6 Things That Make a Stock a 'Buy'

 | Dec 06, 2017 | 2:00 PM EST
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How do you decide if a stock is a buy, sell or hold?

Is it all about chart patterns? Does valuation matter, or just momentum? Do you care if it exceeds, or is discounted to fair value?

There is no one correct answer. It really pays, though, to develop an investment philosophy you can hang your hat on. Whatever you come up with must not only make sense to you, it must also produce solid results over the long haul.

There have been fortunes lost by trading on, what turned out to be, faulty assumptions. 2018 will mark my fortieth year of buying stocks. I've been selling covered calls and naked puts for the last 38 of those years. My preferred system works. It has made me millions of dollars.

The month I turned 50, I stopped going to work. Since then, over more than seventeen years, I've lived quite nicely on the capital gains and dividends which my portfolio produced.

I've invested with money market interest rates at 14% and near zero. I was a Merrill Lynch broker during The Crash of 1987. I traded throughout the tech bubble, the Long Term Capital Management bail out, the 9/11 trading halt and the Crash of 2008-09.

There have been plenty of mistakes along the way. It doesn't matter. The only thing that counts is how your entire portfolio performs over time. With more patience, most of the stocks I sold for losses would have turned into winners.

Here are the things I have found to be most important:

  1. Only buy when a stock sells for below its own historically typical P/E;
  2. Look for stocks with higher than normalized yields compared to their own average payouts;
  3. Expect a regression to the mean from both overpriced and undervalued levels;
  4. Allow enough time for things to get back to normal (12 - 18 months minimum);
  5. Only change your mind, and give up, when fundamentals deteriorate significantly;
  6. Don't be swayed by analyst opinions, trust the numbers.

And now for an example of my kind of a contrarian value play.

Signet (SIG) disappointed in its recent announcement but it remains a highly profitable, industry leader. After dropping to $53 its P/E is just 8.4x the already reduced estimate for this year. Its well covered yield is now 2.34%.

Those metrics compare favorably with Signet's multi-year average multiple of 14.7x along with a typical yield of just 0.86%.

Just a partial regression to the mean valuation could send SIG back to the mid-$70s within a year or so. A full recovery could see it in the $90 to $100 range. Those are far from crazy assumptions. SIG peaked between $79 and $152 during each of the calendar years 2013 through 2017 YTD.

Only after doing my work I like to check out what Morningstar and Standard & Poors have to say. Sometimes they agree and sometimes they don't.

With Signet, they are pretty much in synch with my thoughts. Morningstar rates SIG as a 4-star, out of 5, buy. They see present day fair value as $73.

Standard & Poors carries Signet with just a hold rating. I can't fathom that, however, as they list the shares as among their most undervalued stocks in terms of price to fair value. In fact, S&P call that number as $98.29 per share, about 85% above SIG's Nov. 22, close.

What would make this stock a buy for them? They never say.

Whether Signet reaches $73 or $98 there appears to be a lot of money to be made and quite a bit of safety cushion from a depressed P/E accompanied by a generous yield.

What could make playing Signet even better? Consider selling some long-term put options. Signet offers both Jan. 2019 and Jan. 2020 expiration dates.

I've been writing the 26-month versions to take in the highest premiums while lowering the "if exercised" forced purchase priced to extremely low levels.

Future stock market action can never be guaranteed. We can know for sure, though, that SIG hasn't changed hands for less than $45 since 2012. Signet posted EPS of $4.35 that year while paying just $0.48 in dividends versus the expected $6.30 in earnings and $1.24 in quarterly payments for 2017.

Signet could fall by up to 15.8% without a loss on even the most aggressive of those three option sales.

Why be scared to own SIG at one of its cheapest valuations ever and the highest yield in its entire history?

Successful investing is a numbers game. Build a diversified portfolio out of undervalued shares, then patiently wait for the expected results. You'll be well rewarded a high percentage of the time.

That's all you need to live long, and prosper. Kudus to Mr. Spock.

This commentary originally appeared on Real Money Pro at 07:00 a.m. ET on Dec. 4. Click here to learn about this dynamic market information service for active traders.

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