Do you invest in the Stock Market?
If not… You should…
Because… your wealth has a significant role in determining the quality of your life… and the Stock Market is the greatest wealth creator of our times.
Here, I share briefly what I know on… how to go about investing in the stock market… and, possibly, succeeding at it. If you are new to the stock market… you may find it helpful… if you are not… it might be a refresher for you.
What is a Stock? Why does it go up (or down)?
A stock is a part-ownership in a company. By owning a stock, you stand to gain from the company’s growth – in proportion to your ownership. A stock’s price goes up or down based on how the company’s business prospect evolves. A stock’s price rises when its earnings rise or are expected to rise. Likewise, a stock’s price declines if its earnings decline or are expected to decline in the future.
However, all earnings are not equally valued by the market. The earnings growth must not be a one-time occurrence – it must repeat over the years. This means the earnings growth must be sustainable, and only earnings derived from the firm’s principal operating activities are sustainable.
The capital intensity of the firm’s business – the capital required to generate the firm’s earnings – also matters in determining its stock’s value. The stock of a firm that generates earnings with a smaller capital is highly valued than that of a firm that generates the same earnings but with a larger capital. This can be measured by the ratio: return on capital (RoC).
Why a Strong Competitive Position is Essential?
The single most important attribute of a quality stock is a sustainable competitive advantage which enables its possessor to deliver better value to its customers than its competitors at the same or a similar price.
And for the competitive advantage to be sustainable, it shouldn’t be easily replicable by its competitors. Additionally, a sustainable competitive advantage enables a company to generate superior profitability.
Companies that possess competitive advantage did not gain them by lineal privilege, but through strategic initiatives persistently executed for a long period. It requires an understanding of the marketplace, customers, and competitors.
The path (to competitive advantage) will differ among various industries as different industries have different economics: companies need to understand their industry dynamics thoroughly to formulate an effective competitive strategy. In some industries, particularly with commoditised products, the ability to manufacture at the lowest cost will provide a competitive advantage. However, in most service industries, the customer experience matters more than the price, and thus firms that focus on providing the best customer experience at a reasonable price will achieve a competitive advantage.
The analysis of a company’s gross profit margins, operating profit margins, and cost structure, to a certain extent, can help you to understand its competitive position.
Why Do We Need Financial Statements?
The Financial Statement systematically represents a firm’s business operation, financial position, revenue, cost, earnings, and cash flow. A firm’s financial statement helps you to gauge the firm’s true situation. The study of a company’s financial statement is the most optimal way to understand the company, and its business – and determine the prospect of investing in its stock.
A quality stock should possess a robust balance sheet. A firm with large debt financing is risky. The optimal situation is a firm whose business is financed largely by shareholders’ capital and a low-to-moderate usage of debt during periods of capital investments.
The firm should engage its capital most productively, thus, enabling it to generate a high return on capital, which is usually achieved by investing in its principal business operation. All this important information can be obtained through a detailed analysis of its balance sheet.
As companies follow the accrual accounting method to record their revenue, cost, and profit – it is not essential that the revenue, cost, and profit reported on the income statement are received or incurred in cash. Revenue and costs accrued through credit don’t generate cash for the firm. The ability to generate cash is an essential aspect of a quality stock: a firm should bring in more cash than what goes out of the firm. The analysis of cash flow statements can help you assess the cash generation capacity of a firm.
Management quality is another important requisite of a quality stock. The people who run the business matter – for the firm’s long-term viability – and its long-term growth and profitability. A straightforward way to assess management quality is to measure the firm’s efficiency in allocating capital. A firm’s capital allocation is entrusted to its management. The management should allocate capital in a way that creates value for the firm and its shareholders. The value-destructive capital allocation policies of management are the principal reason behind many of the business failures of our time. The study of a firm’s cash flow can enlighten you on its capital allocation efficiency, and thus, to a large extent, its management quality.
How to Value a Stock?
As we have already discussed, to succeed at investing, you need to have a good understanding of the firm’s business. You must understand the firm’s competitive position. And, most importantly, you must be able to understand a firm’s financial statement. These factors can help you gain an instructive perception of a stock’s investment prospect.
However, to make quality investment decisions, this is not enough: you also need to exploit your understanding of the firm’s business to formulate a value for the firm’s stock – this value is known by multiple names – true value, fair value, intrinsic value – and the process to derive the value is called valuation.
The most common valuation method is the relative valuation method: where the price of a stock is compared to its fundamentals – sales, profit, net worth, dividend, etc. The most popular among them is the price-earnings ratio which compares a firm’s price to its earnings (profit).
A stock is considered overvalued or undervalued by comparing its valuation ratios to that of similar firms or the general market. We strive to buy undervalued stocks – as they are considered to have high prospective returns; whereas we yearn to sell overvalued stocks – as they are considered to have low prospective returns.
Another valuation method is the ‘Discounted Cash Flow’ (DCF) valuation – perhaps, the most widely adopted valuation method by today’s investment professionals. It states that the present value of a firm’s stock is the sum of all cash flows the firm is expected to generate over its useful lifetime, discounted for – the time value of money and the uncertainty of not receiving those cash flows.
Valuation is an intricate subject –perhaps the trickiest step in the investment process. Most of my investment decisions that were made purely on a valuation basis have only backfired. Aswath Damodaran, the eminent valuation expert, advises us to be “as parsimonious as possible with valuation” during the investment decision-making process. Anecdotally, I find the advice truthful. I believe it would be prudent to ‘think again’ if you are going to make an investment decision based solely on the stock’s valuation.
AMN CAPITAL 
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