How Do You Analyze Individual Stocks?

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If you’ve been reading MPFJ for a while, you’ve probably heard me mention before that I am not a big advocate of people investing large amounts of their own money in active management, either through the buying and selling of individual stocks yourself, following the advice of a newsletter, with the help of a “professional” investment advisor, or through an actively managed mutual fund.

Why do I shy away from large investments in individual stocks? Simple. Because the track record of individuals (even professionals) selecting individual stocks does not show proof positive that it is worth the cost involved. In fact, 70% of the stock professionals fail to beat out the market, so why would I think I can do this consistently?

Having said that, I do, however, think that analyzing individual stocks for investing using smaller amounts of play money is a fascinating exercise, and it’s something that I would like to believe in. I just haven’t seen proof that it can be done consistently in an efficient manner, but maybe someone will prove me wrong one day and cause me to switch from my current approach of passive investing using index mutual funds and ETFs.

Anyhow, recently, I received an email from a blog reader asking about how I analyze individual stocks and also what my thoughts were on the specific stock, MGT Capital Investments, Inc. (AMEX symbol: MGT). Since other readers may also be curious of what approach I take to analyze a stock for potential investment (or not – using play money only of course!), I figured this would be a good topic for a blog post and to also answer the reader’s question at the same time.


Step 1 – 30,000 Foot Elevation View of the Company and Long-Term Price Performance

To get a very high level overview of the company, I first turn to Google Finance and look up the ticker symbol.

On Google Finance, I specifically am looking at 3 things – 1) the long term price history, 2) the financials, and 3) the company overview/description. I like to use Google Finance for this purpose because all of these items are displayed on a single page, making it very easy to navigate.

Shown below are these three items for the stock that the reader wanted me to take a look at, MGT. From these screens, I can conclude the following things for this specific stock:

  • Because of the low stock price per share, low institutional ownership, low market cap, and horrible looking financials, this stock is an extremely speculative play, with a very high level of risk involved. 
  • The company seems a little mysterious, as I’m not really sure from reading their description what it is that they do. It states that they have only 9 employees and that they are a holding company that makes investments in order to obtain value-added intellectual property (patent aggregator). So, essentially, it is basically a group of several people investing share-and-bond holder money in to other or new companies/patents to operate.
  • The company has been around for a while now, over ten years. It appears that their stock price started off higher during the euphoric times of 2000-2001, but was not able to recover until just recently. 
    • Because of this, I’d want to look specifically at what caused the decrease in the stock price in 2002 (if it was related or unrelated to the general stock market bubble), what caused the flat-line from 2002-2011, and what recent event has sparked renewed interest in this company (is it legitimate/sustainable, or just speculation?). 
transaction fees phil town individual stocks vs mutual funds individual stocks active management
MGT Long Term Stock Price History
transaction fees phil town individual stocks vs mutual funds individual stocks active management
MGT Financials
transaction fees phil town individual stocks vs mutual funds individual stocks active management
MGT Company Overview/Description

Step 2 – See How the Stock Fits Within Phil Town’s Rule # 1 Investing Analysis System 

As I mentioned previously in my 6 month test run of Phil Town’s Rule # 1 investing system (which showed that its usage did not deliver a market beating return due to the trading commissions involved), I do not believe that Phil’s system is the “magic formula” for beating the market. However, Phil’s approach does involve some very prudent technical and fundamental analysis which I feel can give me a deeper understanding of how the company would function as a potential investment. 


