-all-be-all criteria that should be strictly adhered to? True this is an investing system, but it is not a pure mechanical system. Why? Because the stock market is a dynamic evolving marketplace where human analysis and judgment are needed to modify and tweak the system to adapt to market changes. The objective of our prospect list is to identify the top 20 or so stocks at any given time. If we are in a bull market and the overall market is overvalued this criteria may only return 10-15 potential stocks. In that case I will lower the criterion until I get close to 20 prospects to choose from. Likewise if we are in a bear market where stocks are generally undervalued, we might return 30 stocks, in this case I slowly ratchet up the criteria quality until I get back to around the best 20 stocks again.

This prospect list will generate the best and strongest stocks for the option income system to start your selection process. Newbies to investing and this system should stay close to the list. But are these the only good companies to consider? Not necessarily as you gain more experience you will be able to include other high quality stocks that are worthy of consideration and you can add them to your prospect list as well. The key is to weed out the thousands of lower quality stocks so that the best 20 for this system bubble up to the top!

Next post: The results of our prospect list search criteria.

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