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Financial Planning for Scientists, Part 6: Picking Stocks

In the last few months, we've discussed different strategies to getting your personal finances under control. Last month, we introduced the stock market as a way of investing your money. We talked about how the stock market worked, and the physical mechanics of investing in a company. Today, we're going to chat about how to pick a winning stock.

A winning stock is usually defined as a stock that you buy at a really low price, and sell at a really high price. But that's only one type of "winning stock." Really, a winning stock is any stock you can predict. If you can predict with any certainty that a stock is going to go up, you should buy it. Likewise, if you can predict that a stock is going to go down, you should sell it. (A stock market will let you sell something you don't have, so long as you buy it again at a later date.) Even a stock that doesn't go up or down in value can be a winning stock, if you can predict with any great certainty that the price will remain constant and that the company will pay out a half decent dividend. (A dividend is a payment, usually from the profits of the company, made to the shareholders of the company.)

But everyone else can guess which direction the price of a predictable stock will go, too. So the price of that stock will accurately reflect the stock's future price. That is why you can make more money betting on "riskier" stocks whose performance is harder to predict. If you bet high when everyone else bets low and the stock price increases, your gains will be higher. But there is also a greater chance that you'll lose your shirt if you bet high and the stock price falls.

So what we're going to talk about for the rest of today's discussion is how to predict a stock's future price. I'll be talking about three methods used by experts to predict price: Value investing, trend investing, and growth investing.

But before you read on, you should know a secret almost never admitted by so-called "stock experts." I have no idea how to pick a winning stock. If I did, I'd be sitting on a beach in Maui right now, instead of writing this article. Very few people know how to predict stock prices accurately and consistently--and those people are sitting on a beach in Maui (they got there by private jet) and aren't going to tell you or me their secrets. So I won't be telling you what to do to pick a "winning stock." Instead, I'll be teaching some of the tools that experts often use to "narrow the odds," and increase their chances of predicting the future value of a given stock. But keep in mind that there is always a HUGE risk when buying a stock, regardless of the tools you use.

Value Investing

The whole theory behind value investing is that there are always deals to be had. There are always items that are being sold for less than they are worth, today. The theory is, if you get a great deal on it when you buy it, at some point the market will realize this and be willing to buy it back for more money.

A good analogy is the flea market. Some person at the flea market may be selling a dusty old analytical balance for $30, not realizing that it would be worth $300 to someone who collects vintage scientific instruments. If you recognize it, buy it, and clean it up, chances are you'll be able to find a collector willing to pay more for it when they realize what it really is.

There are several methods that value investors use to find deals in the marketplace. I'll discuss three: the market comparison, the discounted cash flow, and the company breakup value.

The market comparison lists many different but comparable companies in an industry and tries to understand why some are worth more than others. For example, you might make a list of 20 or 30 companies, all with cancer drugs in Phase II of clinical development. For each of these companies, you'd figure out what their market capitalization is by taking the stock price and multiplying it by the number of outstanding shares in the market. This gives you the theoretical amount that the company is worth. Then you'd do research to figure out why some of the companies are worth more than the others are. Does one have more cash in the bank or a licensing deal with a major pharmaceutical company? A CEO everyone loves? Is the company trying to find a cure to a rare cancer or one affecting millions of people? If after doing this analysis you find a company that has a much lower market capitalization than any of the others, but you can't figure out why, it might be a good investment.

Sophisticated users of the market capitalization method use many different measures of company worth, including price-to-earnings ratios, price-to-cash-flow ratios, and all sorts of other technical calculations. Measures will vary depending on the industry you are investing in.

The discounted cash flow method is another way of measuring the value of a company. But instead of comparing the company to others in the same industry, you try to figure out how much cash is going to come out of the company in the years to come, and you discount that cash flow to today's present value. The theory here is that a company is only worth the amount of money that is going to come out of it.

People that use the discounted cash flow method try to predict what the company is going to do in the next 10 (or more) years. By predicting what the company will do, you can also predict their finances, and how much cash the company will generate. Discounting that cash to today's value (because a dollar today is worth more than a dollar tomorrow), and discounting even more to take into account the risk of your predictions being right, the person using this method comes up with what they think the company is worth. Comparing this worth with the market capitalization of the company (which is an indication of how much the rest of the world thinks the company is worth), you can figure out whether buying stock in the company is a "deal" or not. As you can imagine, the discounted cash flow method is probably the most difficult of the methods discussed today, and the one that involves the most research and prediction.

The company breakup value method is a lot simpler. If you were to sell off all of the parts of the company to the highest bidder, right now, how much would the company be worth? If that amount is more than the current market capitalization, you've usually got yourself a great deal. Unfortunately, this doesn't happen too often. But it happens more often than you might think.

Trend Investing

Trend investors don't really care about the true value of a company--they would argue that a company's true value is the stock price. So instead of valuing the company, they try to predict trends in the stock price. This takes the form of either an industry trend or a company trend.

The basic premise of industry trend investing is that there are industry-specific business cycles that create changes in stock price. For example, if you think that the biotech industry is going to go through a renaissance and a tremendous burst of life in the next couple of years, you would buy stock in some of the leading biotech companies. "Leading" is usually defined as the most highly traded, or the one or two companies that are the best in their field. The theory is, if you think the industry is going to do well, the top two or three companies in that industry are almost certainly going to do well. Industry trend investors will often buy several companies in the same industry to minimize the effects of individual company performance.

Company trend investors try to predict trends for individual companies rather than industries.

Trend investors look at the big picture and the general state of the economy, as well as graphical representations of historical trends (such as stock charts).

Growth Investing

Growth investing is also a quite simple concept. If a company grows, it's usually going to be worth more. Growth investors look for companies that are small today, but are going to be big market leaders tomorrow. By buying in right now, they get the company stock for a cheaper price than when the company is large.

But, like the other methods of picking stocks, growth investing is about educating yourself as much as possible about the company. Remember, a stock price is set by the market, not by the company itself, so if everyone thinks a company is going to grow a lot, the value of that growth will be reflected in the price of the stock today. Growth investing is about predicting the growth prospects of a company more accurately than someone else.

That works for the other investment methods as well. Market supply and demand creates the price of a stock. If everyone thinks the price is a deal, everyone will refuse to sell at that price, and the price will go up. Picking a winning stock is about predicting the change in a stock price more accurately than your neighbor--a neighbor that is likely an expert in the field. The methods outlined here try to narrow your odds a little, but it's still a risky game. In a lot of ways, it's like making a bet against the house (the house being the trained, seasoned investors). But people do that, too.

Think you might like to try your hand at investing? Then you need more than just this brief introduction. So next month I'll give you a comprehensive review of several educational Web sites for investors.