Mar 5, 2021
What to Look For When Selecting a Stock
Equity research in a nutshell
To the average investor, selecting a stock was once a task that daunted them for hours if not days. Analyzing the quality of the company, its asset base, industry position, product viability, and any factor that would deem the product to become obsolete are some qualitative factors one can think of prior to investing their hard-earned money into any particular company.
But the truth is that the multitude of factors that are available at any one point in time is highly susceptible to change: the term used on Wall Street for such cases is volatility.
The range of factors that involve any particular stock is what gives rise to volatility. Factors could be associated with the market as a whole, in which case we focus more on systematic risk, or factors could be pertaining to the individual company or sector in which case it is labeled as “unsystematic” risk.
Either way, the process of selecting a stock usually incorporates all these considerations at any given point in time. The key metrics that one can use to analyze whether or not they should invest their money at any given point in time incorporate simple ratios and a line-by-line breakdown of the company’s position. Bearing in mind that the past doesn’t necessarily reflect future potential, analysts on Wall Street and Main Street use the following methodologies to gauge if a stock is worth investing in.
The Foundation
The first step is determining whether you prefer a top-down approach or a bottom-up approach. The top-down investing approach involves looking first at the macroeconomic picture of the country in which one is investing in and then trickling down on to the smaller factors in finer detail.
In contrast, the bottom-up investing approach involves the investor closely examining the fundamentals of a stock and working his way up to the top to gauge whether the stock is in an ideal position to benefit from the policies implemented within the overall economy.
Since we started off with the notion that we are trying to determine whether or not a particular stock is worth investing in, we have automatically opted for the bottom-up approach.
The Key Parameters
1. The reputation of the Management Team and Board of Directors
Before you dive deeper into the quantitative aspect, ensuring management quality and transparency is crucial to long-term investment success. If the people running the organization aren’t accountable to its shareholders then sooner or later this phenomenon will be reflected in the company financials and their stock price.
Phil Fisher, a long-term advocate of management quality, was famous for the depth of his research on companies in which he would invest.
He relied on personal connections (what he called the “business grapevine”) and conversations to learn more about a business before buying its stock. His first and most important book, Common Stocks and Uncommon Profits, published in 1958, devotes careful attention to this concept of networking and gathering information via business contacts. This step ensures complete transparency with regards to understanding company management and testifies the numbers found in the book of accounts.
2. The Financials and Business Model
Financial metrics and how the business makes money are the first two quantitative elements to look at. On rare occasions, I have discarded a few stocks just after this step. My logic to do so depends on the three criteria listed below.
- Absurd Valuation- If the P/E and P/B ratios are unbelievably high, it could signal that either the stock is overvalued or that the markets themselves are overvalued and all the corresponding stocks are riding on the same rally.
The only exception to this rule is technology stocks since it’s extremely difficult to forecast their earnings and correlate their growth with any ratio whatsoever.
A perfect example can be Amazon, which has had P/E ratios of above 40 for months now, but despite that, the company continues to soar in the stock market. Ratios are not a one-size-fits-all kind of parameter, so they should be used with thorough judgment.
- Economies of Scale- if the unit economics do not scale chances of a company continuing to be a profitable decline in the long run. The exception to this rule again is technology stocks. Stocks that redefined the gig-economy for example Uber, Airbnb are prime examples of this phenomenon.
- Unreliable Book of Accounts- When analyzing financial statements, each line item must make sense to you as an investor. If more than three or four line items do not add up or make perfect sense for their allocations, try reading the footnotes. If the management is trying to hide any piece of information the approach taken in the footnotes will clearly help you decipher such anomalies.
3. Competitive Advantage
“A condition or circumstance that puts a company in a favorable or superior business position.”
Warren Buffett believes in investing in stable, durable businesses that have a huge competitive advantage and business economics so strong that they’ll be able to weather out any storm. His portfolio consisting of Coca-Cola, Apple, and a select list of top US banks depict his ideology and is a live proof of the testament, “practice what you preach”.
Competitive advantage can take any shape or form. Here are a few ways one can try and understand what to look for, and what can springboard a company to the next step of the process:
- The network effect: Mainly a focus on identifying potential software apps that could become a billion-dollar unicorn, a network effect is when every incremental user makes the experience better for every other one. A strong network effect of creators and users draws in additional users at lower costs and dries up the competition faster as the years progress.
- Brand: One of the toughest ones to decipher as an investor and build as a company, but one that can lead to phenomenal returns. Brands give companies a unique “moat”.
Similar to moats that used to defend medieval castles, a strong brand protects a company by ingraining the product in the customer’s mind so strongly that they resort to seeking the product every time they have a need that has to be fulfilled. No substitute or complementary good can replace the product due to the emotional leverage the company has managed to acquire in the form of an “addicted consumer”.
