How To: Investing In StocksJun 29, 2021
Every investment product presents hosts of opportunities as well as risks associated with them. You should evaluate the risk versus reward possibilities before investing in the specific asset class. In this article, we will cover basic research requirements before investing in the most popular asset class – Equities.
In contrast to the older generations parking their savings in the bank, real estate or precious metals, the younger generation, especially the millennials have learnt to dabble in stock markets. Global equity markets have been very benevolent whereby investors have reaped handsome rewards. The bull run since the recent past has only added fuel to the fire. The exuberance has caught the attention of frenzied beginner investors, whose hefty gains in equities in a short period of time can primarily be attributed to sheer luck. The invincible wall of multiple risks can potentially damage the northbound speedy ride. Therefore, it is recommended to conduct some basic research, before investing in stocks, to identify the various features, characteristics, and risk factors to avoid an unpleasant outcome of your investments. When normalcy returns to markets, your research will play an important role in your wealth management.
Here are some basic research pointers to consider before investing in stocks.
The severe debt crisis in the Eurozone during 2010-2011, especially among the peripheral nations such as Greece, Cyprus, Portugal was detrimental to equity markets in the region. The quality of the balance sheet did not matter then as the whole economy went in a tailspin. The EU, ECB and the IMF collectively put an end to the crisis finally paving the way for the resurrection of equity markets there.
Or take the case of a tsunami-induced earthquake resulting in the Fukushima nuclear crisis in 2011 that negatively impacted the related businesses such as uranium miners to nuclear power producers.
During the commodity bull phases, commodity and non-commodity businesses alike tend to suffer as input costs rise thereby affecting outputs. Consumers tend to tighten their purse strings, which affects the economy and spending priorities. A sharp or sustained rise in crude oil is one such example of adverse macro conditions.
Although in many instances an inflationary environment may not necessarily derail the economy or stock market rally yet more often than not a high inflation backdrop coupled with stagnated economy (stagnation) does curtail corporate profits. The easiest example of this scenario is the high inflation rate (interest rates were close to 20%), which kept the equity market in check. It was only in 1982 when disinflation kicked in and stock prices finally embarked on what we know as one of the best secular bull market rides.
You should be wary of any rules and regulations that can impact the sector or industry you are interested in investing in. For instance, during the one-child policy in China, it was boom time for companies involved in contraceptive products and relevant surgical procedures. After the Dragon liberalized the policy to 2-children, it was time for the baby products, baby care services, and kindergarten companies to flourish.
Micro Factors (Qualitative Research)
Company’s Relevance in Today’s Times
With the evolution of business, industry, technology and demand, many products have lost their relevance over the past decades. Bulky cameras, analogue watches, box television sets are among thousands of items that were forced to make way for newer and more efficient merchandise. So, investing in a company making huge television antennas may not be the best option.
Company’s Real Source of Income
Not all companies make money from their obvious line of business. For instance, many electronic companies generate their income from consumer financing, and not from actual sale of electronics. World’s most prestigious fast food companies make money via sale of franchises. It is, therefore, important to understand the real source of your favourite company’s revenues.
What good is a ship without a qualified skipper and crew. A company may have great potential but only a competent head can chalk out the right course and steer it in the right direction. Any top management team that comprises a diverse set of directors in terms of background, gender, and ability to drive shareholders’ value gets my vote. A board composed of too many insiders can be short of transparency.
Company’s Competitive Advantage
Any company with a business difficult to imitate or equal stands much greater chances of sustained growth than those that are just one of many fish in a large peer pool. A moat can be business model, brand, research and development capabilities, operational excellence, superior distribution channels, or patent ownership. Taiwan Semiconductor Manufacturing Company, Microsoft and Google are great examples of business models that have built a moat around their respective businesses.
Detection of a “What If” Scenario
It is common human tendency to eye the upside, and ignore the downside. Any business could be a victim of a fundamental shock with long term implications. Some of these unforeseen events include: expiration of a patent; emergence of a formidable competition; introduction of a disruptive technology; shift in company’s focus from its core and profitable businesses – among others.
