How to Buy
Understand the Company
You don’t have to be a programmer to invest in Apple, but you should have a good idea of the competitive landscape for the iPad (and the iPhone and iMac). You should have confidence in a firm’s leaders. Do you believe that new CEO Tim Cook can fill Steve Jobs’s shoes? Some firms—Berkshire Hathaway is another good example—seem hitched to a specific leader. For others, the culture is spread throughout the company.
Use the Right Yardsticks
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An investor in Gap Inc., for example, monitors same-store sales (sales from stores open at least a year); an investor in an oil-and-gas producer, such as Devon Energy, looks at proven reserves. Expect different rhythms: Machinery companies, such as Caterpillar, do well when the economy is roaring, while makers of consumer necessities—think Johnson & Johnson—tend to lead in a downturn.
Dig into the Financial Nitty-Gritty
Look for an upward trend in sales and, especially, in earnings (both historical and forecast). Divide net income by revenues to find a company’s net profit margin. Even in slow times, firms with a handle on costs can improve margins. Dollar General’s net profit margin has expanded from 1.0% in 2008 to an estimated 5.3% in 2011. Especially in today’s tepid economy, look for a clean balance sheet with low levels of debt in relation to equity.
Gauge the Price Relative to Key Measures
Investors typically judge value by looking at the price-earnings ratio. Compare it with the overall market’s P/E (about 12, based on 2011 profit forecasts) and with P/Es of other stocks in the industry. All things being equal, a low P/E signals a bargain. For some businesses, other ratios are key. Use price to book value (assets minus liabilities) for insurers, for example, and price to funds from operations for real estate investment trusts.
When to Sell
The Reason You Bought Changed
The management team has left, or you’ve lost confidence in it. The company has shifted its strategy. Or the outlook for the company, or its industry, has deteriorated significantly. Look no further than the banking industry in 2008 to find examples of stocks to give up on for all of the reasons above.
Earnings Take a Detour
It’s bad enough when earnings disappoint. But when the company says the blows will keep coming, take the news seriously. In June, Research in Motion reported weak quarterly results and warned that profits in the current fiscal year would come in well below already lowered expectations. The dismal outlook was a final confirmation for many that iPhones and Androids were eating BlackBerries’ lunch.
The Ride has Gotten Scary
It’s hard to know when a stock has become too expensive. Pricey stocks often become even pricier before they retreat. Still, it’s a red flag when the P/E becomes astronomical in relation to the market or to similar firms. Cloud-computing darling Salesforce.com sells for 94 times earnings. Consider selling half now, and let the rest ride.