- Tackling Industry Competitors- Whether the company is part of a growing target segment or whether it is doing business in a highly competitive and dying industry will be critical as you progress throughout the years. Holding the stock of a company that has declining profit margins due to increasing competition and declining market demand can sometimes be the “sell” signal one needs to completely exit a stock.
There are plenty of other ways companies can build “moats”, but the fundamental idea of having one is crucial in ensuring long-term success.
The ideal scenario is when a stock you own has little to no competition. This is rare, and usually only happens with smaller market opportunities, but can lead to fantastic results. Warren Buffett calls these businesses “consumer monopolies” as they can often getaway with price discrimination, cartels and collusions without even losing customers due to competition or regulatory affairs.
4. Analysing trends
The two key trends you should focus on are:
· An increase in the trend of earnings (preferably use the dataset for the last 10 years)
· An increase in the dividend payout ratio (or dividend per share)
· An increase in operating cash flow per share
· An increase in the consumer base
· An increase in the asset base
· A decrease in long term debt
Any company that is highly leveraged, will encounter solvency issues as the debts pile up. An increase in assets or a decrease in debt is a good sign showing the companies commitment to pay off its debts and commit the remaining profits to its shareholders.
In cases where the net profit can be manipulated by overstating expenses, it’s a lot harder to manipulate operating cash flow, hence the two metrics should be assessed simultaneously.
A growing demand, consumer base, and asset base shows the company’s commitment to ensure it keeps its focus on gathering more users and making sure that they have a sufficiently strong asset base to keep on increasing production.
5. Calculating the Intrinsic Value
A prima-facie conclusion for the above steps all lead to a calculation called “DCF”. Discounted Cash Flow (DCF) involves discounting the future stream of cash flows one expects from holding the stock and finally discounting it’s terminal value in addition to the other cash flows to arrive at a number that may or may not accurately depict the stock’s “fair value”.
In other words, calculating the intrinsic value involves computing the stock’s fair value as to gauge whether or not the price we pay today to acquire it is “too much or too little”.
Nobody knows for certain whether a company will beat the indices or whether the stock they select will beat the market. The DCF approach very simply tries to quantify a rather mysterious random walk component which is a “stock’s price”.
Using a few conservative predictions for revenue growth, operating/cash flow margins, buybacks/dividends, and any other future valuation metrics to estimate whether a company could beat the market is in my opinion “completely irrational” but it is the best approach to the worst possible kind of dilemma we have, which is trying to decipher fear and greed. It is no easy task quantifying human emotions, just like I mentioned in the beginning that the models we base our calculations on have numerous factors that need to be taken into consideration.
Every industry is different. Analysts use the Dividend Discount Model (DDM) to compute valuations for banks for example since the stream of cash flows generated by banks isn’t really quite predictable in regards to the stream of dividends it pays year-on-year. Similarly, for technology stocks in merger models, we look at accretion/dilution to gross margin per share. In addition to multiples like EV / Revenue, EV / EBITDA, and P / E, as well as the DCF analysis.
Each industry is valued differently when the intrinsic value is being considered, thus the average investor should ideally bear the basics in mind, in addition to applying the optimal ratios to gauge under/ overvaluation.
The Role of Technical Analysis
Technical analysts usually base their buy/sell recommendations on the charts and other mathematical indicators they see on their screens. The indicators are ideally nothing more than a depiction of market sentiment.
It shows the madness of crowds and their immediate responses in real-time or after hours depending on a chart’s settings and time frame.
Technical analysis relies heavily on probability. Even if an indicator is 80 percent accurate, there is a chance it won’t help you obtain the best possible trade the very next day. Trading and investing are two different things. One involves analyzing market sentiment on a daily basis. The other involves analyzing a business thoroughly.
Researching a stock for investment purposes is very different from trading purposes. The current trading volume, RSI, moving averages, candlesticks, Bollinger bands, volatility indices are all relevant for profiting from small pip movements. But none of these matter in fundamental analysis. All that matters for investing purposes is whether or not your stock is trading below its “intrinsic value”.
Concluding remarks
The stock markets are a Ponzi Scheme to some even till this day. They would rather gamble their money away in a Las Vegas casino rather than invest in a “blue-chip” company that will continue to grow and expand in value, entitling its shareholder to massive capital gains or dividend paycheques.
Most of the problems when it comes to investing are centered around human psychology.
The very same psychology gives rise to market inefficiencies which in turn makes this whole process of researching a stock a meaningful and (hopefully) profitable experience.
Disclaimer: This article is for information purposes only and should not be treated as financial advice. Please consult a financial advisor prior to making any investment decisions.