Listed below is how the stock, MGT stacks up against Phil’s investing criteria:
  • Phil Town Criteria # 1 – Only invest in companies that you would be proud to own, trade for > $1 per share, and have > 500,000 average daily trading volume. The type of companies you should invest in should be at the intersection of what you love to do, what you are good at doing, and what you can earn money doing.
    • MGT is trading for >$1 per share, but only has a daily trading volume of 20,000 shares, which means that it is not very liquid.
    • Since MGT holds companies that are involved in the medical field, I would be interested in owning the stock. However, I also found out in this investigation that they are planning to cut out the medical side of their business soon….. 
  • Phil Town Criteria # 2 – Identify if the company has a “moat” – What he explains we are looking for here is >10% annual growth rate over 10 years for the following things: 1) Return on investment capital, 2) sales revenue, 3) EPS growth, 4) Equity per share, and 5) free cash flow growth. We also make sure that the company has enough current free cash flow to be able to pay back it’s long term debt in 3 years or less.
    • A great place to get all of this 10 year historical data in one place is Stock2Own.com. If you type in the ticker symbol of the stock you’d like to analyze in the box at the top, it will then automatically calculate all of these five financial ratios for you. These can be accessed by clicking the Growth Rates option on the left sidebar. 
    • For MGT, unfortunately, the financial calculations above do not look very good because of all of the negative values it is carrying, and as such, are definitely NOT in line with Phil Town’s criteria. Return on investment capital, EPS growth, Equity per share, and free cash flow growth are all either deeply negative or zero. Furthermore, the company has negative free cash flow, but at the same time, they have no long term debt. 
    • At 23% annual growth over the past 9 years, sales revenue does fit the criteria.


Even though MGT does not meet the criteria set forth in the Phil Town method, this is not very surprising because as I mentioned above, it is expected to be a more speculative play, not a rock solid, long term investment.


Because of this, we must also examine the actual financial figures over the past ten years in a more manual style. Shown below is a handy graphic from the Raw Financial Data section of the Stock2Own site for MGT for the years 2002-2011 (displayed left to right in chronological order on the chart):

As you can clearly see in the chart below, many of the numbers are negative, which is definitely a bad thing. However, if you examine the TRENDS closely from left to right, it can be seen that the company seems to be heading in the right direction in the regard that EPS, sales, free cash flow, cash from operating activities, and gross profit are all experiencing positive changes, even though the numbers themselves are in fact negative. This is a good sign for a speculative play. 


transaction fees phil town individual stocks vs mutual funds individual stocks active management
Ten Year Financial Data Trends for MGT for 2002-2011, displayed left to right in chronological order

  • Phil Town Criteria # 3 - Calculate the appropriate sticker price, or what the stock should be selling at given it’s current EPS and EPS growth rate. We then calculate the Margin of Safety price (MOS) to make sure that we buy the stock at a significant enough (50%) discount to shield ourselves from mistakes and be able to achieve higher returns.
    • Fortunately, the tool listed above, Stock2Own.com also has a handy feature that automatically calculates the sticker price (Value Price) and Margin of Safety (MOS) price.
    • To view this in Stock2Own, simply click the Value Price option in the left sidebar. 
    • Unfortunately, for MGT, since their EPS is negative, a MOS/Value Price cannot be calculated, so we don’t have this gauging point to base our decisions off of. 
  • Phil Town Criteria # 4 – Use technical analysis tools to make sure you are either buying or selling at the right time. Phil recommends using three technical tools to make sure of this – 1) 8-17-9 MACD indicator, 2) 14K, 5D Slow Stochastic Oscillator, and the 3) 10-day moving average. Phil recommends that you only buy when all 3 of the tech. indicators say “buy.”
    • To generate these three graphs for a stock analysis, I again use Google Finance. To set it up, you simply click, “Technicals,” at the bottom of any Google Finance stock price history window, and fill out the fields as shown in the below screenshot:
transaction fees phil town individual stocks vs mutual funds individual stocks active management
    • Once you’ve set up the indicators, view the 3 month history graphs for the stock you’re analyzing. Three months seems to be a good time period in order to clearly see whether the technical indicators are saying “buy” or “sell.”
    • For analyzing MGT, we’ll go through the technical indicators one by one. First, the 10 day simple moving average, as shown below (red line), compared to the actual stock price (blue line). With the simple moving average, a “buy” signal is indicated by when the stock price line crosses above the moving average. In the case of MGT, the stock price is currently below the moving average, indicating that we do not want to buy right now.


transaction fees phil town individual stocks vs mutual funds individual stocks active management


    • MGT’s 14K, 5D Slow Stochastic Oscillator is shown below. With stochastic, the K line (blue) is the “buy” line, and the D line (red) is the “sell” line. With this technical indicator, a “buy” signal is indicated by when the buy/K line crosses above the sell/DIn the case of MGT, the K line is currently below the D line, indicating that we do not want to buy right now.
transaction fees phil town individual stocks vs mutual funds individual stocks active management
    • MGT’s 8-17-9 MACD indicator is shown below. With this technical indicator, a “buy” signal is indicated by when the MACD line crosses above the EMA lineIn the case of MGT, the MACD appears to have decreased and is now crossing the EMA, indicating that we do not want to buy right now (this is actually a sell signal if we already owned the stock).


