Stock Picking
Initial work done by all stock pickers is fundamental analysis. The goal of fundamental analysis is to find a stock’s intrinsic value, i.e. what the stockpicker believes the company is actually worth. If the stock picker believes the company to be worth more than the current share price, fundamental analysis would recommend that you buy the stock.
The perfect fundamental analyst may not be the perfect stock picker because of the irrationality of the market. Stock volatility is propagated by the drive of investors to make a profit from their investments. This extra layer of profiteering does not correlate with the underlying fundamentals of the company. Analysts will often also look at trends and tendencies in the marketplace. This is known as technical analysis.
If a fund meets the fundamental and technical criteria for selection, the next stage of the analytical process is qualitative analysis. Qualitative analysis looks at the more subjective qualities of a company. These include
- Who is at the head of the company, what their the background is, how long they’ve been in charge and how they got to be senior managers all come under the subsection of Management.
- Secondly, qualitative analysis requires an understanding what the company does and, therefore, how it makes money. A company may have excellent fundamentals and management, but if it is within an industry that is already highly competitive or dominated by a particularly large company it may well struggle. It is important therefore to understand the market in which the company is competing.
- Consider also the barrier to entry. Existing companies in industries such as pharmaceuticals have a massive advantage over new companies because of the costs involved, regulations, patents, distribution channels etc. A restaurant company, however, can set up with a minimal capital outlay and a low skill base.
- Qualitative analysis tells us not to underestimate the power of a brand name.
- Remember that any company can potentially be a good investment. If you see a local company doing well it may well be worth doing a bit of research.
Research will likely throw up many companies that are suitable for investment (as well as very many that are not!). Which companies you choose to invest in is then dependant on the Stock Picking Strategy you employ. One of the first models for stock picking that was employed was the Value Investing model. The concept is quite simple, find companies trading below their inherent worth. The model always compares the share price of the company to its intrinsic value rather than the historic share price, i.e. value investing not junk investing. This is a long term investment model and does not pay heed to market trends or day-to-day fluctuations. Some ceterus parabus rules of value investing:
- Share price should be no more than two-thirds of intrinsic worth.
- Look at companies with P/E ratios at the lowest 10% of all equity securities.
- PEG should be less than one.
- Stock price should be no more than tangible book value.
- There should be no more debt than equity (i.e. D/E ratio < 1).
- Current assets should be two times current liabilities.
- Dividend yield should be at least two-thirds of the long-term AAA bond yield.
- Earnings growth should be at least 7% per annum compounded over the last 10 years.
Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.
As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology.
Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. The NAIC has developed some basic "universal" guidelines for finding possible growth companies.
- Strong historical growth performance
- Strong forward earnings growth
- Is Earnings per Share increasing correspondingly with increase in Annual Revenue
- Is the Return on Equity stable or increasing when compared to the five year average
- Can the stock price double in 5 years (i.e. 15% annual growth)
There are further Stock Picking Strategies that we will discuss in future articles. If you would like to know more about any aspect of financial planning, please email me or head to the Contact Us page alternative ways of getting in touch.
