How To Pick Top Quality Small Stocks
In this article, we pinpoint five criteria for picking top-quality small stocks…
The Quest For Quality
You’ll reap bigger profits and avoid more pitfalls by buying quality small stocks. Keep on top of each of these criteria by reading the stocks quarterly and annual 10-K reports, typically available on the company’s website. Research the company online by visiting third party platforms like MarketWatch, Seeking Alpha, The Motley Fool, or Yahoo Finance; just to name a few.
Using these guidelines, the stocks you choose are entirely up to your own discretion. Some stocks will perform exceptionally well, while others may not. However, when you invest in individual small stocks, you want to push the odds as much in your favor as possible.
Guideline #1
Rising earning growth for at least ten years. Or for as long as the stock has been publicly traded.
Rising earnings are what propel a small growth stock upward. Stocks with little or no earnings are an unknown quantity. They could turn out to be wildly profitable if their promise translates into rising profits. But there’s nothing to cushion their fall if those expectations turn out to be empty. Generally, the best stocks are those with long-term profit growth rates of at least 10%.
Guideline #2
Rock-solid balance sheet.
Bond ratings from Moody’s or Standard & Poor’s are probably the best ways to gauge a company’s financial strength Ratings of BBB (Baa2 for Moody’s) or higher are preferable. However, because many small companies have not issued bonds or are unrated, that may not be an option. For these companies the best measure of a firm’s financial health is how much debt it has, particularly relative to its “shareholders equity.” Lower debt (20% or less of total capital) means the company will be able to cut costs during an economic downturn. Higher-debt firms can be forced to dramatically curtain expansion plans should sales growth slow unexpectedly.
Guideline #3
Free cash flow.
The company should have money left over after paying all of its expenses, including interest on loans and construction costs. This money is called “free cash flow.” It can be used for stock repurchases, dividend boosts, expansion, buy out other companies, or simply to beef up the company’s investments. In all cases, shareholders benefit.
Guideline #4
Rising operating margins that are at least within a percentage point or two of all-time highs.
This is gross profit from a company’s operations, the best measure of how profitable a company is. A rising margin indicates that the company has secured a profitable niche market, in which its dominance will produce big profits in the years ahead. It’s calculated by dividing a company’s total revenue by total operating expenses (excluding debt repayments).
Guideline #5
Relatively low P/E ratio.
Price to earnings ratio, or P/E, is a way to value a company by comparing the price of a stock to its earnings. The P/E equals the price of a share of stock, divided by the company's earnings-per-share. It tells you how much you are paying for each dollar of earnings. A stock with high growth potential and a low P/E is a rare find indeed. Specifically, you want to find a company whose annual earnings growth for the past five years is no more than 50% lower than their P/E’s. In other words, if a company has a five-year profit growth rate of 10% and a P/E of 30, it’s not acceptable. But if its earnings growth rate were 20%, it would be acceptable.
Stay tuned for our next few articles, which will detail ‘small stock shopping’ guidelines, learning to identify the danger signs, the power of growth and small stocks for the next decade.
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