Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific advice, in this case showing you how we judge winning stock picks. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “Use our TSI Network ratings system to pick the right stocks: Part 2”

Last week in the Investor Toolkit, we looked at 4 of the 9 factors that we use to establish our TSI Network ratings: Highest Quality, Above Average, Average, Extra Risk, Speculative and Start-up. (View the post: How our ratings system finds the best stocks: Part 1.) These ratings appear next to every stock we recommend in our investment newsletters.

We use a point system to award our ratings, as I mentioned last week. This week, we’ll look at the 5 remaining factors we use to assess risk and build a profile of winning stock picks.

5. One point for a long-term record of profit. A company that makes money just about every year will survive a lot longer than one that makes money sporadically, if at all.

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6. One point for a long-term record of dividends. A steady or rising dividend provides a sign of safety. Dividends, after all, are impossible to fake — either the company has the cash to pay dividends, or it doesn’t. Failing or fraudulent companies hardly ever pay dividends.
   
   Two examples of companies with a long history of raising their dividends are Fortis Inc. (symbol FTS on Toronto), a stock we analyze in our flagship advisory, The Successful Investor, and McGraw-Hill (symbol MHP on New York), which we analyze in our newsletter on U.S. stocks for Canadian investors, Wall Street Stock Forecaster.
   
   Fortis is the main supplier of electrical power in Newfoundland and Prince Edward Island. It also operates power plants in the U.S., Belize and the Cayman Islands, and has other businesses across Canada.
   
   McGraw-Hill announced in September 2011 it will split into two separate companies: McGraw-Hill Markets, which will sell a variety of financial-information products and McGraw-Hill Education, which will publish textbooks for schools and colleges.
   
   Both companies have raised their dividends for 39 consecutive years. Fortis’ annual rate of $1.20 a share yields 3.6%. McGraw-Hill’s annual rate of $1.02 yields 2.2%.
7. One point for an attractive balance sheet, with adequate equity and manageable debt. When bad times hit, debt-heavy companies go broke first.
8. One point for being able to serve all shareholders. The best stocks in this area are free of heavy-handed government regulation, free of too much dependence on a single supplier and free from abuse by insiders.
9. One point for Canada-wide operations, or two points for multinational operations. Companies that are confined to one geographical area are inherently more speculative than those whose operations are more spread out.

If you’d like me to personally apply my time-tested investment advice to your portfolio, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice, including the best use of financial ratios in your stock research. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “Assessing a company’s debt is important, but you can be misled by the numbers.”

The issue of debt appears regularly in the media these days—whether it’s the debt of governments or the indebtedness of the population at large. Deciding whether a company has too much debt is certainly an important factor for investors.

Many experienced investors begin their stock research by looking at ratios such as a company’s debt-to-equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity.

A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. However, this ratio can mislead, because it compares a hard number with a soft one.

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Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are fuzzier. They mostly reflect asset values as they appear on the balance sheet (minus debt, of course).

But figures on a balance sheet may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by trimming them back or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

Stock research: The debt-to-market-cap ratio can say more about a company’s long-term prospects

Instead of overemphasizing the debt-to-equity ratio, we recommend that you expand your stock research to look at the ratio between a company’s debt and its market capitalization or “market cap” (the value of all shares the company has outstanding).

Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market-cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.

A great example that we like to cite is Coca-Cola Co. (symbol KO on New York). The company has long-term debt of $13.7 billion, which represents a moderately high 41% of its $33.4-billion shareholders’ equity. But that debt is just 8.5% of its market cap.

The difference reflects the fact that the company’s balance sheet doesn’t show the true value of its most valuable asset — its so-called intellectual property. In Coke’s case, one key asset is the secret formula for Coca-Cola, which is reputedly carried on the company’s books at one dollar (and was recently moved with great fanfare to a new vault in Atlanta). More important, the Coke brand name carries no value on the company’s balance sheet. However, these are reflected in its huge market cap of $160.6 billion. So, put into perspective, the company’s debt is very low.

In contrast, penny mines often have low debt-to-equity ratios. But their shareholders’ equity reflects a lot of investments in mineral properties that will almost certainly never result in any significant revenue. And one good reason that their debt is low is simply that no one wants to lend them money.

If you’d like me to personally apply my time-tested investment approach to your portfolio, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

Recently, one of our Inner Circle members asked about a stock certificate for Consolidated Denison Mines, a company that no longer trades on any stock exchange. Our research showed that Consolidated Denison had merged in 1960 with Can-Met Explorations and was renamed Denison Mines Limited. That company now trades in Toronto under the symbol DML. We gave him the number of the transfer agent for Denison Mines Limited to see if he could exchange his shares for those of the existing company.

