To pick stocks for swing trading, it makes sense to start by finding a range of potential companies meeting fundamental criteria. Even traders focused on the purely technical indicators of price and volume will rec-ognize the fundamentals as an important test of (1) stock price risk, (2) capital strength or weakness, and (3) long-term price growth potential.
The fundamentals are backward-looking in the sense that actual financial reporting is historical; but fundamental trends and tests of capital strength also reveal a lot about future potential on a technical level.
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Personal preference is part of your selection process along with other price and financially based criteria.
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Fundamental and technical analysis help you not only to pick stocks matching your risk profile, but also to eliminate compa-nies that do not represent a good fit.
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Some very basic questions you will want to ask about companies fore including them in a list of swing trade possibilities include issues be-yond the details of revenue and earnings or current capitalization. Ask these questions as a method for narrowing your swing trading list:
1. Has the company ever reported a net profit? At a minimum require-ment, a listed company should report profitable operations. Some corporations have loss years, and that may be part of a normal cy-cle in operations. Some companies have never reported a profit.
This means that current value is all based on potential for future growth, and this is where a lot of trouble may come into the price equation. The dot.com years make this lesson well; a company should have reported profits at some point in the recent past be-fore it should be seriously considered for swing trading.
2. Has corporate management been scandal-free? Recent history has shown that many prestigious corporations may be led poorly. It makes no sense to trade in the stock of a company with question-able accounting or whose management is under investigation.
Such problems distort price and may also distort the normal cyclical trends, making it impossible to time and predict how price is going to behave in the short term.
It is inherently impossible to judge a company based on funda-mental principles if the company has never reported a profit.
The lack of success in the market may be even more profound, however; why would you buy stock in a company that has lost money every year?
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Corporate scandals are not only in the past. Any evasiveness or questionable activity should be a red flag for anyone thinking about investing in a company.
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3. Have earnings been fairly consistent, or irreg-ular? A sound test of a company’s stability is consistency. Have revenues and earnings been steady and regular? Or are annual results erratic and inconsistent? A lot of emphasis is placed on price volatility but fundamental volatility is also an important test. Erratic reported earnings are a sign of poor management, questionable account-ing change, or turmoil within the company.
Any of these may affect the dependability of price trends as well.
Also check core earnings to determine a corpora-tion’s reporting consistency. These earnings, calculated by Standard & Poor’s, are reported as part of the S&P stock report summaries offered free of charge on some discount brokerage websites, such as Charles Schwab
& Company (http://www.schwab.com). The consis-tency in core earnings is equally as important as fully-reported earnings.
4. Is the company a leader in its industry? Does it offer a product that is not becoming obsolete? Competition often defines profitability. So a corporation that leads its industry has many attributes that manifest in the stock price. As the industry leader’s price rises or falls, the rest of the competitors in the same industry tend to fol-low suit. A company does not have to be number one in the in-dustry to justify swing trading; but the leader often sets the tone of trading for many other companies.
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A well-managed company should be able to manage its rate of growth; this means that revenue and earnings should be consis-tent and not highly volatile from year to year.
Key Point year to the next.
core earnings earn-ings that are not part of a corpora-tion’s “core” busi-ness, including nonrecurring revenues and net earnings.
Over time, some products suffer from obsolescence. This is un-avoidable. However, if a company is not able to change with the times, its entire product line is at risk. For example, a few years ago Polaroid filed bankruptcy. It had created a revolution with the instant photo industry but did not keep pace with the emerg-ing digital technology. And Kodak, historically dominant in the film sales business, has in recent years also fallen behind as many competitors have passed the company in development of digital technology—meaning that to some degree, Kodak was so depen-dent on its film lines that it failed to recognize how significantly the whole business was changing. These types of emerging changes in technology provide a glimpse of how corporations evolve over time or, in some cases, fall behind their more aggres-sive competitors. This affects value in the long time as well as price trends in the short term. Even though swing trading is a short-term trading strategy, it makes sense to limit this activity to corporations that are competitive and well managed, and that are most likely to have stock price behavior in line with “typical” or
“average” short-term trends.
5. Is the company diversified? Is it vulnerable to cyclical problems?
There are many forms of diversification. Most people think about placing capital in several different products as the most obvious form of diversification. But this may also refer to investing in dis-similar markets or products; avoiding stocks vulnerable to the same cycles; or allocating money to entirely different markets.
Within the corporation itself, diversification refers to dissimilar product or service lines of business. For example, Altria Corpora-tion (MO) is best-known for its Phillip Morris line of business, but it also owns Kraft Foods, which diversifies its overall holdings into an entirely dissimilar market. So, in terms of how you pick stocks, the question of internal diversification is as important as the portfolio-related forms most investors understand well.
It makes sense to concentrate on sector leaders for swing trad-ing. There is a tendency for nonleaders in the sector to follow and track the leading company’s stock.
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A company not well diversified is vulnera-ble to cyclical changes. For example, a retail corporation is going to suffer when con-sumer buying trends are in a down cycle, so one way to offset this cyclical problem is through diversification into lines other than the primary retail line.
6. What current problems does the company face?
Other than the current and historical finan-cial reports, what else do you need to know when picking companies? Is there any on-going legal problem or potential labor union disputes? Companies dependent on large unionized labor forces are vulnerable to strikes, for example. And extensive litigation also adversely affects profitability. Merck (MRK) had thousands of outstanding law-suits as of 2006 due to the widely advertised ill effects of its drug Vioxx. And the tobacco industry has faced thousands of lawsuits over many years. These issues may adversely affect a company’s value or, if the company prevails or suffers less than expected in judgments of these lawsuits, stock prices could also rise. So the existence of thousands of lawsuits is not, by itself, reason to avoid a company or an industry. However, it is one of the extra-financial factors to be considered. Besides lawsuits, any other form of contingent liabil-ity may affect value and perceived value of a company, and should be reviewed as part of your judgment to buy or not.
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Diversification comes in many forms. From the corporate per-spective, diversification by product lines is a good way to offset cyclical change and to expand outside of a primary industry.
Key Point a form of corpo-rate diversifica-tion of capital into dissimilar product or service lines of business.
contingent liability a liability that might or might not materialize, and whose dollar value may not be known.
Typically,
7. Has the company been in business long enough to have a track record?
In selecting one stock over another, it is impossible to make a sound judgment without a track record. How long has the com-pany been in business? Can you tell whether there has been growth in net worth, or a reduction? What is the reputation of management? Does the company pay dividends, and what is the current dividend yield? Have dividend payments been consistent, or have some been missed? These questions define corporations and provide you with a means for comparison and selection.