This past week I read an article on forecasting trends, and it made me think about the problems we have doing the same thing for stocks. Ultimately, our goal is to buy stock that will go up in value -- hopefully more than the market's average return. If it does not outperform the market, we might be better off just buying an index fund. As I thought about this, I realized that there are a few ways of forecasting that come to mind. Here they are:
Technical analysis: Most Fools don't endorse this method. The idea is to try to analyze the psychology of investors by stock charts showing volume of sales, moving averages, and various patterns. Only one form of technical analysis is often used by us -- relative strength.
Relative strength is the stock's price behavior relative to the rest of the market. The problem with technical analysis, especially for us as Drip investors, is that it is short-term. Also, I have problems understanding how to read the charts (because there is no right way, in the end!), and some of the "formations" make little sense to me (maybe because there is no measured sense to them). I suspect some people read what they want to in a chart, just like you can when you look at an inkblot.
Discounted cash flow: We've covered discounted cash flow in earlier columns. This a method of valuing a stock based on future cash flow streams. It has its good points. However, it requires a forecast for earnings and a value of the stock at a certain future date. It is applying a mathematical method to a guess.
Mechanical investing: These methods involve mechanical approaches to picking companies, such as the Foolish Four (the Workshop on our site has many other methods). These approaches value companies by formulas that have been back tested over several years. Stocks determined to have strong nearer-term prospects when measured by a set formula are purchased and held for a set amount of time. At the end of that period, the portfolio is again evaluated by that formula and readjusted. Because of the set period of time, and the readjusting that is necessary, this approach is not suitable for Drip investing.
Fortunately, in Drip Investing, we don't need to choose a stock that is thought to be undervalued relative to the market. Over time, a Drip stock will likely be undervalued, and at other times overvalued. Because of dollar cost averaging through regular purchases, the problem of purchasing the stock at the "right" price is mitigated. A more difficult problem presents itself to us: How do we find stocks that will beat the market over a long period of time?
What we need to do boils down to two steps. First, we need to choose companies out of a sector that is seeing growth. The sector has to be one in which we can expect expansion over at least the next few years, if not the next few dozen. Often, we can find sectors we are intimately familiar with in our day-to-day lives. For me, it has been companies that are expanding the Internet -- what I call the Pathfinders. Also, I like the home building supply centers, since I also work in the home building industry and I've seen the amount of business that these large outlets have been generating.
The second step is to find a leader in that sector. My favorite way is to compare competitors in like businesses based on financial measures. I look at such items as the Foolish Flow Ratio, days sales outstanding (receivables/annual sales/360), inventory turnover (sales/inventory), return on equity, and debt. Beyond the math, I keep my eyes and ears open to try to learn about the strongest competitors. In most consumer businesses, it isn't too difficult to surmise.
I also spend an awful lot of time reading and studying companies and industries that interest me. Some of the books are rather dry, but some are very good. If you get a chance and haven't read it yet, you should read Only The Paranoid Survive by Andy Grove, the former CEO of Intel (Nasdaq: INTC). It is one book that teaches lessons applicable to all businesses.
Some businesses, like telecommunications, require an exhaustive amount of study. The technology can be complex and difficult to understand. Reading books on this subject can be time-consuming and difficult, and requires dedication and maybe even some technical background. To be successful, you need to choose an area that you feel comfortable with.
In the end, the success of our Drip investments depends on our ability to forecast the strongest trends and the strongest companies. Which industries will continue to grow for the next few decades? Which companies will lead that growth? Although this sounds rather complex, if we invest in what we know and spend a little time doing our homework, it shouldn't be too daunting; in fact, it could be... fun!
Your Turn:
Start at the beginning: Which industries do you believe will offer investors the best growth over the next 10 years? Post your thoughts!
