Analysing Stocks
Introduction…
Investing, like most other things, requires that you have a general philosophy about how to do things in order to avoid careless errors and enhance the possibility of positive outcomes.
One of the single most important factors in any investing strategy is that the strategy is consistently applied. Many strategies have been proven to be successful, but switching from one strategy to another is usually disastrous. Whatever style you choose (value investing is the Sage’s chosen specialty), make sure you are disciplined and stick to it.
Your strategy must be well-defined also. Would you play cello in the London Philharmonic Orchestra without sheet music? Would you aim a high soft wedge shot to the green without checking the wind direction? Surely not. And while investing is not nearly as difficult as mastering the cello or the golf swing (what could possibly be more frustrating unless your first name is “tiger” or “shark”), you certainly need a considered plan before investing your hard earned savings.
Fundamental Analysis-Buying a Business, not a stock! Many people rightly believe that when you buy a share of stock you are buying a proportional share in a business. As a consequence, to figure out how much the stock is worth, you should determine how much the business is worth. Investors generally do this by assessing the company’s financials in terms of per-share values in order to calculate how much the proportional share of the business is worth. This is known as “fundamental” analysis by some, and most who use it view it as the only kind of rational stock analysis.
Although analyzing a business might seem like a straightforward activity, there are many flavors of fundamental analysis. Investors often create oppositions and subcategories in order to better understand their specific investing philosophy.
In the end, most investors come up with an approach that is a blend of a number of different approaches. Many of the distinctions are more academic inventions than actual practical differences.
For instance, value and growth have been codified by economists who study the stock market even though market practitioners do not find these labels to be quite as useful. The Sagely investor, which you, my student, aspire to… would have trouble finding “value” in a business with no “growth”!
In the following descriptions, we will focus on what most investors mean when they use these labels, although you always have to be careful to double-check what someone using them really means.
VALUE A cynic, as the saying goes, is someone who knows the price of everything and the value of nothing. An investor’s purpose, though, should be to know both the price and the value of a company’s stock. The goal of the value investor is to purchase companies at a large discount to their “intrinsic value”-what the business would be worth if it were sold tomorrow. In a sense, all investors are “value” investors-they want to buy a stock that is worth more than what they paid.
Typically those who describe themselves as value investors are focused on the liquidation value of a company, or what it might be worth if all of its assets were sold tomorrow. However, value can be a very confusing label as the idea of intrinsic value is not specifically limited to the notion of liquidation value. Novices should understand that although most value investors believe in certain things, not all who use the work “value” mean the same thing.
The person viewed as providing the foundation for modern value investing is Benjamin Graham, whose 1934 book Security Analysis (co-authored with David Dodd) is still widely used today. Other investors viewed as serious practitioners of the value approach include Sir John Templeton and Michael Price. These value investors tend to have very strict, absolute rules governing how they purchase a company’s stock.
These rules are usually based on relationships between the current market price of the company and certain business fundamentals.
Some examples include:
Price/Earnings ratio (P/E), below a certain absolute limit
Dividend Yield, above a certain absolute limit
Book Value, per share at a certain level relative to the share price
Total Sales relative to Market Capitalization or Market Value
Growth Growth investing is the idea that you should buy stock in companies whose potential for growth in sales and earnings is excellent. Growth investors tend to focus more on the company’s value as an ongoing concern. Many plan to hold these stocks for long periods of time, although this is not always the case. At a certain point, “growth” as a label is as dysfunctional as “value,” given that very few people want to buy companies that are not growing. The concept of growth investing crystallized in the 1940s and the 1950s in the USA with the work of T. Rowe Price, who founded the mutual fund company of the same name, and Phil Fisher, who wrote one of the most significant investment books ever written, Common Stocks and Uncommon Profits.
Growth investors look at the underlying quality of the business and the rate at which it is growing in order to analyze whether to buy it. Excited by new companies, new industries, and new markets, growth investors normally buy companies that they believe are capable of increasing sales, earnings, and other important business metrics by a minimum amount each year. Growth is often discussed in opposition to value, but sometimes the lines between the two approaches become quite fuzzy in practice. In fact, the Sage sees this line between Value and Growth so blurred… that there is no line!