Perhaps you have an old stock certificate like this in your files. The certificate may be registered in your name, or in the name of an earlier owner—a friend or relation who left it to you, or a total stranger. Is it worth something?

One way to find out whether the certificate has any value is to try and deposit it in an account with a discount broker. If the issuing company’s corporate charter has been cancelled, the broker will reject the certificate and return it to you. If the stock has been taken over by another company, the broker may try to collect the securities or cash that the buying company paid for it.

Stock market advice: You don’t find pearls at the bottom of a junk drawer

Still, certificates like these almost always turn out to be worthless (although they may have some value in the field of scripophily—the study and collection of stock and bond certificates). People take care of items that have some value. For stock certificates, that means keeping them in a safe deposit box, or with a brokerage account. Certificates of defunct stocks are more likely to be deposited at the bottom of a file drawer, “just in case they ever come back to life.” They don’t.

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Another reason why most old stock certificates are worthless is simple arithmetic: It’s much easier to launch a company and sell stock to the public than to launch a business and make a success of it. That was truer decades ago than it is today—it’s now much harder and more expensive to launch a new public company. But it’s still easier than starting a profitable new business.

This highlights important stock market advice that can keep your buys from winding up at the bottom of an old file drawer:

1. It’s essential to invest mainly in well-established stocks with a history of sales and earnings, if not profits. If you break this rule and invest in, say, junior mines or Internet startups, you should only do so if you have a high opinion of the value of the junior’s assets and/or business plan. And you should buy the stock with money you can afford to lose. You could be mistaken about its value. Someone might eventually find your low-quality buys gathering dust at the back of a drawer and wonder if they were ever worth anything.
2. “Holding for the long term” only pays off with investments in high-quality, well-established companies. If you buy low-quality or speculative stocks, time tends to work against you. The longer you hold them, the likelier you are to lose money.

You can follow our safety-conscious advice in the Canadian Wealth Advisor. We help you discover stocks whose built-in value limits losses during downturns—and produces superior gains over time as the markets rebound.

You can get a special risk-free introductory subscription to Canadian Wealth Advisor at a savings of $80.00 off the regular rate. Best of all, your subscription contains 5 in-depth Special Reports, and much more. Click here start your introductory trial subscription to Canadian Wealth Advisor now.

P/e ratios (the ratio of a stock’s price to its per-share earnings) are published regularly in newspapers and on the Internet. These financial ratios are widely followed, and are an important part of many investors’ decision making.

Typically, you calculate p/e’s using a stock’s current price and its earnings for the previous 12 months. The general rule is that the lower a stock’s p/e, the better. And a p/e of less than, say, 10, represents excellent value. A low p/e implies more profit for every dollar you invest.

P/e financial ratios are just a starting point when you research stocks

P/e financial ratios are a good starting point for researching a stock you’re considering buying (or selling). But relying too heavily on these financial ratios can expose you to serious risk.

Successful investors treat p/e’s as just one of many tools, and not a deciding factor. This is the approach we follow when we use these financial ratios to evaluate stocks for our newsletters and investment services.

Here are 3 risks of relying too heavily on p/e ratios. All can seriously hurt your portfolio’s long-term returns:

1. One-time gains can artificially inflate a company’s p/e: Make sure you factor out low p/e’s that arise if a company sells off assets or subsidiaries and records a large one-time gain. That inflates the p/e, and is not representative of the company’s true ongoing operating earnings. Similarly, you should add back any one-time write-offs so you don’t miss any stocks that have low p/e’s on an ongoing basis.

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2. A low p/e ratio can be a danger sign: It pays to be wary of stocks that trade at suspiciously low p/e’s. Low p/e’s may come about because well-informed investors are selling the stock and pushing the price down, regardless of earnings. In other words, unusually low p/e’s can be a sign of danger rather than a clue to a bargain.
   
   Some companies, especially in the cyclical manufacturing and resources sectors, go through periodic booms and busts that can balloon their earnings in the space of a few quarters, then deflate them overnight. If earnings are high and p/e’s are low on a company or industry, it usually means investors expect a profit setback. These stocks could easily plunge when growth turns down. Often the riskiest time to buy stocks in these industries is when p/e’s are at their lowest.
3. Don’t discount stocks with high p/e’s: You should expect to pay high p/e’s for stocks with lots of growth potential. As well, you may want to buy shares of high-p/e firms that report earnings even in bad times. This shows a high-quality company. This is true even if a company stays marginally profitable, or avoids eye-catching losses, in bad times.
   
