COMMON INVESTING MISTAKES AND HOW TO AVOID THEM

While making mistakes is part of the learning process, it’s all too often that plain old common sense separates a successful investor from a poor one. Being perfect may be impossible, but knowing some of the common investing errors can help deter you from going down the path of losers. We are going to discuss some of the most common investing mistakes made by both the new and experienced investors.

  1. Day Trading – Day trading should only be attempted by the most seasoned investors. In addition to investment savvy, a successful day trader needs access to special equipment that is rarely available to the average trader. Unless you have the expertise, equipment and access to speedy order execution, think twice before day trading.
  2. Buying on Unfounded Tips – Buying on media tips is often unfounded on nothing more than a speculative gamble. If a stock tips really grabs your attention, first consider the source, then do your research to get the facts right on what and why you are buying.
  3. Using too much Margin – Margin is the use of borrowed Money to purchase securities.  Margin can help you make more money and can also exaggerate your loses. The worst thing you can do as a new investor is become carried away with what seems like free money-if you use margin and your investment doesn’t go your way, you end up with a large debt obligation for nothing. Using margin requires you to monitor your positions much more closely because of the exaggerated gains and loses that accompany small movements in price. New investors should use the margin sparingly, if at all. Use it only if you understand all its aspects and dangers.
  4. Compounding Your losses by averaging down – If one of your stocks has a sharp decrease in its price, it is better to try to determine the reasons for the change and assess whether the company is a good investment for the future other than holding on it and hoping for the best. Letting your pride get in the way of sound investment decisions is not  a wise move and can decimate your portfolio’s value in a short amount of time. The best thing to do is to remain rational and act appropriately when you are inevitably confronted with a loss on what seemed a good investment.
  5. Underestimating your Abilities – With a little time devoted to learning and research, any investor can become well equipped to control their own portfolio and investing decisions and be profitable. You shouldn’t underestimate your abilities or your own potential.
  6. When buying stock, overlooking the, “Big Picture” – Attempting to identify buy and sell opportunities with complex technical analysis may work a great deal of the time, but if the world is changing against your company, sooner or later you will lose. Assessing a company from a qualitative standpoint is as important as looking at the sales and earnings. Qualitative analysis or looking at big picture is a strategy that is one of the easiest and most effective for evaluating a potential investment.

  7. Buying stocks that appear cheap – It is always pays to analyze why a stock has decreased before making a decision to buy it or not, other than just buying because the price has fallen. Deteriorating fundamentals, increased competition or even CEO resignation are all possible reasons for the lower stock’s price but they also provide good reasons to suspect that the stock’s price might not increase anytime soon. Do your homework and analyze a stock’s outlook before you invest in it.  Join our Newsletter List.

KEY INVESTING LESSONS LEARNED FROM WARREN BUFFET

Warren Buffett is one of the greatest investor of all time and also one of the best teachers of investing. Here we discuss some of the lessons he has offered through his annual reports and countless interviews that you can use to invest better and reach your financial goals.   Warren Buffett