Income Although today common stocks are widely purchased by people who expect the share to increase in value, there are still many people who buy stocks primarily because of the stream of dividends they generate. Called income investors, these individuals often entirely forego companies whose shares have the possibility of capital appreciation for high-yielding dividend-paying companies in slow-growth industries. These investors focus on companies that pay high dividends like utilities and realestate investment trusts (REITs), although many times they may invest in companies undergoing significant business problems whose share prices have sunk so low that the dividend yield is consequently very high.
Growth At Reasonable Price (GARP) The GARP investor combines the value and growth approaches and adds a numerical slant. Practitioners look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business, getting a “double play” as earnings increase and the P/E ratios at which those earnings are valued increase as well. Peter Lynch, who may be familiar to you through his starring role in Fidelity Investments (the largest US mutual fund company) fund manager for flagship equity fund called Magellan, which outperformed the S&P 500 stock index for many years under his leadership, is the most famous GARP practitioner.
One of the most common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company’s earnings per share grow, the P/E of the company will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected. If the growth does not come, however, the GARP investor’s perceived bargain can disappear very quickly.
Because GARP presents so many opportunities to focus just on numbers instead of looking at the business, many GARP approaches, like the nearly ubiquitous PEG ratio and Jim O’Shaughnessy’s work in What Works on Wall Street are really hybrids of fundamental analysis and another type of analysis-quantitative analysis.
Quality Most investors today use a hybrid of value, growth, and GARP approaches. These investors are looking for high-quality businesses selling for “reasonable” prices. Although they do not have any shorthand rules for what kind of numerical relationships there should be between the share price and business fundamentals, they do share a similar philosophy of looking at the company’s valuation and at the inherent quality of the company as measured both quantitatively by concepts like Return on Equity (ROE) and qualitatively by the competence of management. Many of them describe themselves as value investors, although they concentrate much more on the value of the company as an ongoing concern rather than on liquidation value.
Warren Buffett of Berkshire Hathaway is probably the most famous practitioner of this approach (if not simply the most famous, and without doubt most successful, stock investor in the history of our world!!!). He studied under Benjamin Graham at Columbia Business School but was eventually swayed by his partner, Charlie Munger, to also pay attention to Phil Fisher’s message of growth and quality. A read of Buffett’s Berkshire Hathaway annual reports over the last two decades is more than any MBA could ever teach the aspiring Sage. Buffett is a one-of-a-kind genious who has the uncanny ability to spot value where others miss it. He accumulated over 5% of the Coca-Cola Company during the late 1980s when it had a P/E over 40, and most analysts and brokerages saw it as overvalued. Over the following years, Coca-Cola plowed into international markets, improved margins and ROE faster than nearly any other company, and the share price skyrocketed, giving Buffett billions of dollars in profits. Buffett invests very selectively in just a hand full of companies and considers himself an owner of the business and acts accordingly. Many books have been written on his investment savvy, and his ingenious ability to calculate a company’s “intrinsic value” based on it’s ability to generate cash many years into the future and discounting that cash value back to the present. Even the humble Sage is no match for Mr. Buffett, and readily admits it!
Arguments Against Fundamental Analysis Those who do not use fundamental analysis have two major arguments against it. The first is that they believe that this type of investing is based on exactly the kind of information that all major participants in publicly traded markets already know, so therefore it can provide no real advantage. If you cannot get a leg up by doing all of this fundamental work understanding the business, why bother? The second is that much of the fundamental information is “fuzzy” or “squishy,” meaning that it is often up to the person looking at it to interpret its significance. Although gifted individuals can succeed, this group reasons, the average person would be better served by not paying attention to this kind of information. (note: Sage does not subscribe to this logic!)
Quantitative Analysis-Buying the Numbers Pure quantitative analysts look only at numbers with almost no regard for the underlying business. The more you find yourself talking about numbers, the more likely you are to be using a purely quantitative approach. Although even fundamental analysis requires some numerical inputs, the primary concern is always the underlying business, focusing on things like management’s expertise, the competitive environment, the market potential for new products, and the like. Quantitative analysts view these things as subjective judgments, and instead focus on the incontrovertible objective data that can be analyzed.
