The 7 Critical Steps to Profitable Investing

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Editor’s Note: Cabot’s own Nancy Zambell has written a book! Titled, “Make Money Buying and Selling Stocks: The Cabot Wealth Introduction to Investing,” the book is available in paperback on Amazon for less than $10! To give you a taste of Nancy’s comprehensive deep-dive into how she and Cabot have consistently made money for subscribers for decades, the following is an excerpt from the book on the 7 Critical Steps to Profitable Investing. Enjoy!

You only need to turn on the TV to see gurus and best-selling authors who can’t wait to sell you their latest stock market gimmicks that promise you “instant millions.” Their ‘guaranteed’ technical trading systems, proprietary methodologies, complex economic models, and even some that chart astrological systems, are generally not worth the paper they are written on. They’re not the shortcuts to profitable investing that they’re billed to be.

In my years of investing, I have yet to see any of these “systems” consistently beat a good old-fashioned look at a company, its industry and how it relates to the current and projected economic realities.

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If a business is fundamentally strong (i.e. it actually makes money), has a diversified product line, and is in a solid position in its market, you are 90% of the way to finding a good investment. The remaining 10% is just a matter of looking at a few parameters – no matter what the company does – to determine if it’s the best stock for your investment dollars.

Here, I want to discuss seven key metrics that should be reviewed before buying any stock. These indicators should pave the way to profitable investing by helping you get most of the way in understanding a company, its operations, and its underlying business.

7 Key Metrics for Profitable Investing

1. Institutional activity. Pension funds, mutual funds, hedge funds, insurance companies and corporations that buy and sell huge blocks of shares can create tremendous volatility in prices. To lessen this risk in your investments, try to buy shares in companies where institutions own less than 40% of their shares. You can find this information at http://finance.yahoo.com, in the Holders section.

2. Analyst coverage. Another indication of future share volatility is the number of Wall Street analysts covering a stock. Analysts—like the big institutions—have a herd mentality. When one sells, often, so do the rest, resulting in great numbers of shares changing hands, and usually leading to price declines. It’s best to avoid companies with more than 20, or fewer than two analysts following them. (You need some analyst interest, or you may be waiting a long time for price appreciation, even in the strongest and most undervalued company). You can locate the number of analysts at http://finance.yahoo.com; then select Analysis. Many times, the companies in which you are interested will also publish which analysts cover their stock, on their Investor Relations page.

3. Price-earnings ratio (P/E). The price of one share of a company’s stock divided by four quarters of its earnings per share (usually the last four quarters, the trailing P/E ratio), the P/E ratio is of utmost importance in determining if a company’s shares are overvalued or undervalued. For the best perspective, go to https://www.reuters.com/finance/stocks/overview, enter your stock symbol, then select Financials and compare the current P/E of the company to its average P/E for the last 3-5 years, to its estimated future P/E and to the average P/E of its industry or sector. One note: If a company’s P/E is more than 35, it might be too pricey. You may want to stick with companies that are trading at lower P/Es, particularly if you are fairly new to investing. Almost any financial website will feature trailing P/E ratios and forward P/E ratios for a given stock. Note: Reuters has almost 50 comparative ratios on its site.

4. Cash flow. One of the most important parts of a financial report is its Statement of Cash Flows, which is a summary of how the company made and spent its money. Go to http://finance.yahoo.com, Financials, then to Cash Flow and select Annual or Quarterly, depending on which period you want to review. Then find Total Cash Flow From Operating Activities, which represents the cash the company took in from its primary business operations. If it sells clothes, it’s the cash collected from selling clothes.

It’s important that this number be positive, or at least trending positive over the course of a year. After all, if the business isn’t making money from its primary product—not from investing in real estate or the stock market—then you probably want to pass it by.

5. Debt/equity. This ratio is how much debt per dollar of ownership the business has incurred. Compare the firm’s historic debt/equity ratios, so you can find out if its debt level over the past few years has been rising too rapidly. Debt isn’t bad, as long as it is used as a springboard to grow sales and earnings. Next, contrast the company’s ratio with its competitors and its industry so you can further determine if your company’s debt position is reasonable. These ratios can also be found at https://www.reuters.com/finance/stocks/overview, under the Financials tab.

6. Growing sales and income. A rule of thumb that has always served me well: Buy shares in companies whose sales and net income are growing at double-digit rates. I cannot emphasize this enough, as appreciation in stock prices is generally precipitated by growth in earnings (which usually follows expansion of sales). It’s certainly possible to buy stock in a company that has no earnings growth (a new business, or a tech company in the late ‘90s, for example) and still make money on the shares—short term—but it’s not a formula for serious, successful long-term investing. This ratio can also be found on https://www.reuters.com/finance/stocks/overview, on the Financials page.

7. Insider activity. Investors will also want to review the buying and selling activities of a company’s insiders—its top officers and directors. A sudden rush to sell large quantities of the firm’s shares may be a good indicator that the business is falling on rough times. Likewise, a large increase in purchases may mean good news is on the way. The website, https://www.nasdaq.com/, under the Insiders tab, lists all the recent insider activity at the company, as well as the number of shares remaining after the sale—an extremely important figure.

I would like to leave you with one last thought on using these indicators: Remember that no one ratio will determine the validity or potential of your investment. It is of utmost importance that you take a complete look at a company’s financial strength and its future prospects, by conducting a thorough analysis—over time—usually a 3-5-year track record.

With these seven critical factors in hand, it won’t be long before you feel very comfortable in analyzing stocks in almost any industry. And feeling comfortable is a major key to profitable investing.

Nancy Zambell

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Nancy Zambell, Editor of Wall Street’s Best Investments, has spent 30 years helping investors navigate the minefields of the financial industry. Nancy scours more than 200 advisories and research reports to select the top recommendations, which she collects for you in this easy-to-read digest.

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