It doesn’t matter whether you’re looking for the next rocket to jump on or researching slow moving value plays, priority number one must be to avoid companies that might run short of cash in the event of an unexpected business slowdown. In a bankruptcy, shareholders typically lose everything and, in fact, just the rumors that your stock might be facing bankruptcy would ruin your day.
Thus, it’s best to stick with stocks that are unlikely to suffer that fate. I call them “bulletproof stocks.”
Identifying bulletproof stocks requires defining a set of requirements that firms with problematic balance sheets can’t possibly meet. Once you’ve done that, you can use a stock screening program to generate your list of bulletproof stocks. Stock screeners are programs available on certain financial websites that allow you to search the entire market for stocks meeting your specific requirements. Here’s what you need to specify to identify bulletproof stocks.
No Debt – No Problem
Start by limiting your list to debt-free firms. The debt to equity ratio compares long-term debt to shareholders equity (book value). Zero values reflect no long-term debt and the higher the ratio, the higher the debt. Although specifying a zero ratio may sound like a good idea, most firms do carry some incidental debt such as long-term leases. So specify 0.2 for maximum allowable D/E.
Cash is King
Next, isolate stocks with sufficient cash on hand to cover current bills. The quick ratio compares the total of cash in the bank plus accounts receivables (cash due from customers) to current bills (current liabilities). Specify a minimum quick ratio of 1.0 to assure that cash plus receivables can cover current liabilities.
Avoid Cash Burners
While having cash in the bank is important, you also need to confirm that passing firms aren’t burning through available cash. Do that by checking operating cash flow, which measures the actual cash that flowed into or out of a firm’s bank accounts from its main operations. Unlike earnings, which can be manipulated, cash flow must match real bank balances. You only need to establish that cash flowed into a firm’s bank accounts, not out (burning cash), the amount doesn’t matter. So require a positive number for operating cash flow. If your screener doesn’t offer a cash flow parameter, requiring a positive price/cash flow ratio would be just as good.
Trust But Verify
While the positive cash flow requirement should be sufficient to assure that passing firms are profitable, you can’t underestimate the creativity of motivated accountants. Check for positive net income helps to assure that the firm is profitable. Requiring a positive number for the price/earnings ratio would accomplish that.
Sometimes a stock screen can turn up firms that don’t have real businesses. Rule them out by requiring at least $50 million of revenues (sales) over the past 12-months. Almost all stocks could easily beat that requirement.
Avoid Cheap Stocks
Cheap stocks get that way when savvy investors spy serious problems ahead. Require a minimum $10 per share minimum trading price to rule out stocks facing issues that your screen may have missed.
Qualifying as bulletproof means that a stock isn’t a bankruptcy candidate, not that you’ll make money owning it. There’s a lot more that goes into that equation. Follow this link to see the list.
For tips and information on the best utilities and dividend stocks from Harry Domash, please check out Dividend Detective.
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