   You’ll also pay more for companies with a long-term earnings pattern. However, few are worth more than 20 to 25 times normal earnings in the midst of an economic cycle. So you should avoid loading your portfolio up with high-p/e stocks. Should the market go into a broad setback, these stocks are particularly vulnerable.

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

Some investors follow a “sector rotation” approach to investing. That’s when you try to hop from sector to sector, underweighting or overweighting their holdings in certain sectors of the stock market depending on a forecast of the stage of the economic cycle, or other factors.

Sector rotation can work in any one year, say. However, it’s difficult if not impossible to produce consistent longer-term returns. Here are 2 reasons why:

1. You need to guess right three times to profit in sector rotation: You have to pick the top sectors, then pick the stocks that will rise within those sectors, then sell before the sector stumbles. It’s virtually impossible to consistently succeed at all three over long periods. But that’s not the only problem with sector rotation.
2. Sector rotation can overweight you in the worst-performing sectors: There are many theories about which sectors will outperform at any given stage of the economic cycle. But trying to pick winning sectors — and staying out of other sectors — seldom works over long periods. Investors who attempt to do so often wind up with heavy holdings in the worst-performing sectors. That would be devastating to your portfolio, even if you confine your investments to well-established companies.

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Our investment advice: Instead of sector rotation, we recommend that you diversify your portfolio by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance and Utilities).

(This is a key part of our three-part investing program. The other two parts are to invest mainly in well-established, dividend-paying companies and to avoid or downplay stocks in the broker/public-relations limelight.)

If you diversify as we advise, you improve your chances of making money over long periods, no matter what happens in the market.

For example, manufacturing stocks may suffer if raw-material prices rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the value of your Utilities stocks.

You can get our investing advice, plus buy/sell/hold advice on stock market picks you may be considering buying in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.

Toromont is one of the growth stocks we analyze in Stock Pickers Digest.

In the three months ended June 30, 2011, this Canadian stock pick’s revenue rose 9.3% to $344.6 million from $315.3 million a year earlier, due to higher new equipment sales and increased rental revenue.

Earnings per share, excluding one-time items, rose 30.4% to $0.30 from $0.23 on the higher revenues and improved profit margins.

Order bookings were up 15% in the quarter from a year earlier reflecting strength in mining, construction and road building. The company’s total backlog now stands at $335 million, up over 45% from a year ago.

The company has increased its quarterly dividend by 10.0%, to $0.11 a share from $0.10. The shares now yield 2.5%.

Earlier this year, the Canadian stock pick’s shareholders have now approved the spinoff of Enerflex. The new Toromont continues to distribute Caterpillar and industrial equipment; Enerflex will sell natural-gas production and processing equipment.

You can get our clear buy/sell/hold advice on Toromont and dozens of other Canadian stock picks that may be appropriate for the part of your portfolio you devote to aggressive investing when you subscribe to Stock Pickers Digest. What’s more, you can get the latest issue absolutely free. Click here to learn how.

Goodwill is an accounting entry that reflects the price that the company paid for its acquisitions, minus the value of the tangible assets, like land and equipment, that it received as part of the acquisition. The term means “value as a going concern.”

However, goodwill acquired in an unwise acquisition can lose value overnight. When that happens, the company has to write it off against earnings. At worst, the company might have to write off most, if not all, of its goodwill.

If that writeoff wipes out most of the company’s shareholders’ equity, and/or most of a year’s earnings, it can devastate the share price. That’s a situation you should avoid at all costs.

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Stock market research: It pays to go beyond the numbers when assessing a company’s goodwill

Even though companies with high goodwill carry a greater risk of writedowns, your investing strategy shouldn’t automatically dismiss these firms. Canada Bread (symbol CBY on Toronto), provides an example of this kind of situation.

Canada Bread has $261.6 million of goodwill on its balance sheet. That’s a high 40.9% of shareholders’ equity of $639.3 million. But it’s a more reasonable 23.4% of the company’s $1.1-billion market cap (the company’s share price multiplied by the number of shares outstanding).

