One of the fundamental tenants of the trading method we teach at OptionsANIMAL, is that you should be very familiar with each and every equity that you
trade. That means more than simply studying a chart. Knowing a company means understanding its business model, pulling back the curtain and looking at the
company’s profitability, understanding whether or not it has a lot of debt and how well it can service that debt. In short, it means looking at the
fundamentals as well as the technical picture presented by the chart.
This is not simply an academic exercise. When you know a company, you are better able to anticipate its price movement, you are better able to analyze the
effect of any news events. You also know where the possible pitfalls may be hiding. No company is perfect and understanding your company’s potential
vulnerabilities is just as important as knowing its strengths. Clearly, it is not possible to have this level of comfort with the thousands of publicly
traded companies or for companies gleaned from a scan looking for chart patterns. The best way to have this kind of facility with your equities is to build
and maintain a reasonable watch list of high-quality companies that make good trading candidates. The idea of limiting your trading universe often gives
new students a bit of anxiety. However, it is the best way to become proficient and increase your returns.
What criteria you choose to create your watch list will depend on innumerable factors including your trading style, your personal knowledge of the
industries you want to trade, and your desired income. I have found the following works well for me and my personal needs.
- The company must have decent options chains. I am an options trader and even when I want to hold equities over time, and I want the ability to protect
myself and increase my returns through the use of options. At a minimum, I want the equity to have weekly options available. Although I do not have a
specific cutoff, I also look for a narrow bid/ask spread.
I must understand the business model. If I do not understand how the company intends to make money, I have no way of predicting its future. I have no
way of analyzing the news and its potential effects on my profits going forward. For this reason, I do not currently trade banks. Banks are difficult to
value, and until I have a solid understanding of how to do that, I will not risk my money.
- The company must have positive free cash flow. One of the most important metrics for me is whether or not the company has staying power. Even if my
trades begin as short term plays, I may end up trading the company long term if my initial expectations do not come to pass. Free cash flow is the amount
of cash that remains when you subtract a company’s capital expenditures (that is the money spent to maintain and run the business) from the cash brought in
from the operations of the business. This is different from the company’s earnings. Companies can claim something as earnings even though no cash is
brought in. However, cash is what keeps the lights on and the doors open. A company that can’t bring in enough cash to keep itself going is too risky for
me. Free Cash flow is my favorite indicator that the company is stable enough to be around for the long term.
The company must have a reasonable PE ratio. This does not mean I only trade companies with low PE ratios. I am perfectly happy to trade a solid company
with high a high PE ratio as long as the number makes sense given the company’s growth potential. For example, Facebook’s PE seems justified to me given
the expectation of growth and its history of meeting those expectations. If Facebook delivers on these growth expectations over time, the price paid today
would be more than justified. On the other hand, there are companies whose growth potential does not warrant its price in my estimation, and those do not
make it onto my list.
The company must be able to service its debt. We often look at the company’s Debt to Equity ratio as a way to estimate how vulnerable a company would be
to an economic slowdown. If earnings decrease, interest payments still need to be made which could prove problematic. However, the Debt to Equity ratio is
only one of many ways to figure out how liquid a company is. While, high Debt to Equity ratio might give me pause, what I want to know is how burdensome
are the actual interest payments. For this, I like to look at the company’s Interest Coverage Ratio. It compares a company’s earnings before interest and
taxes, or IBIT, to its interest expense. It is a little like comparing a buyer’s potential mortgage payments to his income to make sure that the mortgage
is affordable. A ratio under 1 indicates that the company may be having trouble generating enough income to cover its expenses. While I do not have a firm
cutoff for this number, Ideally, I want to see a ratio of 3 or higher.
I want to believe in the company’s principals and share their vision for the company’s future. Each quarter when the company reports earnings, it also
holds a conference call. During that call, the principals discuss the company’s performance during the prior quarter and detail their expectations going
forward. Listening to these calls or reading the available transcripts, can give you an excellent idea of where the company is headed. Listening to the
principal’s talk about their plans for the future can bring you a level of understanding far deeper than you can get just by looking at the numbers. You
can decide if the company’s plans make sense, if they excite you or if you feel that they are floundering. When you know where a company is headed, you are
far better able to decipher how future events, news and complications can affect your company.
These are not the only metrics I look at when bringing a company onto my watch list, but they provide a minimum that I am willing to accept. Trading with
confidence in the underlying equity makes me a better trader and more flexible trader. Having that confidence makes me better able to take chances and far
less likely to panic if things do not immediately go my way. I encourage all of you to come up with your own list of factors to narrow the universe of
equities and make you a successful trader.