One of the principal minds behind fundamental analysis, Benjamin Graham, was also one of the original proponents of this trend. While running the Graham-Newman partnership, Graham exhorted his analysts to never talk to management when analyzing a company and focus completely on the numbers, as management could always lead one astray.
In recent years as computers have been used to do a lot of number crunching, many “quants,” as they like to call themselves, have gone completely native and will only buy and sell companies on a purely quantitative basis, without regard for the actual business or the current valuation-a radical departure from fundamental analysis. “Quants” will often mix in ideas like a stock’s relative strength, a measure of how well the stock has performed relative to the market as a whole. Many investors believe that if they just find the right kinds of numbers, they can always find winning investments. D. E. Shaw is widely viewed as the current King of the Quants, using sophisticated mathematical algorithms to find minute price discrepancies in the markets. His partnership sometimes accounts for as much as 50% of the trading volume on the New York Stock Exchange in a single day!
Company Size…
Some investors purposefully narrow their range of investments to only companies of a certain size, measured either by market capitalization or by revenues. The most common way to do this is to break up companies by market capitalization and call them micro-caps, small-caps, mid-caps, and large-caps, with “cap” being short for “capitalization”. Different-size companies have shown different returns over time, with the returns being higher the smaller the company. Others believe that because a company’s market capitalization is as much a factor of the market’s excitement about the company as it is the size, revenues are a much better way to break up the company universe. Although there is no set breakdown used by all investors, most distinctions look something like this:
MICRO-CAP: $100 million or less
SMALL-CAP: $100 million to $500 million
MID-CAP: $500 million to $5 billion
LARGE-CAP: $5 billion or more
The majority of publicly traded companies fall into the micro or small categories. Some statisticians believe that the perceived outperformance of these smaller companies may have more to do with “survivor” bias than actual superiority, as many of the databases used to do this performance testing routinely expunged bankrupt companies until pretty recently. Since smaller companies have higher rates of bankruptcy, excluding this factor is still being debated.
The LARGE-CAP companies tend to be very visible well-known companies like Singapore Press Holdings, Singapore Airlines, DBS Bank and Natsteel. They are not only well known, they are extensively studied by brokerages and analysts of every kind, with no secret unturned. The MICRO-CAP companies, on the other hand, are often not familiar names and often not covered by any brokerages or analysts, and seldom mentioned in the financial newspapers or magazines. It is the Sage’s belief, for just this reason, that most hidden value will be found by studying MICRO-CAP companies in Singapore.
Screen-Based Investing Many quantitative analysts use “screens” to select their investments, meaning that they use a number of quantitative criteria and examine only the companies that meet these criteria. As the use of computers has become widespread, this approach has increased in popularity because it is easy to do. Screens can look at any number of factors about a company’s business or its stock over many time periods.
While some investors use screens to generate ideas and then apply fundamental analysis to assess those specific ideas, others view screens as “mechanical models” and buy and sell purely based on what comes up on the screen. These investors claim that using the screen removes emotions from the investing process. (Those who do not use screens would counter that using a screen mechanically also removes most of the intelligence from the process.) One of the proponents of using screens as a starting point is Eric Ryback, and one of the most famous advocates of screens as a mechanical system is James O’Shaughnessy. One of the most well-known stock screens is the Dow Dividend Approach, also known as the Dogs of the Dow…because the screen involves screening the 30 Dow stocks for the ten with the highest dividends…then investing in the five lowest priced of these ten high dividend stocks each calendar year.
Many Singapore Brokerages now have Internet trading sites that include Singapore Exchange stock screening capabilities. You can very quickly scan the Singapore Stock universe for stocks of interest, such as P/E values below 20 and growth rates above 20%. This screening technique is interesting as a starting point for further investigation for aspiring young Sages.