  • Invest unemotionally – Many people make systematic errors in their investment thinking due to their emotions, egos and innate cognitive biases. Emotions reduces investment returns, in contrast Warren Buffet investment decisions are insulated from such emotions.  He thinks long-term, and so he doesn’t panic when the market falls, instead he sees drops as buying opportunities. To invest better, learn how emotions lead to cognitive errors, so that you can avoid those errors and benefit when others make them.
  • Ignore modern financial theory – Buffet believes that modern financial theory is fundamentally flawed. His consistent long-term success is evidence that the efficient market hypothesis is wrong. He thinks diversification is counterproductive for anyone skilled at investment selection. He says that financial models oversimplify things, underestimating the frequency of black swans and assuming that what hasn’t happen can’t happen. Markets are more dependent on behavioral science than physical science, but the models don’t adequately factor in human behavior. Investing is part art and part science. and the models don’t capture the artistic side of the process. Buffett therefore believes that you are better off ignoring most of the modern financial theory.
  • Stock Picking isn’t hobby – Everybody can be an investor but not everyone should choose their own investment. To be a successful investor requires thousands of hours of deliberate effort to master the necessary skills and then thousands more to use those skills to find worthwhile investments. If you aren’t willing to put in the time and effort that stock picking requires, the person on the other side of your trades is likely to know more than you, which leads to under performance.
  • Invest in what you understand – Buffett puts more focus on the importance of having a circle of competence, a clearly defined industry, business model, asset class, investment style etc. and investing only within that circle. You should continue to learn and thereby expand your circle of competence, but until you do, you shouldn’t invest where you aren’t skilled. He wants understandable businesses because he intends to hold long-term and wants to be able to predict roughly what the business will look like in five or ten years.
  • Know what a good company looks like – Buffet wants a business that is easy to understand, with a consistent operating history, good long-term prospects, possibly due to some durable competitive advantages, trustworthy, high-quality management team, solid financials ( high margins, high return on equity and high free cash flow).
  • Stock Ownership is a business ownership – When you buy stock, don’t think of it as a line on a chart you hope will move up. Think of it as partial ownership in the underlying business. If the business does well over time, the stock price eventually follows.
  • Be Cheap – The key to Buffett’s strategy is to find good companies at good prices. Price is what you pay, value is what you get. When value exceeds price, we have a margin of safety. A large margin of safety enables you to be successful even if your valuation is slightly off or things don’t go as expected.
  • Be loss-averse – Don’t strive to make every last dollar of potential profit; doing so exposes you to too much risk, instead make preservation of capital your top goal. By staying focused on loss avoidance, you will naturally gravitate towards investments with more upside potential than downward potential which will help your returns.
  • Be Patient – To resist the temptation to trade in and out positions, Buffett suggests pretending you can only make twenty trades your whole life. Under this restriction, you would be much more likely to do detailed research, and only move forward on a trade if you were very confident in it. This would force you to be patient both when buying and while holding. The right mentality is to get rich slow.
  • Volatility is your friend – Being risk-averse doesn’t mean avoiding volatility. Volatility is the best friend of the unemotional, patient, debt-free investor. A wildly fluctuating market means that solid businesses will occasionally be available for you to buy at irrationally low prices.
  • Learn from Masters  – Find some experts who have proven record of outstanding risk-adjusted performance in good times & bad, and who openly and honestly share their lessons, and then listen to them.
  • Avoid Taxes – Know the tax laws and use them to your advantage. Know how an investment will be taxed before you buy it. Avoid highly taxed short-term capital gains or use short-term losses tactically to offset them. If possible, structure your assets or your business or your career to emphasize capital gains rather than income, which generally has higher tax rates.  Avoid but not evade taxes. Pay all the taxes you are legally required to, but not more than that. Join our Newsletter List.

KEY INVESTMENT PRINCIPLES REVEALED BY WARREN BUFFETT

Warren Buffett has created his wealth by making investments in various companies including stock markets. At writing of this article, Warren Buffett is the CEO of Berkshire Hathaway. The principles discussed here are revealed by Warren in what he calls Berkshire Owner’s Manual. 

Let’s look at each principle in-depth as follows:

