It may sound funny that here I am, the self admitted “technical” trader, about to tell you about a “fundamental” indicator for picking consistently, outperforming stocks. If an investor were to only use this one stock selecting tool and nothing else, the returns would be an unbelievable string of winners.
A little bit of math and a small amount of research and the winning trades would blow your mind. But, therein lies the problem. Tell the average investor that there’s a way to consistently beat the markets and you’ve got their full attention… then you tell them there are some simple mathematical calculations and their vision starts to blur and they can’t hearrrrrr you because of the ringing in their ears.
Some would have you believe that finding any type of indicator that produced a steady stream of winning trades is like finding the holy grail… “it doesn’t exist,” they would say.
Well, I’m here to tell you that it does, and not only does it exist, but I’m going to tell you exactly what it is and how to use it.
Stock market analysts typically tell their clients that picking stocks is too complicated for the average investor and that it’s best left to professionals. After all, they do have to protect their livelihoods. If anyone could do it successfully, why would someone pay them for their mediocre performance. They themselves are sheepish in nature, usually checking with other analysts to see what they’re recommending and comparing strategies. They don’t care if they’re right or wrong or whether you make money or not. The only thing that is important is that our analyst didn’t do worse than the other guy or the benchmark index they compare their performance to. The market could be down 50% but if he/she were only down 40%… they beat the benchmark! They had a great year! I can see them slapping each other on the back congratulating themselves on what a great job they did for their clients… and these guys get paid for this? This simple technique will put them all to shame.
The Inside Track
If you want the inside track on huge momentum plays with explosive gains you need to focus on one of the most useful ratios available to stock pickers.
It’s called, “Return On Equity” (ROE). Return on equity gives you the most complete snapshot of a company’s profitability. It shows exactly how much profit a company generates from the cash money it’s shareholders have invested. I will now show you how you can determine what this number is and how profitable it can be. Incidentally, return on equity has been the leading indicator used by Warren Buffet for the past fifty years to determine a business’s profitability before he invested in them (and we know that worked out for him).
You calculate ROE by dividing “net income” by “shareholder’s equity.” The higher the number, the more effective a company is at using it’s assets and employees to generate cash for it’s investors. That’s why people invest to begin with, to earn a return on invested dollars in the form of growth in equity.
Here’s an example. From 1999 to 2003, Dell Computer’s enormously efficient business model and high profit-margins paid off in the form of earnings growth and a double-digit ROE of 46%. During that same period Dell’s shares rose 96% cascading money down on it’s shareholders.
The ROE Formula
Net Income / Shareholder Equity = ROE
Taking the net operating income and dividing it by shareholder’s equity (number of shares outstanding) gives you the return on equity as a percentage.
The only way this ratio stays elevated is by reducing the number of outstanding shares (shareholder equity) or to increase the company’s net income. If management attempts to dilute the earnings by issuing more shares (a common practice is for management to issue stock options as a way of sucking out excess liquidity or issuing more shares through a seasoned equity offering), you will be alerted by the drop in the ratio. Investors who only focus on net income will not be aware of this situation because the net income will stay the same. ROE is the strongest and most reliable indicator of effective management and out-performing growth.
ROE is easy to track from a number of free financial websites like Google Finance and Yahoo! Finance.
Using the “get quote” search box to look up a particular selection. Select “key statistics.” On the same page in “management effectiveness” section you will see the value for “Return on Equity (ttm).” This will be expressed in a percentage of profits being generated for shareholders.
A higher ROE number shows how effective it’s management is in it’s growth strategy, a company’s profitability and if the stock in undervalued. Watch this number closely and you’ll notice how ROE changes (hopefully increasing).
You are looking for double-digit percentages for ROE. Double-Digit ROE is one of the most reliable, fundamental indicators you can use for picking consistent winners.
Ray
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