Chuck Hughes - Stock Selection (The Fail Safe Financial Program pgs. 155-158)


Stock Selection

This is focused on people who want to purchase individual stocks. I would like to share along with you the methods I have tried personally through the years to select stocks which i have discovered to become consistently profitable in actual trading. I prefer to use a mixture of fundamental and technical analysis for selecting stocks. My experience indicates that successful stock selection involves two steps:

1.    Select a regular using the fundamental analysis presented then
2.    Confirm that the stock is definitely an uptrend as indicated by the 50-Day Exponential Moving Average Line (EMA) being above the 100-Day EMA

This two-step process boosts the odds the stock you select will be profitable. It offers a signal to market a stock that has not performed as expected if it�s 50-Day EMA drops below its 100-Day EMA. It is another useful way of selecting stocks for covered call writing, a different sort of strategy.

Fundamental Analysis

Fundamental analysis may be the study of monetary data for example earnings, dividends and cash flow, which influence the pricing of securities. I use fundamental analysis to help select securities for future price appreciation. Over time I have tried personally many methods for measuring a company�s rate of growth so that they can predict its stock�s future price performance. I have used methods for example earnings growth and return on equity. I have found that these methods are not always reliable or predictive.

Earning Growth
For example, corporate net earnings are susceptible to vague bookkeeping practices for example depreciation, cash flow, inventory adjustment and reserves. These are subject to interpretation by accountants. Today more than ever before, corporations they are under increasing pressure to beat analyst�s earnings estimates which leads to more aggressive accounting interpretations. Some corporations take special �one time� write-offs on their balance sheet for things like failed mergers or acquisitions, restructuring, unprofitable divisions, failed product development, etc. Many times these write-offs are not reflected as a drag on earnings growth but instead appear like a footnote on a financial report. These �one time� write-offs occur with increased frequency than you may expect. Many companies that from the Dow Jones Industrial Average took such write-offs.

Return on Equity
Another popular indicator, which I have found isn't necessarily predictive of stock price appreciation, is return on equity (ROE). Conventional wisdom correlates a higher return on equity with successful corporate management that is maximizing shareholder value (the larger the ROE the better).

Which company is more successful?
Coca-Cola (KO) having a Return on Equity of 46% or
Merrill Lynch (MER) having a Return on Equity of 18%

The reply is Merrill Lynch by measure. But Coca-Cola has a higher ROE. How is that this possible?

Return on equity is calculated by dividing a company�s net income by stockholder�s equity. Coca-Cola is so over valued that its stockholder�s equity is just equal to about 5% from the total market value from the company. The stockholder equity is so small that almost any amount of net income will produce a favorable ROE.


Merrill Lynch on the other hand, has stockholder�s equity comparable to 42% from the market value from the company and requires a greater net income figure to make a comparable ROE. My point is the fact that ROE does not compare apples to apples therefore is not a good relative indicator in comparing company performance.


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