  • Investors should rejoice when the Stock Markets Fall. This should be Great News to them – As per Warren’s advice, investors should be happy to see a sinking stock market. There can’t be a better time to stock up their portfolio with excellent stocks at very cheap prices than the times when stock markets are sinking. At this time, investors should buy as much as they can in falling markets.
  • Invest in Companies with High Promoter’s Holding –Warren says that this is beneficial to the investors as the stakes of owners and investors remain aligned to each other.
  • View Shares as Part-Ownership in the underlying Business – Warren advises stock market investors to see themselves as the owners in the company’s business rather holding a piece of paper in hand which can be sold whenever its price changes. This ownership attitude separates an investor from a speculator and forms the basis of  fundamental stock investing.   Warren Buffett Investment Principles
  • Avoid Companies which frequently resolve to stock Issuance/Equity Dilution to raise funds citing that the stock issue is undervalued – Warren’s principle cautions investor against companies that keep on issuing new stock/equity to raise funds to apply in operations.  By such activities, companies are able to show larger asset base and higher sales but they hurt the interests of existing shareholders as their stake is diluted. Warren believes in comparing companies’ performance on per share basis rather aggregate values i.e. Investors should compare companies’ performance on per share sales or assets to assess whether the company is creating or destroying value for the shareholders.
  • Investors should Invest in Debt-free or Low Debt Companies – Warren’s principles indicate that an investor should invest in companies which are conservatively financed and do not carry large debts on their balance sheets. The investor should understand that debt-free companies never go bankrupt.
  • Investors should Never Take Loans to invest in Stock Markets – Warren believes that the risk of taking loans to make some extra money is not worth the effort & stress.
  • Investor should Monitor Business Progress of Companies and not their Stock Price Movements – Warren advises investors to focus on the business performance of companies in their portfolio and ignore their daily stock price movements. In fact, he believes that short-term price movements should be meaningless for investors. Investors should use such movements only to buy shares if prices become attractive.
  • Investor should Check whether management is Creating or Destroying  Shareholders value – Warren believes that if a company is not able to generate wealth for its shareholders from the amount of profits it retains with itself, then it should release the money to shareholders by way of dividends or share buybacks. It would allow shareholders to deploy their funds on their own.
  • Investors should avoid companies which frequently acquire other companies in the name of Diversification – Warren’s Investing Principles warn investors that such activities many times represent managerial hubris where companies’ management tries to achieve their self-aggrandizing motives at the cost of shareholders.

  • When to Sell Stock – Warren believes that if a company is doing well, then its stock should never be sold. Investors should stay invested in companies whose business is performing well, irrespective of their share price. Join our Newsletter List

Bottom Line

Warren Buffet believes in fundamental stock investing. He prefers to invest in conservatively  financed companies which have good long-term prospects and run by honest & competent management. Whenever he finds such a company he likes to hold it until its business prospects are maintained.

CHOOSING BETWEEN MUTUAL FUNDS AND STOCKS

Every investor is usually faced with two main options: Mutual Funds or Individual Stocks. Mutual funds are actively managed group of stocks, usually designed to beat the market with the assistance of a fund manager. Individual stocks can be bought by any investor through a brokerage, and it becomes the responsibility of the individual investor to maintain his/her portfolio. Mutual Funds are widely regarded as a passive form of investing while investing in individual stocks is more of active form. Though both carry inherent advantages they do also have  risks associated with them, it is therefore paramount for investors to understand the differences between them. Mutual Funds vs. Individual stocks

Mutual Funds

Mutual funds appeal to most beginner investors since they are automatically diversified, presenting the investors with a large variety of flavors from sector based funds such as Tech, Financial, Retail, Energy , Commodities to Foreign indexes. Mutual Funds generally hold a large number of stocks with each equity only comprising a small percentage of the portfolio. This is both its strength and weakness.

Let look at an example, a Tech Mutual Fund may claim Microsoft as one its top holdings, but a rally in Microsoft shares may barely move the mutual fund, on account of Microsoft only comprising 1.5% of the overall portfolio, and the remaining 98.5 % being composed of industry Laggards such as Cisco. However, a crash in Microsoft shares will also be cushioned by its low portfolio weight and buffered by other less volatile stocks.  Even though the growth of mutual funds may be limited, the downside is limited as well.

