how to pick stocks
oct. 24, 2007
Morgen Peck
Equity Research Analyst
Fidelity Investments
Morgen Peck graduated from Harvard 2003 with a BA in Economics with Honors. She worked most of her
undergrad (~40hrs/week) as a research assistant to HBS Professor Paul Gompers with focus on proxies &
corporate governance. She started at Fidelity in Fall 2003 focusing on small cap consumer stocks (like
Smuckers), then moved up her market cap exposure by looking at supermarkets (like Whole Foods). She
covered consumer for 2.5 years, then made the move this past spring to the small cap team (looking at
companies under $2B) with focus on healthcare services & medtech (less so pharma & biotech). She has
looked at roughly 100-150 stocks over her career at Fidelity. She just passed level 3 of the CFA exam and
she is eagerly awaiting her charter. She has no desire currently to go back to business school, but she says
that it could always change. She wants to ultimately manage diversified money at Fidelity. Other interests
include running (trying to run Boston Marathon this year) and reading (mostly "dorky finance books") and
spending time with her family.
P/E ratio –a ratio of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") used
to measure how cheap or expensive share prices are. It is probably the single most consistent red flag to
excessive optimism and over-investment. It also serves, regularly, as a marker of business problems and
opportunities. By relating price and earnings per share for a company, one can analyze the market's
valuation of a company's shares relative to the wealth the company is actually creating. A P/E ratio is
calculated as Price per share/Earnings per share
Earnings Per Share (EPS) – the portion of a company's profit allocated to each outstanding share of
common stock. EPS serves as an indicator of a company's profitability
Revenues – the total financial amount earned by the company through revenues and sales of its goods
and/or services
Net Income (Earnings) - the amount of money the business has earned after paying income taxes
Growth Stock – a stock with earnings’ growth at a rapid pace that is expected to continue to grow at high
levels in the future
Income Stock – a stock with a history of paying consistently high dividends on a regular basis
Blue Chip – stock of a well-established and financially sound company that has demonstrated its ability to
pay dividends during economic booms and recessions, making it less risky than many other stocks; its
performance usually follows that of the S&P 500 since many blue chips are part of that index
Value Stock – a stock in which the intrinsic value of the stock is greater than the stock’s market value
(current price), as determined by a valuation model assessing what the intrinsic price would be and how
much the company would be worth
Porter’s 5 Forces – a framework for industry analysis and business strategy development developed in 1979
by Michael Porter of Harvard Business School. He devised 5 forces that determine the competitive
intensity and therefore attractiveness of a market within that industry (microenvironment) and in relation to
the overall market (macroenvironment). These forces relate to a company’s ability to serve its customers and
make a profit
1. Rivalry – discusses the competitiveness of the industry and markets in which the company is
located. Rivalry within that industry will be higher when there are:
¤ A large number of firms – companies have to compete for the same finite customers and
resources
¤ High fixed costs – companies have to produce at capacity to attain lowest production costs and
highest profits, leading to high production levels and large quantities
¤ High storage costs or highly perishable products – producers must sell goods as soon as possible,
leading to market flooding and price cuts to induce consumers to buy
¤ Low switching costs – customers can switch between products easily, leading to less brand
loyalty
¤ High exit barriers – high costs associated with abandoning a product will prevent a fast exit from
the market, esp. when products used to make product are specialized and difficult to resell
2. Threat of Substitutes – a product’s demand is affected by the price change of a substitute product
or there is a product that could be easily substituted. As more substitutes become available, the
demand for a product becomes more elastic as customers have more alternatives and it constrains a
company from raising prices
3. Buyer Power: the impact that customers have or can exert on a producing industry; when buyer
power is strong, the buyer has more influence in setting the price and there are multiple suppliers
Buyers are powerful if they:
¤ Are concentrated such that a few buyers have a significant market share
¤ Purchase a significant proportion of output
¤ Can threaten to buy products from a rival firm
Buyers are weak if:
¤ Producers can take over their own distribution and retailing and not need the buyer to do it
¤ There are significant buyer switching costs (fees for breaking contracts early) or there is no
substitute product to which the buyer can switch
¤ They are fragmented such that no buyer has significant market share or ability to influence
prices
¤ Producers supply critical portions of buyers’ input
4. Supplier Power – the impact that the supplier-buyer relationship has on the buying firm that
purchases raw materials and inputs from another. Suppliers can influence costs by charging higher
prices depending on their positioning. Suppliers are powerful if:
¤ There is a credible forward integration threat by suppliers
¤ Suppliers are concentrated and coordinate together
¤ There are significant costs to switch suppliers
¤ Customers are powerful and can influence which suppliers a firm chooses
Suppliers are weak if:
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There are many competitive suppliers and non holds a strong market share
The product delivered is standardized and can be supplied by many suppliers
They purchase commodity products
Purchasers are concentrated and can push back on suppliers
Customers are weak and cannot dictate which suppliers firms use
5. Barriers to Entry – characteristics within an industry that protect the high profit levels of firms and
inhibit additional rival companies from entering the market.
¤ Entry-deterring pricing: when firms keep prices artificially low to minimize profits and to
prevent potential entrants from entering the market
¤ Government barriers – monopoly restrictions, natural utility monopolies
¤ Patents and proprietary knowledge
¤ Asset specificity
¤ Restricted distribution channels
¤ Customer brand loyalty and difficulty in brand switching
Price-to-Book (P/B) – a ratio used to compare a stock’s market value to its book value. A low ratio could
indicate either that the company is undervalued relative to the assets it owns or there is something
fundamentally wrong with the company. It also gives a general estimate if you would be paying too much
for the company if it were to go bankrupt
P/B = Stock Price / (Total Assets – Intangible Assets and Liabilities)
Source: www.investopedia.com
http://www.quickmba.com/strategy/porter.shtml