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The Test - Buy, Sell or Hold That Stock?

The Test - Buy, Sell or Hold That Stock?

Sometimes you need to make snap decisions. Should you buy, sell or hold that stock?

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By Investopedia.com 20.02.2012

Sometimes you need to make snap decisions. Should you buy, sell or hold that stock? You don't always have time to consult a firm's stock analysts, interview management or read lengthy research reports to make a decision. So what do you do? One simple trick is to look at the company's last two earnings reports.

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Increasing Sales

Is the company growing its sales, and if so, is the sales growth real, or related to one-time events? This means you'll have to read the entire press release to both take in what management said about the quarter, as well as look at the numbers. Did the company experience internal growth, or did it sell an asset or experience some other windfall that makes it seem like it's growing?

In general, it's a good idea to look at smaller companies (in the $100 million to $1 billion in sales range) that are growing in excess of 10% annually. When looking at larger companies, their sales should be growing by at least 3% to be of interest. Lastly, compare a company's growth in sales not only from last year, but from last quarter (both year-over-year and sequentially). If quarterly sales have exhibited an upward trend, it's usually another good sign.

Improving Margins

The sales line is improving. Is its cost of goods sold line item, or its selling, general and administrative expense line on its income statement going up at a faster rate? If so, it could be because the company is just entering into a new business or launching a new product and is experiencing some growing pains or paying for some start-up costs. However, this could also mean that the company is doing a poor job of managing its expenses. Management's discussion of the quarterly results will help you glean that information.

Guidance

Many companies offer the market some sort of guidance on future earnings. Has the company recently increased or decreased its future (earnings) guidance? Are the numbers the company is expecting better or worse than what analysts are expecting? This information will give you an idea of whether the company has the potential to "wow" the market, or if it is more likely to disappoint with its future numbers.

Delving a bit deeper into the psychology behind earnings guidance, if a company ups its guidance for the current quarter, but downplays expectations beyond that, its stock will probably sell off. Conversely, if a company reduces its estimates for the current quarter, but raises its full year estimate, the common stock will probably take off. As a rule of thumb, keep your eye on the long term, because in most instances, the market will overlook a short-term stumble if it is convinced that there may be a tangible catalyst on the horizon.

Stock Buyback Programs

Is the company buying back stock in the open market? When companies buy back their stock rather than use the cash to make acquisitions or pay dividends, it's usually a good sign that management feels the stock is undervalued. Buyback programs will probably be mentioned in the press release.

That said, in some cases management may have ulterior motives behind buying back shares. Some management teams do it to reduce total share count in the public domain, in order to improve financial ratios or boost earnings, thus making the company more attractive to the analyst community. Other buyback programs are instituted as a public relations ploy to get investors to think the stock is worth more.

Share buyback programs are usually a good sign that better times may lie ahead. Just ask yourself, would you rather buy a company that is repurchasing its stock near its 52-week low, or one that refuses to buy back shares in spite of having the cash to do so?

Rising Share Count

Ideally, you want to see the total number of outstanding shares staying the same or falling, perhaps as a result of a buyback program. This way, future earnings are spread across fewer shares, making earnings per share higher. As shares outstanding increases, earnings are divided among a larger pool of investors and become diluted, decreasing your potential for profit.

New Products

In a short period of time, it's almost impossible to determine whether a product will be a winner or not. However, it could be a big mistake to overlook these stocks, because new products will often garner a lot of attention from both consumers and investors. This often helps move the share price higher in the near term. In addition, the company has probably already spent a huge amount of money on R&D and initial promotions as it positions itself to take in a whole lot of money with fewer (namely R&D) expenses.

Take, for example, Apple's release of the iPod in 2001. Initially, some investors and analysts were sceptical of whether the company would be able to deliver meaningful revenues from this product. However, the product turned out to be highly successful; the company's growth in past years was propelled by the iPod's success; the company shipped out 42.6 million iPods in 2011, alone. New products don't always turn out to be cash cows for the companies that produce them, but if you get in on a good one early, there can be a dramatic potential for profit.

Language Use

Read the press release. What is your impression of what occurred in the quarter? Was it a positive report in which management talked about "opportunities" and relished its past growth, or did management talk about the many "challenges" facing the company? Was its earnings guidance raised or lowered? Are there any new potential catalysts such as new products or potential acquisition candidates that management is talking about that might help drive the stock higher? The language that is used in these press releases is very deliberate. It is reviewed by many eyes in the both the press and the legal departments. An upbeat report is an especially good sign, while a report containing muted language should be viewed with suspicion.

A word of warning: Reports that are overly upbeat should be viewed with caution as well. If a company fails to deliver what it has previously promised or falls short of its future expectations, the stock is likely to be clobbered.

Technical Indicators

Next, look at the stock chart for the last year and last five years. Are there seasonal variations in the stock price? Does it typically trade higher or lower in certain parts of the year? This could be valuable information.

Is the stock trading above or below its 50- and 200-day moving averages? Determine the trend this stock is trading in. Is it a thinly traded stock, or does it trade millions of shares per day? Has the volume recently increased or decreased? Decreasing volume could be a sign of less interest in the shares, which could cause a decline in share price. Increases are generally favorable if the underlying fundamentals are solid, meaning the company has solid growth opportunities and is well capitalised.

The 10,000-metre View

Beyond the last couple of press releases, consider the macro trends that might impact the stock. Are rising interest rates, higher taxes or buying patterns within the industry going to have an impact on the stock? Is there some other external factor, such as an industry-wide downturn, that might affect the company? These considerations are just as important as the fundamentals and the technical indicators.

Taking a 10,000-metre view of the company will allow you to take in the external factors that could keep a stock from being profitable.

The Bottom Line

By necessity, investors and their brokers often need to analyse companies on the fly. Zeroing in on the information listed above should allow you to make sense of the company's prospects while avoiding a rash decision.

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