Key points to note when dealing with mutual Funds:

  • Investors don’t define the exact number of shares to purchase, but rather they will order a set dollar amount from a brokerage, and the brokerage will calculate the shares to be bought based on the day’s closing price.
  • The share price of a mutual fund doesn’t fluctuate during the day, it is only reported after the market close based on the closing prices of its underlying securities.
  • Investors who may be interested in actively trading mutual funds should invest in Exchange Traded Funds (ETFs).
  • Each mutual fund has its own set of fees and expenses, these can include: The fund manager’s fee, front-end load upon initial purchase, a back-end load upon sale, as well as early redemption charges.
  • Index funds, which are passively managed Mutual funds are a lower-cost alternative option if the investor wants to avoid the fees associated with actively managed Mutual funds. Index funds simply mirror a set market index e.g. the S&P 500.
  • Mutual funds investors should allow a longer time frame to observe the slow and steady growth. They should invest regularly hence taking advantage of dollar cost averaging i.e. purchasing more shares when the price is low and fewer shares when the price is higher. You can also use automatic dividend reinvestment plan to reinvest your dividends into the fund hence sidestepping the capital gains tax on cash dividends and brokerage commission charged for purchasing additional shares.

Individual Stocks

Individual stocks usually bring in more returns as compared to mutual funds.

Key Points when dealing with Individual Stocks:

  • Purchasing can be done directly through any brokerage, with the only fees being the commission paid upon the purchase of shares and the capital gains tax paid upon the sale.
  • Investors define exactly the amount of shares to purchase, and the desired price.
  • Dividends from the stocks can be reinvested into the company.
  • Investing in a single company can be a high risk, high reward affair. To offset this risk, most investors will choose a small basket of stocks to counterbalance each other to diversify and minimize risk.

Generally, investing in individual stocks requires more work on part of the investor in terms of studying the market terminology, assessing the current state of their portfolios, paying attention to quarterly earnings, commodity prices, interest rates etc.

Bottom Line

Individual stocks are more involving emotional affair as compared to Mutual funds but either way each has its own merits and demerits. If you aren’t sure which investment to choose, it is advisable to involve the services of a Financial advisor or Investment advisor. Join our Newsletter List.

UNDERSTANDING FUNDAMENTAL ANALYSIS VERSUS TECHNICAL ANALYSIS

Fundamental analysis and Technical analysis are two common methodologies used when analyzing any given investment. This article explains Fundamental Analysis vs. Technical Analysis investment methodologies to help you better understand how and when each is used.

Fundamental Analysis

Fundamental analysis is the approach whereby one tries to calculate the intrinsic value of a given stock by looking at the basic economic factors, the fundamentals which would impact its value. Some of the factors that will be looked at include:

  • Growth prospects for the company.
  • The competitive factors the company faces.
  • Revenues, expenses and income.
  • Expected return on equity or assets in the industry.

The main goal of this analysis is to establish a value for the stock that would factor in all of these underlying factors. This is considered as a long-term investment approach as it doesn’t look at the short-term pricing and trading swings. This methodology is considered to build a valuation based on backward and forward-looking information.

Technical Analysis

This is an investment methodology that evaluates investments purely on the market activity surrounding them, and doesn’t  look into the actual operations or value of the company itself. Some of the factors that are looked at include:

  • Trading volumes over time.
  • Historical Pricing of the shares.
  • Industry trading trends.

This methodology tends to capitalize on pricing opportunities and trends that can be identified in the market activity around each share. Since this methodology is purely based on historical market activity, it is considered a backward looking methodology.  Join our Newsletter List

Fundamental Analysis vs. Technical Analysis

Key Factors to be considered when choosing a methodology between the two:

  • Time horizon – Fundamental analysis is a long-term investment strategy whereas technical analysis is considered far more of a short-term methodology. By pricing on intrinsic values fundamental analysis is working towards the long-term value of a company whereas by trading on market trends technical analysis is considered to be short-term focused. 

  • Investment Approach – Are you an investor or a trader? Fundamental analysis is investing in companies and relying on their underlying value to drive your return while Technical Analysis is like a trading strategy where you are aiming to drive returns out of identified trends and opportunities.

Bottom Line

Though major funds invest millions of dollars in sophisticated technical analysis trading software, the average investor will likely be far better served if he/she just focuses on fundamental analysis investment strategy.

