Risk versus reward

When you decide to invest in the stock market, keep in mind something that professional analysts must remember: Investing always requires weighing potential risk against potential award.

In broad terms, analysts generally weigh three issues: fundamental business factors, the technical position of the stock and intangible factors that might provide a sense of how reliable a stock might be.

Business fundamentals are the first factors to consider. For example, does the company have a projected earnings growth rate that is substantially better than that of the Standard & Poors 500 Index? Is the company first or second in its industry in terms of market share of its products and services? If not, is it gaining market share against its larger competitors? Is the company the lowest-cost operator in the industry?

Technical analysts seek clues to a stock's future performance by charting its historical price and volume action. Questions they ask themselves include: Is the stock in a long-running uptrend? Are there signs that it might be building to a peak from which it is likely to fall? Is the industry sector in or out of favor with investors or consumers? Has the stock been displaying above-average relative strength compared to the broad market? Finally, does the stock trade in enough volume to make it relatively easy to buy and sell?

Some parts of the stock market are impossible to quantify. For example, does the company have a growth record that can capture the imagination of other investors? Does it seem likely it will attract institutional buyers?

On a more objective level, is the stock widely followed by Wall Street analysts? Or is it followed by only a few firms, possibly making it vulnerable to an analyst's downgrade?

Finally, you must consider the stock's performance history. What were the causes of any large sell-offs over the past decade? Were they related to company or industry developments or to the consequences of general market weakness?

Valuation

Is the stock you're considering just a trading vehicle, or are there enough positive answers to the previous questions to suggest that it may have the potential for an enduring rise? If your answer is the latter but the stock's price-to-earnings ratio (P/E) seems too high, there is another factor to consider: the further into the future that you can project a stream of growing earnings, the more likely it may be that the stock could trade at a high P/E ratio for an extended period of time, and quite possibly, outperform many issues that look less expensive.

All stocks won't measure up to these standards, but weighing these criteria when evaluating a stock can provide the potential for rewarding investments.

Dr. Fox has owned and operated a mixed animal practice in Taos, N.M. He is currently with Morgan Stanley in San Diego. He can be reached directly at (800) 473-1331; or e-mail: steven.fox@morganstanley.com