Micro Factors (Quantitative Research)
Revenue, often referred to as the “top line,” is the sum of money generated by a company during the specified period. Revenue can be classified as “operating revenue” and “non-operating revenue.” The former comes from the company’s core business, and is more reflective of a company's ability to generate income, while the latter is more of a result of a one-time business activity, such as sale of an asset.
Net income, also known as the bottom line, is the most important figure in the stream of cash generation. This figure is the net total amount of money a company makes after operating expenses, taxes and depreciation. Revenue is akin to your monthly gross salary, while net income can be described as what is left after your taxes and living expenses.
Earnings Per Share (EPS)
Dividing total earnings by the number of outstanding shares gives you earnings per share. EPS is a reflection of a company’s profitability on a per-share basis. Some companies reinvest their earnings in the business. Others use them to reward their shareholders by paying dividends.
Price-Earnings Ratio (P/E)
Dividing a company’s current stock price by its earnings per share (over the last 12 months) gives you its trailing P/E ratio. So, ABC stock selling @$100 with a $10 earnings can be described as trading at 10x trailing P/E.
Dividing a company’s current stock price by the Street estimates for next year gives you the forward P/E ratio. The same ABC stock with a $20 earnings expectation for next year would be trading at 5x forward P/E. This measure of a stock’s value indicates how much the market is willing to pay to receive $1 of the company’s current earnings.
P/E ratio, on a stand-alone basis, is not the most reliable metric to judge a stock though.
Return on Equity (ROE) and Return of Assets (ROA)
Return on equity shows how much profit a company makes with each Dollar shareholders have invested. ROE is expressed in percentage terms. The equity is shareholder equity.
Return on assets reflects the percentage of profits a company creates with each Dollar of its assets.
Each of these is derived from dividing the company’s annual net income by one of those measures. Both these metrics reflect a company’s efficiency at generating profits.
Debt-Equity Ratio (DER)
Just like individuals, companies also borrow to run their business and maximize returns by leveraging their balance sheet. DER is the proportion of assets which is being used to finance the assets of the company. A $100 worth of debt with $100 of assets is 1:1 ratio. A debt of $200 would get you the DER 2:1. Higher the leverage, higher the interest cost, and higher the potential profit or loss.
Some of the capital-intensive industries include capital goods, oil, gas and metals. They tend to have a higher DER than companies involved in the service industry.
Fundamental Versus Technical
Fundamental research is the most widely used tool by investors and professional money managers alike. As the word “fundamental” indicates this type of research looks at the core basis of stock investing. It encompasses a company's financial health, industry trends, competition, regulatory environment etc. Fundamental research has more emphasis on the value of a stock than the price of a stock because the latter does not hold much importance in the process.
In contrast to fundamental research, technical research lays more emphasis on the price of the stock. The process helps determine the future trend by analysing the past values of the stock. Factors considered in technical research include price movement, volume, volatility, market psychology, etc. among many others. Technical research is mostly used for short term outlook, and is, hence, popular among traders. It can help identify breakdown levels in a stock thereby limiting any potential loss with “stop-loss” orders.
Many money managers, including myself, use technical research for the long term along with fundamental research to identify a viable name with an attractive entry, and subsequently an exit point. Implementation of both research methodologies can help you get maximum return on your investment.
Taking a plunge into any financial endeavour is never void of risks. It is always wise to do a reasonable, if not a thorough, due diligence to invest in any asset class. Equities are no exception. Although you can never accurately predict the outcome of any investment yet armed with some research you can make more informed decisions while investing. Hasty decisions made on hear-say basis, or popularity alone e.g. digital currency are not reliable ways to create wealth.
- Ramesh Sadhwani
– Former Wall Street Broker, Global Portfolio Manager, and Senior Technical Analyst.
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