More important, the goodwill was largely added to Canada Bread’s balance sheet from a series of acquisitions the company made in 2002. Most of the companies that Canada Bread bought were small. But they did include its December 2002 purchase of parent company Maple Leaf Foods’ U.S. and U.K. bakeries, including Grace Baking Company, for $262 million.

The companies that Canada Bread bought in 2002 have proven profitable, and are a stable part of its operations, so the chance of a writedown at this point, over nine years later, is small.

When we do our in-depth stock market research for safety-conscious investors, goodwill is just one of the important factors we take into account. To discover more of our comprehensive advice on lower-risk investments, you can start a 1-month FREE trial to Canadian Wealth Advisor today.

Best of all, in addition to the latest issue of Canadian Wealth Advisor, your FREE trial contains 5 in-depth Special Reports and much more. Don’t wait! Click here start your 1-month FREE trial to Canadian Wealth Advisor now.

However, while a renewed economic slide is a possibility, I don’t expect to see it happen. My view is that the economy is stagnating because of uncertainty over the outlook for deficits, tax increases, regulatory changes and so on. Once that uncertainty clears up, I expect a new rise in the market.

A further setback is always possible, but if it happens, I think it will end by sometime this fall. I strongly doubt that it will turn into anything like the market plunge of 2008-2009.

Of course, nobody can consistently predict market trends. That’s why, instead of focusing on vague worries about the economy, safety-conscious investors are far better off continuing to stick with our three-part portfolio-building philosophy:

1. Invest mainly in well-established, high-quality companies with a record of sales and earnings, if not dividends.

High-quality stocks hold their value better than most in market downturns. They also rebound faster when conditions improve.

2. Diversify across the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.

3. Downplay or avoid stocks in the broker/media limelight.

Today’s tip: “The best way to use technical analysis to find winning stocks”

Some investors rely on technical analysis (or chart reading) when they’re picking stocks. That’s because relying on charts seems much simpler than delving into and weighing a company’s fundamentals.

Some successful investors find it helps to know a little about charts. But if you rely on charts at all, you should view them as just one of many things to consider when you make investment decisions.

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Zeroing in on share prices will eventually cost you money

The main problem with technical analysis is that it focuses too narrowly on a stock’s past price movements in an attempt to determine its future price. It’s not concerned with other crucial parts of a company’s business, such as financial statements or management. Instead, technical analysis zeroes in on how stock prices have behaved in the past, and the clues that may offer about future price movements.

In fact, an investor who relies solely only charts might buy and sell a stock while knowing little or nothing about the underlying company.

The appeal of technical analysis is that it often seems to work, at least in small ways, but this may be an illusion. You may only remember your successful chart interpretations. More important, technical analysis tends to work in spurts. The risk here is that you may find it leads you to make five or even 10 small wins, then steers you wrong at the worst possible moment. That next mistaken trade may cost you much more than your winnings to date.

Our investment advice? Use technical analysis to support—not determine—your view of whether companies are good investments. A far better approach is to look at chart reading as one tool among many. However, don’t look at the chart for a prediction of what’s going to happen. Look to see if the pattern on the chart seems to support your view of the stock, based on its finances and other fundamentals. But remember that the stock market follows a multitude of factors to varying extents, and the most important or influential factors continually change.

It’s encouraging if your analysis and the chart seem to match. But sometimes they don’t. If a company looks promising, but its chart shows a lengthy falling trend, insiders may know something you don’t. That’s when you know you have to dig deeper, and perhaps wait until the situation clarifies itself.

If you’re looking for stocks with the potential for gains of 50% or more in 6 months or less, you should subscribe to Stock Pickers Digest.

The latest issue of Stock Pickers Digest gives you our full analysis, including clear buy/sell/hold advice, on 19 stocks that may be suitable for the part of your portfolio you devote to aggressive investing. What’s more, you can get this issue ABSOLUTELY FREE. Click here to learn how.

However, I strongly doubt that we’ve set off on a new multi-year market decline. More likely, we are in a short-term setback — a “correction.” But nobody can consistently predict market trends.

That’s why I continue to advise that you limit aggressive investments to no more than, say, 30% of your portfolio.

You can cut risk all the more by taking a conservative approach. For instance, you should hold your aggressive investments within a portfolio that reflects our three-pronged TSINetwork wealth building philosophy.

That is, invest mainly in well-established companies; spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry, Resources, Consumer, Finance, Utilities); and downplay stocks that are in the broker/media limelight.

You may invest more heavily in Manufacturing and Resources, the two riskiest sectors. If so, take care to spread your money out across the many industries within each of these sectors.