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Step 3 – Qualitative Research on the company, the management (CEO especially), current news, and that no insider selling is happening

As the title above suggests, the next step I take to analyze a company is to perform some qualitative research about what they do and how they do it. This is also a good time to research any questions that have popped up from the more quantitative investigations discussed above. 
Listed below is how I tackle this step, using the stock, MGT, as an example:
  • Management Analysis (done through Google Finance and Reuters.com) – The current CEO of MGT, Robert Ladd, joined the company in 2010 as a director and became CEO in early 2012. This occurred almost exactly the same time at which the stock price for the company increased from almost $0 to $4 per share. There was also a stock split at this same time. At a high level, this appears that the market took the news of a new CEO as good and that Mr. Ladd was assessed as a good leader. Ladd also has a long history of investment analysis, which is important in his role as head of a holding company where he is making investments as his primary business. I also found another article stating that Mr. Ladd is “responsible for rejuvenating the company.”
  • Insider Trading (done through company website or MSN Money)  – In looking at the recent transactions of company insiders, there have only been stock purchases over the last year or so, which is a good thing. It is also encouraging to note that the management only have reported income that they pay themselves of $200 per year or so, so it appears that their salary is heavily weighted in stock options/stock performance. That’s also a good thing. 
  • Additional Clarity About What the Company Does/Its Current Position (find the “news” columns on Reuters, Yahoo/Google Finance, etc after you bring up the chart for a specific stock) - On the MGT company website, I found a presentation from late 2012 that stated that they “have a cash rich balance sheet.” However, in looking at their balance sheet from that time, I really didn’t understand how they could make that claim. 
    • It wasn’t until I read up on the developments at MGT within the past 3 months or so that I was able to obtain a complete picture of the company. Because none of these events are yet reflected in their SEC filings/reported financial figures, it makes judging the decision to buy or not more difficult and involving more guesswork.
    • First, I found out that they obtained about $6MM in additional financing in late 2012 from equity offerings. This will definitely help free up some cash flow and pay off short term debts.
    • Second (and more importantly), I found out that MGT is selling off its medical holdings because it did not fit and wasn’t profitable for them. They have decided only to focus on their gaming patent development for now. The fact that the company is focusing on its core competencies and will obtain a large amount of cash to improve its balance sheet from the sale is definitely a good sign to me. The general “buzz” in the community is that this stock is set to “take off” this year because of these recent events. 
  • Lastly, as I mentioned in my high level review, MGT’s stock price started off higher during the euphoric times of 2000-2001, but was not able to recover until just recently. Because of this, I said that I wanted to look specifically at what caused the decrease in the stock price in 2002 (if it was related or unrelated to the general stock market bubble), what caused the flat-line from 2002-2011, and what recent event has sparked renewed interest in this company (is it legitimate/sustainable, or just speculation?). Unfortunately, I couldn’t find information about what caused the decrease in 2002. However, I found a press release stating that the increase in 2012 was not for some shady insider event, so that is a good sign! 

Step 4 – Review and Decision to Buy or Not

Having now completed all of the analysis, it’s now time to bring it all together, summarize the findings, and make a decision for if I would buy a specific stock using play money or not. 