HOW TO INVEST IN FOREIGN STOCKS

Investing in foreign stocks means holding shares of companies that are not only based in different geographical locations but also driven by the respective economy-specific factors. Investing in foreign stocks helps to spread the investment risk among the international markets that are different from the home economies.  

People who choose to invest in international markets look to gain from the diversification and growth in other economies. This is an important factor since no particular market has consistently remained on the top, and there are a wide range of high-performance markets all over the world.

But note that, just like most other things, International investing has its flip side. When measured in terms of Volatility, foreign stocks are considered to be more risky.  Besides, the risk of dramatic changes in their market value, international stocks also have other risks associated with them e.g. Currency Risk which stems from potential unfavorable movements against the home currency. But at times currency movement can also work in favor of the investor and help in enhancing his/her returns. Political Risk that arises from an unstable government or military action in the country of investment. We also have a Inadequate Regulation Risk in the global markets as compared to developed markets like those in the United States. This increases the risk of manipulation or fraud. Another Risk is Insufficient Information available about various international markets, which can limit the investor’s precision of market movements. You can have difficulties interpreting the international market’s information  as an outsider investor in addition you need to take note of the fees involved like the commissions and Taxes.

The are various Routes that one can trade foreign stocks as discussed below:

  1. Direct Investing – There are two ways by which investors can invest directly in foreign stocks. The first way is by opening a global account with a broker in their home country, providing the ability to buy foreign stocks like E*TRADECharles SchwabFidelity etc. in the United States. The second way is to open an account with a local broker in the target country that offers services to international investors like OCBC Securities in Singapore , Boom’s Trading Platform in the Hong Kong. These two trading Platforms gives access not only to local market but other stock markets. Investors should make sure that these brokers are registered with the market regulator in the home country. In order for investors to pick the right trading platform based on their investing style and interest, they need consider other factors like fees, costs, and facilities provided by the brokerage firm. It is not advisable for small investors to go direct as the system is complicated involving so many things like currency conversions, costs, taxation issues, technical support, research etc. Only serious and established investors should indulge in this process.
  2. American Depository Receipt (ADR) – ADRs work well for investors as well as for non-US companies. ADRs offer investors a convenient way to hold foreign stocks and also provide an opportunity to non-US companies to establish an US presence and even raise capital in the US stock Markets.  Example is one of Alibaba Group Holding Limited World’s largest IPO. The ADRs can be either sponsored or not and have 3 different levels depending upon foreign companies’ access to US markets, as well as disclosure and compliance requirements. Level 1 ADRs cannot be used to raise capital and are only traded over the counter while level 2 and level 3 ADRs are both listed on an established stock exchange e.g. NYSENASDAQ only Level 3 ADRs can be used to raise capital.
  3. Global Depository Receipts (GDRs) – With GDRs a depository bank issues shares of foreign companies in international markets typically in Europe and are available to investors within the US giving them an opportunity to invest in foreign stocks. Though they GDRs are dominated in US dollars and at times in Euros or Sterling Pound, they are typically traded, cleared, and settled in the same way as domestic stocks. London and Luxembourg stock exchanges are the most common destination for listing of GDRs other exchanges include those in Singapore, Frankfurt and Dubai.
  4. Mutual Funds – These funds are like regular mutual funds in terms of the benefits they offer and how they work. except they hold a portfolio of foreign stocks rather than domestic stocks. These funds come in a variety of flavors with something for everyone from aggressive to conservative investors. The main types of funds that invest in foreign funds are Global Funds, International Funds, Region or country specific funds and international Index Funds. But note that just like many other international investments, these funds tend to be costlier than domestic counterparts.
  5. Exchange-Traded Funds (ETFs) – Picking the right ETFs is easier for investors than constructing a portfolio of stocks by themselves. While a single ETF can offer a way to invest globally, there are ETFs that offer more concentrated picks e.g. on a particular country. There are a wide range of international ETFs within different categories like Geographical Region, Market capitalization, Investment style, sectors etc. Some of the ETFs come from Providers like Schwab, Flexshares, iShares, SPDR, Vanguard etc. Investors should research the costs involved, liquidity, fees, trading volume, taxation and portfolio before buying any international ETFs. Find Investing Books
  6. Multinational Corporations – If you are not comfortable investing in international stock using the above methods, then  you can look for domestic companies that have a majority of their sales and revenue overseas. For an US investor Coca-cola company(KO) or the McDonald’s Corporation (MCD) provide a good example.

