Comfort Zone Investing: What to buy when everything's on sale

It's not enough to simply look at where a stock price has been and compare it to where it trades now. The most likely reason the stock is low is that its earnings are way off or it will soon be taking large losses to wipe out earnings and equity. Looking in the rear view mirror is a sure way of crashing.

Remember, what you own in a stock is the current equity and future earnings. It only makes sense that the more earnings a company makes (operating earnings especially, not earnings from buying other companies or selling assets), the more valuable the company becomes. Check for increasing earnings as the first step to finding good stocks.

Second, look at the capital base, the equity in the firm. This is also known as shareholder's equity or Book Value. The more equity a firm has, the better it can weather these economic storms. Strongly capitalized companies can take a quarter or two of lower earnings or even losses and still have enough capital to grow when times change. It's often referred to as the "cushion" a company builds to withstand severe downturns in a market or the economy in general. The more equity a firm has, the better.

Third, consider the amount of debt on the books. For a quick way to determine if a company has too much, look at the Debt to Equity ratio. That's the amount of debt divided by the equity. If the ratio is over 1, it may be a warning sign. Too much debt can sink any company. Debt requires interest payments, and if the company isn't earning enough to pay the interest on its debt, it needs to use more debt or sell assets to pay it. But all debt needs to be put in perspective. If an industry (such as utilities or railroads) typically shows a lot of debt to finance large construction projects or heavy equipment, then companies in that industry will have higher debt to equity ratios.

Fourth, look at Return on Equity (ROE). This measures how well management is caring for your capital. It gives you the return your investment has made. A high ROE is always good when it comes from operating earnings. A consistently high ROE (see KO as an example) is even better. If you can find a company that is close to 20% ROE for the last 5 years, that's a well run company.

Fifth, find out about management. Great management is always in short supply. Even good management is hard to find. If you do research on a company's CEO (chief executive officer), you can have a good insight into what might lie ahead. Any CEO that has continuously managed capital well by having a high Return on Equity (ROE) has proven his/her mettle. Use a Google Search on any CEO of a stock you're considering. Find out if he/she has been groomed inside the company or came from outside. You can also see a description of any officer in a company's annual report or at the SEC site.

These are five elements that help you sort through the many stocks that are currently on sale. Some of them deserve to be there and will no doubt go to the Clearance bin before going to zero. Many others are there because of fear from investors. There's nothing wrong with them except the current economic difficulties. The strongest among these will lead the whole market higher.

Using the above criteria will help you pick the winners.