Picking stocks is like picking the right diamond. They all have different characteristics and values. Some are precious and dazzling. Others are flawed.
June remains the most popular month for weddings, but the autumn months are busy with people buying diamond rings. Diamonds are a traditional gift to commemorate an engagement, or a milestone anniversary. Stocks are a less common (and certainly less romantic) gift.
Fear not – I’m not advocating we replace diamond solitaires with stock certificates. But it might surprise you to consider that the quality of stocks and diamonds can be viewed through a similar lens! When considering the “four Cs” of color, clarity, cut and carat weight, what creates values for gemstones also applies to stocks.
A diamond’s color actually refers to absence of color. The more color, the lower the gem’s quality. The same is true for businesses. The more transparent a business is, the easier it is for analysts and investors to properly evaluate the business. In contrast, the more opaque the model, the more confusing it becomes for investors.
Google (GOOG) recently reorganized its corporate structure to offer investors greater transparency. Before, investors had difficulty parsing out its more speculative businesses, such as self-driving cars, from its basic search and ad operations.
Clarity refers to defects on the gem’s inside or outside. Diamonds are formed over eons, with tremendous pressure and heat refining imperfections. Investors can look at a company’s investments over time, including its use of cash, management tenure and performance, and contrast all of these under various economic cycles. Data viewed over longer periods improves clarity when determining a reasonable price for the stock.
Surprisingly, cut doesn’t describe a particular shape as much as it indicates how a diamond reflects light. Some economists believe our economy functions in a four- or five-year cycle, cresting at a peak, contracting into recession and finally expanding until it reaches another peak. Stocks then track how the economy is faring.
This theory posits that the economy moves in predictable cycles and that different types of companies will naturally fare better at different stages of the cycle. For example, consumer staples providers should perform better in a recession than industrial companies. In a recession, food, drugs and soap don’t see sales sag because they are necessities; that’s not so for diesel engines.
This perspective seems reasonable enough, but it is far from perfect when the economic landscape shows two opposing sectors – staples and consumer discretionary (items like cars, clothing and refrigerators) – moving in the same direction, as is the case currently. All Standard & Poor’s 500 sectors over the past three months are in the red, except for utilities, which is up 2.9%. But the No. 2 and No. 3 performers are staples, down 1.8%, and discretionary, off 3.7%.
The final C when evaluating diamonds is carat weight, which often serves as a price indicator. The investment world would replace carat weight with market capitalization to determine a stock’s size, but would also consider factors like price-to-earnings ratio to compare expenses between companies.
The higher the ratio, the more investors pay for the stock relative to current earnings. That’s why the P/E ratio is only one metric in the valuation. Typically, companies with smaller market capitalization have higher P/E ratios than businesses with large market capitalizations.
Applying the metrics used to evaluate gems to the process of evaluating companies and their stocks may seem unusual but the point is simple: It isn’t just a stone and it’s not just a stock. We are in a stock picker’s market right now and may the best gemologist win.
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Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He is the host of Consider This with Big Joe Clark, found on WQME and iTunes. Big Joe can be reached at [email protected], or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.
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