Bottom Line

There are many routes to choose from if you want to invest in foreign stocks but it is paramount that the investor first learn about the product they are investing in before they make an informed decision which one he/she can pick besides having knowledge about the political and economic conditions in the country of investment which is essential to understanding the factors that could affect the investment returns. Investors should put focus on their investment objectives, costs and prospective returns, balancing it with their risk tolerance when they are making a choice on international foreign stocks. Join our Newsletter List.

 

KEY PRINCIPLES TO INVESTING IN A STOCK

In this article we look at the four keys that we believe every stock investment should have. These are not new things but rather the core principles that successful investors have been following for decades.

  1. Invest in sectors and industries that you understand – Becoming an expert in certain areas of the market will give you an upper hand when it comes to selecting stocks to buy. This is like a foundation for all other steps that follows. Pick a given sector or industry and try to get information on it as much as possible. This will enable you to make informed decision when it comes to buying stock.

  2. Find companies with a Long-Term Competitive Advantages – Companies with long-term competitive advantage have an ”economic moat” i.e. Economic protection.  These companies have the following advantages:
  • A recognized brand.
  • The ability to produce products cheaper than anyone else.
  • The ability to sell their products cheaper than anyone else.
  • Barriers to entry that make it difficult for competitors or new companies to compete.
  • The opportunity to grow at a cheaper cost than anyone else.
  • A duopoly situation where two companies dominate the industry like Airbus or Boeing.
  • Networking effect where the users of the product or service makes the business more valuable like Google.

3. Look for companies with Excellent Management – This can be done by reading annual and quarterly reports and studying the history of the company’s current management in an attempt to understand what the management is currently doing and what they may do in the future. You can look at the following:

  • The management’s history of decision-making. Do they have a track record of someone who we would actually hire if given a choice?
  • Understanding how management is compensated. Is their compensation based upon the success of the firm?
  • Ensuring that management is shareholder friendly. Do they do things that have the best interest of shareholders in mind?

These questions will help you to answer the question as to whether or not we trust the management enough to purchase the stock.

4. Buy When the stock is at a Good Price. Discounted to Intrinsic Value —Find stocks that are currently trading below the market price. If you can be able to find stocks that are trading below their intrinsic value and have the other three core principles then we would have the formula for a sound stock investment.  If you find a stock with the first 3 principles but is not trading below the market price, then it is better you wait. Any investor should know that the price at which he/she pays at, is a critical piece of investing. If you get it wrong then the investment will have a hard time making money.

Bottom Line

When all the four principles align then the possibilities of making money increase, though this does not guarantee that you will make money but rather increases the probability of making money.  Join our Newsletter List.

RISKS THAT EVERY STOCK FACES

We have sector & company specific risks in investing. Here we look at some universal risks that every stock faces irrespective of its business.