Using our example of MGT, here are my conclusions:
  • Seems like an understandable and good business model (now that I have performed a little more analysis).
  • Since the long-term financials are not very good and/or negative, the investment involves a lot of risk. However, although the financials are negative, the recent trends definitely point upwards for MGT.
  • In addition, there is nothing but good current news on the horizon for MGT, including a lot of positive effects not currently reflected in their SEC filings. They also have a strong CEO and no negative insider trading. 
  • All 3 of the technical indicators dictate that NOW is not a good time to buy shares of MGT. 
  • Because of that, my final conclusion for this play is to keep monitoring the technical indicators and news for MGT, and I will place a small amount of play money in this stock when the technical indicators all give me the green light, either in my account at Sogotrade.com or TradeKing.

How about you all? What is your approach to analyzing individual stocks for potential investment? How much of your money do you allocate to individual stocks vs. mutual funds?

Share your experiences by commenting below!

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***Photo courtesy of http://farm3.staticflickr.com/2339/1563208173_867ddc9717_z.jpg?zz=1

Comments

  1. myfijourney says:

    To sum up a very long process in just a sentence: I start with dividend related metrics like yield, payout ratio, dividend growth trends, years of consecutive dividend growth, etc. and then build out from there with some valuation metrics like discount models, PE ratio, and moats.
    My recent post A Primer on Federal Income and Investment Taxes

    • Thanks for sharing myfijourney!

      I've noticed that a great deal of folks in the pf blogging community are very in to dividend stocks. Do you ever invest in dividend specific mutual funds or etfs?
      My recent post Is Mystery Shopping Right For You? – Lessons From Personal Experience

      • myfijourney says:

        The only ETF or mutual fund worth holding IMHO is a market fund (stock market, bond market, etc). Here's why I generally believe that.

        - The more specialized the fund, the greater the fees.
        - There's a lot of sub-optimal investments in a fund or ETF. Consider how many dividend funds have stocks paying a measly 1-2%.
        - I don't see any reason to pay for what I can easily do myself. If I were going to be really lazy, I could just look up the top 20-30 holdings of a dividend specific mutual fund see which ones are dividend champions, contenders, or challengers, and then buy those. This is maybe an hour's worth of work and produces a portfolio with no maintenance fees.
        - Mutual funds and ETFs are generally not value investing driven. They can't be, since they have to buy and sell every time someone adds or subtracts money.
        My recent post The Pitfalls of Ethical Investing

  2. This is an interesting post. While I agree with you that the majority of managed funds struggle to beat the market, dividend paying stocks consistently have outperformed the market over long periods of time. Its why I am comfortable holding a portfolio of individual dividend paying stocks and why I am comfortable holding these stocks to provide a passive dividend income to fund my financial independence (which I hope to happen in the next 5 years). I don't use technical indicators, because i am happy holding these stocks for years, so a 5% or so either way in terms of entry price isn't material to me.
    I start with the assessing dividend yield, dividend growth and ultimately stock fair value. I also look to have a qualitative view on why I believe earnings and dividends will continue to grow for a given business 5-10 years out.
    My recent post How should you construct a dividend growth portfolio?

    • Very cool Integrator. Thanks for sharing! I'm curious – what report did you see that showed that dividend stocks have outperformed the market over long periods of time? In the books, I have read, such as A Random Walk Down Wall Street and Stocks for the Long Run, they say that dividends stocks don't necessarily outperform. Just curious..
      My recent post Is Mystery Shopping Right For You? – Lessons From Personal Experience

      • There is a report by Ned David Research that looked at the performance of a broad index on stocks (S&P 500) from 1960 to 2010. It concluded that dividend paying stocks (specifically dividend growth stocks) returned almost 10% over the period, higher than dividend stocks that didn't increase their dividends 8.8% and non dividend paying stocks returned only 2%.
        My recent post Why you should be cautious of “artificial” dividend growth

        • Very interesting! Could you share the link and/or title of that report? I'd like to research it. Thanks!
          My recent post Is Mystery Shopping Right For You? – Lessons From Personal Experience

  3. The attached whitepaper by Ridgeworth investments references the research and the outcomes https://www.ridgeworth.com/assets/files/n9/divide
    My recent post Why you should be cautious of “artificial” dividend growth

    • Thanks so much for sharing that! I'll look in to this in the near future!
      My recent post Should Short-Term or Intermediate-Term Bonds Make Up Your Fixed Income Asset Allocation?

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