We are pleased to introduce a new series to the blog, covering the basics of investing and our general approach when evaluating stocks. This series aims to help beginner investors form a good understanding of fundamental investing and to share a brief overview of our methodology when selecting stocks.
STOCK INVESTING VS. STOCK TRADING
As an introduction, we wish to reiterate the key differences between the two concepts, despite being covered extensively in most articles and books related to stock investing.
Stock Investing (Fundamental analysis)
- Intention when purchasing a stock is to own a percentage of ownership in a business / company.
- Investment objective is to obtain a share of the company’s future profits / cash flow
- Investment decision considers for a company’s background, financials and prospects etc. Minimal consideration is given on technical charting
- Investment horizon typically ranges from a year to forever – a company’s worth is unlikely to change within a day, a week, or a month
Stock Trading (Technical analysis)
- Objective is solely to gain from short-term movements of a company’s share price. Consider stocks as a ticker that fluctuates in value every second
- Trading decisions are reliant on technical charting, news sources, or even gut feels. A company’s background, financials and prospects do not play a large part when making a trading decision
- Horizon of trade is relatively short, usually within a day, a week, a month, or any period of less than a year.
As an advocate of fundamental investing, we favor and hope to encourage stock investing amongst our readers and followers.
The remaining of the article is an overview of our methodology when selecting investment targets.
IDENTIFY AND SHORLIST INVESTMENT TARGETS
Our approach can be simplified into a 4-step process, which we’ll walk through briefly as follows. We will cover them more extensively in future articles on the ‘Investing Basics’ series.
Step 1: Pick a target
Considering stock picking more of an art than a science, we usually start by picking a company / business that is understandable and interesting to us, either in terms of industry, business model, products & services and growth prospects etc.
Having selected a few targets, we would prioritize our research on the top few with superior financial standings. Several of the common figures and financial ratios that we analyze are a company’s 5-year revenue growth rate, profit margin trend, cash flow position, capital expansion plans, gearing level, price-to-earnings (“PE”) ratio, dividend yield, etc.
Step 2: Perform background and due diligence checks
After deciding on a target to pursue, we would then perform thorough research on the company’s background, business fundamentals, and historical financial performance. Details that we gather and analyze include, but is not limited to the below:
- The company’s business model – What do they sell? How do they generate sales? Do they own the brand? Do they distribute themselves / via a distributor?
- Who are the company’s direct / indirect competitors?
- Background and experience of the management team – Were there any adverse news or reports on their misconduct?
- What are the key risks associated with a company / business, and its industry?
- Historical financial performance of a company, including the strength of its financial position
At the end of Step 2, we would have understood a company’s business model, its strengths, key risks and opportunities. With these insights, we can then evaluate if a particular company is worth investing in, taking all factors into considerations.
At times where we do not fully understand a company’s business model, risks, prospects, or whatsoever, we would not hesitate to forego the investment opportunity.
This step is the most critical as facts and information gathered at this stage would form our basis in the following steps. Step 3 – ‘Predict the future’ and Step 4 – ‘Determine a value’ would only be accurate and relevant if this step was performed accurately and comprehensively.
In future articles, we will be elaborating more of the above, with case studies on Malaysia-listed companies, for your better understanding.
Step 3: Predict the future
Having shortlisted the remaining company/(ies) from Step 2, we would then form an objective opinion on the company’s growth prospects including predicting its future growth rate, validating its prospects to its peers and industry news, and identifying risks that may stumble on its growth, before deciding on an investment decision.
Generally, we’d want to avoid companies that are facing stagnant or slowing growth and those with declining market share.
Step 4: Determine a value
The objective of the final step is to arrive at a value that we deem reasonable to invest, based on all information available to us. There are various valuation methods, and every investor has their preference.
In future articles, we will cover some basic valuation methods that we have found useful.
Once we have determined a ‘fair value’ of a company’s stock, we then compare it to the price the company is trading at currently. If the market is pricing it above what we deem fair, we would wait for the price to return to reasonable levels.
We monitor the price patiently and would only initiate a position if it is reasonably priced.
Once we have initiated a position in a stock, we continuously monitor the performance of the company, its industry, and business landscape to ensure its fundamentals and our assumptions made during our previous analysis remain intact. On occasions, we also revisit our valuation on each company, if necessary
WHEN TO SELL?
In our opinion, we only sell if we can answer yes to one or more of the following:
- Did I make a mistake? – If we have made a mistake analyzing the company, and our original reason for buying is no longer valid, selling is likely to be our best option.
- Has the company changed for the worse? – If the fundamentals of a company change permanently—not temporarily—for the worse, we would not hesitate to sell.
- Is there a better place for my money? – The best investors are always looking for the best places for their money. Selling a modestly undervalued stock to fund the purchase of a super cheap stock is a smart strategy. So is selling an overvalued stock and parking the proceeds in cash if there aren’t any attractively priced stocks at the time.
- Has the stock become too large a portion of my portfolio? – Selling a stock when it becomes a huge part of your portfolio can make sense, depending on your risk tolerance.
Selling just because a stock price has dropped makes absolutely no sense whatsoever unless the value of the business has declined as well. Conversely, selling just because a stock has skyrocketed makes no sense, unless the value of the business has not increased in tandem.
It’s very tempting to use the past performance of the stocks in your
portfolio to decide when to sell. Remember, though, that what matters is how
you expect a business to perform in the future, not how its share price has
performed in the past.
We hope this article has been informative to you. We will cover various topics introduced here more thoroughly in future posts. If you have any questions / feedback / discussion, do drop them in the comments below.