How Stocks Are Like Diamonds – Nasdaq

Picking stocks is like picking the right diamond. They all have
different characteristics and values. Some are precious and
dazzling. Others are flawed.

June remains the most popular month for weddings, but the autumn
months are busy with people buying diamond rings. Diamonds are a
traditional gift to commemorate an engagement, or a milestone
anniversary.  Stocks are a less common (and certainly less
romantic) gift.

Fear not – I’m not advocating we replace diamond solitaires with
stock certificates. But it might surprise you to consider that the
quality of stocks and diamonds can be viewed through a similar
lens! When considering the ”
four Cs

” of color, clarity, cut and carat weight, what creates values for
gemstones also applies to stocks.

A diamond’s color actually refers to absence of color. The more
color, the lower the gem’s quality. The same is true for
businesses. The more transparent a business is, the easier it is
for analysts and investors to properly evaluate the business. In
contrast, the more opaque the model, the more confusing it becomes
for investors. 

Google

(
GOOG

) recently
reorganized its corporate structure

to offer investors greater transparency. Before, investors had
difficulty parsing out its more speculative businesses, such as
self-driving cars, from its basic search and ad operations.

Clarity refers to defects on the gem’s inside or outside.
Diamonds are formed over eons, with tremendous pressure and heat
refining imperfections. Investors can look at a company’s
investments over time, including its use of cash, management tenure
and performance, and contrast all of these under various economic
cycles. Data viewed over longer periods improves clarity when
determining a reasonable price for the stock.

Surprisingly, cut doesn’t describe a particular shape as much as
it indicates how a diamond reflects light. Some economists believe
our economy functions in a four- or five-year cycle, cresting at a
peak, contracting into recession and finally expanding until it
reaches another peak. Stocks then track how the economy is
faring.

This theory posits that the economy moves in predictable cycles
and that different types of companies will naturally fare better at
different stages of the cycle. For example,
consumer staples

providers should perform better in a recession than industrial
companies. In a recession, food, drugs and soap don’t see sales sag
because they are necessities; that’s not so for diesel engines.

This perspective seems reasonable enough, but it is far from
perfect when the economic landscape shows
two opposing sectors

– staples and
consumer discretionary

(items like cars, clothing and refrigerators) – moving in the same
direction, as is the case currently. All Standard & Poor’s 500
sectors over the past three months are in the red, except for
utilities, which is up 2.9%. But the No. 2 and No. 3 performers are
staples, down 1.8%, and discretionary, off 3.7%.

The final C when evaluating diamonds is carat weight, which
often serves as a price indicator. The investment world would
replace carat weight with market capitalization to determine a
stock’s size, but would also consider factors like
price-to-earnings ratio to compare expenses between companies.

The higher the ratio, the more investors pay for the stock
relative to current earnings. That’s why the P/E ratio is only one
metric in the valuation. Typically, companies with smaller market
capitalization have higher P/E ratios than businesses with large
market capitalizations.

Applying the metrics used to evaluate gems to the process of
evaluating companies and their stocks may seem unusual but the
point is simple: It isn’t just a stone and it’s not just a stock.
We are in a stock picker’s market right now and may the best
gemologist win.

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.

Joseph “Big Joe” Clark, CFP, is the managing partner of the
Financial Enhancement Group LLC, an SEC Registered Investment
Advisory firm in Indiana. He is the host of Consider This
with Big Joe Clark, found on WQME and iTunes. Big Joe can be
reached at 


bigjoe@yourlifeafterwork.com

, or (765) 640-1524. Follow him on Twitter at


@Big Joe Clark

and on Facebook at 


http://www.facebook.com/FinancialEnhancementGroup

.

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