Momentum Momentum investors look for companies that are not just doing well, but that are flying high enough to get nose bleeds. “Well” is defined as either relative to what investors were expecting or relative to all public companies as a whole. Momentum companies often routinely beat analyst estimates for earnings per share or revenues or have high quarterly and annual earnings and sales growth relative to all other companies, particularly when the rate of this growth is increasing every quarter. This kind of growth is viewed as a sign that things are really, really good for the company. High relative strength is often a category in momentum screens, as these investors want to buy stocks that have outperformed all other stocks over the past few months.
CANSLIMis a system pioneered by Willian J. O’Neil that is a hybrid of quantitative analysis and technical analysis, detailed in his book How to Make Money in Stocks. According to Investor’s Business Daily, O’Neil’s newspaper, the “C” and “A” of the CANSLIM formula tell investors to look for companies with accelerating Current and Annual earnings. The “N” stands for New, as in new products, markets, or management. “S” stands for Small capitalization and big volume demand. “L” tells investors to figure out whether the company is a Leader or Laggard. “I” has them look for Institutional sponsorship, and “M” concentrates on the direction of the Market.
Technical Analysis-Buying the Charts What would you do if you truly believed that all information about publicly traded companies was efficiently distributed and that nobody could get an edge on anyone else by either understanding the business or analyzing the numbers? You might consider simply giving up on beating the market’s returns and buying an index fund. Some investors have taken an alternate route, attempting to create a set of tools that might tell them what other investors thought about a stock at any given time, particularly looking for the footprints of large institutional investors that tend to cause the most extreme price changes. Investors who focus on this kind of psychological information call themselves technical analysts and believe that charts can sometimes provide insight into the psychology surrounding a stock. Although there are plenty of pure chartists, some investors just use charts to time investments after looking at them from a fundamental or quantitative perspective.
Chart-viewing is very popular in Singapore, as technical analysts are frequently quoted in leading investing newspapers and magazines and even on TV shows. There is no set of clearly defined approaches to technical analysis, but there are a number of different tools. The most important indicators seem to be specific chart formations that show certain price movements at times when trading volume is at a certain level. The most common kinds of charts include point and figure charts, logarithmic charts, and Japanese candlesticks, to name but a few.
Sagely investors should be aware that most of the statistical work done by academics to determine whether the chart patterns are actually predictive has been inconclusive at best, as detailed in Burton Malkiel’s A Random Walk Down Wall Street. Much of the faith in technical analysis hinges on anecdotal experience, not any kind of long-term statistical evidence, unlike certain quantitative and fundamental methodologies that have been shown in many instances to be accurately predictive. Critics of technical analysis (Sage among them), feel that it is basically as useful as reading tea leaves.
Trading As trading commissions begin to fall in Singapore next year, and with there still being no capital gains taxes, and with more and more people gaining Internet access to instantaneous data about stock prices, trading will likely become more popular… likely much too popular the Sage thinks! Traders normally use a hodgepodge of fundamental, quantitative, and technical techniques (or simply rumors) with a short-term orientation. Trading tends to be a highly charged experience where one looks to make a few percentage points from each trade. Although widespread, trading is far from a systematized, philosophical body of knowledge that is easily explained in a few paragraphs.
Many novice investors, lulled by the apparently easy casino-like gains possible in trading, tend to lose a lot of money before they realize that when there are thousands of other traders out there looking for the same things, it is often those who are fastest, have the most experience, and own the best equipment that make money-normally not the people just starting out. All traders emphasize that successful trading requires careful attention, discipline, and a lot of work, so anyone who thinks that he or she can use a Quotrek in between meetings to make a fortune might want to reconsider.
Trading is clearly a time-consuming adventure. Although there are a number of very famous and successful traders, many individuals ignore the fact that these traders are well equipped to trade and have all day to do so. Given the time and effort most successful traders put into their trading, the potential for amateurs to reap the same rewards with less effort and fewer resources is very low. With so much money competing in the one-day to one-year investment time-frame, an individual with minimal amounts of time will probably be more successful finding businesses to own for the long term and not trying to engage in high-octane, almost gambling-like behavior.