  • Rating Risk – This occurs whenever a business is given a number to either achieve or maintain.  Every business has a very important number as far as its credit rating is concerned. The credit rating directly affects the price a business will pay for financing. For public traded companies they have analysts rating which is even more significant value than the credit rating. Any changes to the analysts rating on a stock seem to have much bigger psychological impact on the market. The shifts in ratings, whether negative or positive often cause swings far larger than justified by the events that led the analysts to adjust the ratings.   
  • Commodity Price Risk – This is simply the risk of a swing in commodity prices affecting the business. Companies that sell commodities benefit when prices go up, but suffer when they drop. Companies that use commodities as inputs will get affected when we have swings in prices, in addition this may  affect the whole economy especially when commodity prices go up as people restrain from spending.
  • Headline Risk – This is the risk associated with stories in the media that will hurt a company’s business. One bit of bad news can lead to a market backlash against a specific company or an entire sector.
  • Obsolescence Risk – This is a risk that a company’s business may become obsolete. The biggest obsolescence risk is that another person may find a way to make a similar product at a cheaper price.
  • Detection Risk – This is the risk associated with the auditor, Regulator or any other authority that checks your business compliance to the set requirements or standards. If the companies earnings or any other financial malpractices are happening, the market reckoning will come when the news surfaces. With the detection risk, the damage to the company’s reputation may be difficulty to repair and in some cases, the company may never recover.
  • Legislative Risk – This risk refers to the tentative relationship between government and business. Specifically it is the risk that government actions will constrain a corporation or industry, thereby adversely affecting an investor’s holdings in that company or industry. This risk can be realized in several ways: new regulations or standards, specific taxes etc.
  • Model Risk – This is the risk that the assumptions underlying economic and business models within the economy are wrong.  The mortgage crisis or 2008-2009 is a perfect example of what happens when models don’t give a true representation, in this case risk exposure model doesn’t give a true representation of what they are supposed to be measuring.
  • Inflation Risk and Interest Rate Risk – Interest rate risk, refers to the problems that a rising interest rate causes to businesses that need financing. As their costs go up due to interest rates, it is harder for them to stay in business. If this rise in rates is occurring in a time of inflation, and usually rising rates are used to fight inflation then a company could potentially see its financing costs climb as the value of the dollars its bringing in decreases. A rise in interest rates and inflation combined with  a weak consumer can lead to a weaker economy.



Bottom Line

Every investor should know that there isn’t  a risk-free stock or business. The rewards of investing can still outweigh the risks that every stock faces be it universal risks or risks specific to the business. The best thing to do as an investor is to know the risks before you buy in. Join our Newsletter List.

 

PARAMETERS TO CHECK WHEN SELECTING STOCKS TO BUY

For you to best invest your money in stocks, there are parameters that you must check when analyzing the stocks.

Here we take a look at factors that you should check, when doing financial analysis, valuation analysis, business & industry analysis & management analysis.

FINANCIAL ANALYSIS

  • Sales growth – Growth should be consistent year on year. A growth of >15% for say last 7-10 years. Ignore companies where sudden spurt in sales in one year is compounding the 10 years performance. Very high growth rates of >50% are unsuitable.
  • Profitability – Look for companies with sustained operating & net profit margins over the years. A Net profit margin >8%
  • Tax Payout – Tax rate should be near general corporate tax rate unless some specific tax incentives are applicable to the company.  Tax payout of >30%
  • Debt to Equity Ratio – Look for companies with D/E ratio of as low as possible. Preferably zero debt.  D/E ratio should be <0.5
  • Interest Coverage should be >3
  • Current ratio >1.25
  • Cash Flow – Positive CFO is necessary, CFO >0
  • Cumulative PAT vs. CFO – Cumulative PAT & CFO should be similar for last 10 years i.e. cPAT∼cCFO

VALUATION ANALYSIS

  • Ensure P/E ratio <10, companies with such a P/E ratio provide a good margin of safety.
  • P/E to Growth ratio <1
  • Earnings Yield (EY) >10 year G-sec yield – EY should be greater than long-term government bond yields or bank fixed deposit interest rates.
  • P/B ratio <1 especially for financial services sector
  • Price to sales ratio (P/S ratio) <1.5 – For example you can buy when the P/S ratio is <1.5 and sell if >3
  • Dividend Yield (DY) >0% The higher the better. DY of > 5% is very attractive. But do not put much focus on DY for companies that are in a fast growth phase.

