How To Find The Best Stocks

We just recently unleashed which has preset defined scans on how to find the best stocks to trade, but if you want to search for companies that actually make money, well, trading challenge student N.L. has a useful guest blog post for you:

Companies are created with the sole purpose of making money. After all the growth that companies aim for it comes down to how many stacks of cash they make. When you are looking for stocks that have a good chance of one day popping you can look to small, low-priced companies that still manage to make cash.

Download the key points of this post as PDF.

Setting up a Screen

There are many parameters you could set to discover these, but a few are basic. A price under $10 seems like a good place to start. You can tweak this all you want, but $10 always seems like a good number to find stocks that are more on the fringes.

Mutual funds are falling out of favor because of ETFs, but they are still big players. Many have bylaws that do not allow positions in low priced stocks. This can help make $5 and $10 critical levels. ETFs might have the same bylaws, you’d have to check for each ETF.

The next parameter should be the market cap. This one is very flexible. Setting it to $250M minimum is a solid starting point, though you can go as low as $100M to cast the net wide. On the upper end $1B or $2B seems like a good place. You can leave it uncapped if you like. After all huge companies with a low price and making money are fine as well. However, with a larger company I would keep an eye on the PE ratio. I will talk about the PE later.

The final parameter for a simple screen is the free cash flow. When using a screen the trailing twelve months is a better thing to look at. However, free cash can vary wildly so when evaluating a company it might be better to just look at the quarterly numbers of the last few years. On the screen you can just set free cash to be greater than 0. That is the widest net possible.

Potential Modifications

Using those parameters you can get a few hundred hits. You could easily just work your way down the market cap ladder, but there are a few parameters you can use to narrow the field and get yourself thinking. For each of these you would run one or a number of them on top of the original ones you used setting up the screen. However, consider removing them and going with a different set too.

Revenue growth is a great measure for a small company that has free cash. Some companies just make money but do not really grow. This is a way to have a growing company, but that have robust profit margins that outstrip their capital expenditures. You do not need to use an EPS measure, because looking at free cash flow and its growth is good enough.

You can filter by the PE ratio too, though just glancing on them when you build a watch list. This one is really dealer’s choice. Obviously, you should always consider if the stock is overvalued. If I set this as a parameter I would use a wide berth so as to render it fairly moot. Though getting a good picture of the entire list by using a PE TTM filter of 15 and below can help narrow things down.

Companies with consistent free cash flow don’t normally have debt problems, but generally you can look for any red flags. An extremely high PEG ratio would be one, but really it just depends company to company. Free cash flow is such an endgame metric that you can be sure that there probably are not too many red flags, especially if you include revenue growth.

What are you Looking for?

You are just making a watch list so just choose your favorite 20-50, depending on your ability to keep track of that many. Really you would be looking for quick overviews once a month and just scanning it every day for odd movements. If a cheap stock with free cash flow and growing revenue is increasing by 2% per day, then it is something to take a look at. It really does not take a lot of time. Most phone brokerage apps have the ability to have watchlists and you can just scan down the list after the market closes. They are color coded, though you do have to read the numbers yourself.

Companies making cash but neglected by the market might not stay that way. This is especially true if they are small and growing. It can happen with companies in low overhead, high return businesses. An example would be a subscription-based business where the cost of adding new subscribers is minimal and actually reduces the average cost per subscriber. You still charge them the same so it gives fatter and fatter margins.