Page 307 - How to Make Money in Stocks Trilogy

184 A WINNING SYSTEM

A Low Corporate Debt-to-Equity Ratio Is Generally Better

After you’ve found a stock with a reasonable number of shares, check the
percentage of the company’s total capitalization represented by long-term
debt or bonds. Usually, the lower the debt ratio, the safer and better the
company. The earnings per share of companies with high debt-to-equity
ratios could be clobbered in difficult periods when interest rates are high or
during more severe recessions. These highly leveraged companies are gen-
erally of lower quality and carry substantially higher risk.
The use of extreme leverage of up to 40-to-1 or 50-to-1 was common
among banks, brokers, mortgage lenders, and quasi-government agencies
like Fannie Mae and Freddie Mac starting in 1995 and continuing until
2007. These institutions were strongly encouraged by the federal govern-
ment’s actions to invest large amounts of money in subprime loans to lower-
income buyers, which ultimately led to the financial and credit crisis in 2008.

Rule 1 for all competent investors and homeowners is never
ever borrow more than you can pay back. Excessive debt
hurts all people, companies, and governments.
A corporation that’s been reducing its debt as a percentage of equity over
the last two or three years is worth considering. If nothing else, interest
costs will be sharply reduced, helping to generate higher earnings per share.
Another thing to watch for is the presence of convertible bonds in the
capital structure; earnings could be diluted if and when the bonds are con-
verted into shares of common stock.

Evaluating Supply and Demand

The best way to measure a stock’s supply and demand is by watching its daily
trading volume. This is uniquely important. It’s why Investor’s Business
Daily’s stock tables show both a stock’s trading volume each day and the per-
centage volume is above or below the stock’s average daily volume in the last
three months. These facts, plus a proprietary rating of the amount of recent
accumulation or distribution in the stock, are key information available in no
other daily publication, including the Wall Street Journal.
When a stock pulls back in price, you typically want to see volume dry up
at some point, indicating there is no further selling pressure. When the
stock rallies in price, in most situations you want to see volume rise, which
usually represents buying by institutions, not the public.
When a stock breaks out of a price consolidation area (see Chapter 2 on
chart reading of price patterns of winning stocks), trading volume should