In the financial market, prices and movement of prices are signals to investors. A sharp rise in share price indicates an increase in desirability while the converse shows otherwise. However, do all movement in prices necessary reflect the fundamental value of the company?
As value investors, we believe that this is not always the case.
Stock prices in the short run are primarily motivated by the vicissitudes of sentiments in the market. Sometimes investors feel depressed and prices plunge while other times they get optimistic and prices head for the sky.
However, ultimately, prices will revert to the intrinsic value in the long term. No one in the right mind will hold an expensive stock yielding 0.3% return just for its ‘growth’ in the long term (that’s Amazon by the way).
Hence, we strongly suggest for you to ignore stock prices and focus on at least these three fundamentals to assess the company. There will be a lesser likelihood that you will be influenced by the market.
This is to prevent confirmation bias like this, ‘Ah, so that is why the market loves this company! I better get in while I can.’.
Once you know that the market has fallen for the company, your mind will naturally look for and overemphasis on possible news surrounding the company.
The business model & the industry
One of the most important thing in evaluating stocks is to first understand the story behind the numbers. Many analysts fall into the trap of analyzing the numbers without going in depth into understanding the company first. They believe that they already possess the knowledge required to decipher the figures, they are wrong.
Some industries are naturally more desirable than others. Some operate in the cycle while others are defensive. Know the characteristics of the industry and gain the macro perspective of things. By looking at the big picture, you know which the areas are more prone to market inefficiencies.
For instance, if you know very well about the capital cycle in the property industry, you will be able to find more opportunities during the bad times. While others are in fear, scrambling about, you are busy picking up the unloved gems they threw behind.
Apart from understanding of the general macro trends of the industry, you have to go deeper by learning about the inner workings of the industry.
What is the average maintenance capital expenditure of the companies and why? Do they require high levels of innovation to stay competitive or is the moat constructed by intangible assets like branding? How is the supply chain like, are there plenty of options of suppliers or are they at their mercy?
Possessing industry knowledge will allow you to pinpoint the vulnerabilities of the companies and their value propositions.
You can invest in the next Apple but without a capable management with a clear vision, your Apple may end up becoming Nokia instead. Understanding the industry and the company will only reveal information about the environment the company is in. An understanding of the management will reveal the driving force behind the company’s value.
Exceptional leadership will multiply your investments while unscrupulous ones will wipe out whatever you have. There is a lack of emphasis on accessing the quality of management due to its elusive nature. It is extremely difficult to evaluate how well or poor the management is.
Many believe that it is also pointless to be analyzing the annual report as all management will litter the letters with flowery languages and assuring words. However, this may not necessarily true for all cases.
In another article, we will be exploring in depth into how a retail investor like you can access the quality of the management.
In the meantime, we suggest reading this book called Investing between the lines by L. J. Rittenhouse.
Now, after equipping yourself with all the relevant background information, you are reading to get your hands dirty and interpret the figures! Only by having a good understanding of the context will you now be able to identify the important things that matter amidst the multitudes of noises.
To point out a few to take note of, you may want to understand the capital structure by analyzing the historical trend of earnings, cash flow and margins. Know how long the capital cycle of the industry or the company usually is. Why is this company’s recovery stronger or weaker than its peers and does the share price reflect that?
Is the industry highly leverage due to its high capital expenditure requirement? Perhaps even during the bad times, the company has to constantly take on more debt to stay afloat. This hugely affects your margin of safety as the company is taking on a much larger financial risk. You have to now consider the economic outlook and likelihood of credit availability. The more factors to consider, the more uncertain your analysis will be.
The above three aspects are important and crucial. You shouldn’t be making decisions based on 1 or 2 of the points and ignore the third. Regardless of how much you believe in the story behind a certain company (let’s say Tesla), but the numbers are disagreeable, you should really think twice about taking a plunge.
Otherwise, you can always reduce exposure when taking such educated ‘bets’.
Interested in receiving first hand and in-depth stock ideas? Check out our latest ValueScreener below, where we share monthly stock screeners and ideas!