BUSINESS & INDUSTRY ANALYSIS

  • Comparison with industry peers – The company should show sales growth higher than peers. If its sales growth is similar to peers, then there is no competitive advantage.
  • Increase in production capacity and sales volume – Company mush have shown increased market penetration by selling higher volumes of its product/service.
  • Conversion of sales growth into profits – A more competitive firm would show increased profits with increasing sales. Otherwise, sales growth would  only be a result of unnecessary expansion or aggressive marketing push, which can erode value in the long-term.
  • Conversions of profits into cash – if cPAT>>cCFO then either the profits could be fictitious or the company isn’t collecting money from its sales.
  • Creation of value of shareholders from the profits retained – The company should show increase in Market Capitalization in the last 10 years. Increase in retained profits in the last 10 years. Otherwise the company is destroying the wealth of its shareholders.

MANAGEMENT ANALYSIS

Subjective parameters

  • Background check of promoters & directors – You can do a web search on this. There shouldn’t be any information questioning the integrity of promoters & directors.
  • Management succession plans – Good succession plan should be in place. Salaries being paid to potential successors should be in line with their experience.

Objective parameters

  • Salary of promoters vs. net profits – No salary increase with declining profits/losses. The promoters should not have a history of seeking increase in remuneration when the profits of the company declined in the past.
  • Consistent increase in dividend payments – Dividends should be increasing with increasing profits of the company.
  • Project execution skills – The company should have shown good project execution skills with cost and time overruns. Exclude capacity increase by mergers & acquisitions.
  • Promoter shareholding should be >51% the higher the better.
  • Promoter buying the shares – if the promoter of the company buys its shares, investors should buy too.
  • FII shareholding ∼0% the lower the better.

OTHER PARAMETERS

  • Product diversification – Company should be either a pure play ( only one business segment) or related products. Pure play model ensures that the management is specialized in what they are doing.  Refrain from buying into companies offering entirely different unrelated products/services. An investor should rather buy stocks of different companies, if he/she wants diversification.

  • Government Influence – There should be no government interference in profit-making. No cap on profit returns or pricing of product. No compulsion to supply to certain clients.  Join our Newsletter List

Bottom line

If you diligently follow these parameters by investing in stocks that promise good fundamentals, and doesn’t spend so much on them then you can be assured of good returns from your investments over time. However, the above parameters aren’t the complete list of what should look for when picking stocks. You should read further about investment analysis and you can add or even remove some of the above parameters per your understanding.

BEST WAYS IN WHICH YOU CAN INVEST YOUR MONEY

Here are tips on how to best invest your money.

  • Focus on the fundamentals – Always make sure you understand the fundamentals of any investment vehicle you are looking at, be it stocks, bonds, or mutual funds. Understanding the fundamentals and comparing them to competitors can go a long way in helping you make a sound investment decision.  
  • Understand the risk – Out there, you will find a lot of tips and tricks on how to best invest your money but they all come with their own relative degree of risk. The opportunity for high returns comes with a higher relative degree of risk, so your tolerance for actually losing money is something you need to consider. You need to understand where your risk threshold stands to be a good investor.
  • Investment and Management fees – Make sure you keep a close eye on the terms and conditions of your brokerage account and the management fees of any funds you invest in otherwise you may discover when it is too late that your gains are being eroded by the costs of investing. Make sure the brokerage account you are using has the lowest cost structure available for your needs. Also take a good look at the management expense rate charged by investment funds or mutual funds you put money into. Try to make a comparison with their competitors to avoid those funds with extra unnecessary costs.
  • Look for Tax Treatments  – Tax treatment of your investment is an important aspect to look at since it doesn’t make sense if you are going to pay more in taxes on your investment than the expected return.

  • Diversify Your Portfolio –Don’t put all your eggs in one basket when investing. Having all of your investments in  a single market or a single industry exposes you to downturns in those sectors that can cost you significantly. Diversifying your investments into different sectors like Manufacturing, Oil and Gas, Technology while at the same time investing in different geographical regions i.e. Europe, America, Asia can protect you from poor performance in any individual sector and ensure that you benefit from the sector upturns in a maximum way. Join our Newsletter List.