HISTORICALLY, stocks have achieved higher returns than bonds or cash over the long term. Stocks are also seen as investments that will outpace inflation. But stock investing also carries greater volatility and risk. The basic principle of buying low and selling high may sound easy, but is tough to carry out in reality.
Drivers of stock prices
Stock prices can be affected by many macro and company-specific factors. Macro factors include changes in regulations, economic conditions, political climate, industry competition, and behaviours of overseas financial markets. Asset classes (eg stocks, bonds) change in their perceived values and they perform differently at various phases of the business cycle.
Company-specific matters such as business prospects, dividend policy, management track record, product innovations, changing consumer tastes, management-labour relations and other company developments all influence stock price movements. Sometimes, changes in research analysts' stock recommendations would also cause share price volatility.
The goal is to make informed forecasts and a valuation judgement on the attractiveness of a stock/company. A starting point to measure a company's worth would be its financial statements. Among the key information analysed would be a company's earnings power, debt ratio, management quality, business model and relative share price performance.
Different valuation methods can be applied to determine the fair value of stocks. These valuation techniques may include cash flow discounting, and widely-used ratios such as price-to-earnings ratio (P/E), price-to-cash flow ratio (P/CF), price-to-book value (P/BV), and enterprise value to earnings before interest, taxes, depreciation and amortisation (EV/EBITDA). An investor or analyst may use a combination of valuation methods to arrive at a range of fair value for a stock. Even though models are quantitative, they rely on subjective inputs. Hence, one needs a clear understanding of the firm and its business.
Investors use these valuation methods and ratios to help them screen stocks. Typically, investors prefer stocks that are considered under-valued - that is, the current share price is trading below the stock's fair value, derived by applying the equity valuation methods. If the stock is trading above its fair value, it is over-valued. For over-valued stocks, investors may want to avoid or sell them until the stocks fall back to more attractive levels.
Some investors also learn from other successful investors such as Benjamin Graham, Warren Buffett, John Neff, Peter Lynch, John Templeton, Mark Mobius and many others. They get insights on how these investment gurus think and assess opportunities. Investors hope to understand their investment philosophies, and learn from their successes, trading styles and strategies. For instance, Benjamin Graham laid out the principles of 'value-oriented investment' - the use of fundamentals - in guiding the valuation of stocks. Many investors also follow Warren Buffett's investment strategy of discipline, patience and value.
Stock picking
The basic stock price is the fundamental value based on tangible assets in a company. As assets become increasingly intangible, there is a so-called 'weightless price' which is the price based on qualitative and intangible assets such as business connections, management expertise and human intellectual capital.
Stocks in different sectors have diverse operational and financial characteristics. They also produce different performances at various stages of the economic cycle. Stocks in the cyclical sectors such as auto, leisure, tourism and property, are the best performers during economic expansion. Stocks in defensive sectors like utilities, healthcare and food staples are steady performers regardless of how the economy behaves. When the economy slows, investors tend to seek refuge in defensive sectors and stocks. Recognising that various sectors perform diversely during different economic phases, stock investors would rotate or switch among the sectors/stocks.
Financial markets are driven by investors' expectations. The aggregate decisions of individual human beings are manifested through financial market and stock price movements. Human beings, however, are not always rational. Greed and fear are commonly known to influence our investment decisions and cause wild swings in stock prices. Investors are prone to be extremely optimistic at the top of the market when prices are high and very pessimistic at the bottom when prices are low.
History is replete with examples of financial market bubbles such as the Tulip craze, South Sea Company bubble, Japanese Stock Market and Dotcom mania. Charles Mackay's book, 'Extraordinary Popular Delusions and the Madness of Crowds' depicted how greed and fear led to speculative human behaviours and the bursting of bubbles in the last few centuries. The human element in investment decision-making introduces a 'psychological price' that is influenced by market pressures and irrationality.
Conclusion
To discover undervalued stocks before other investors do is the objective of most market savvy investors. However, undervalued stocks or companies do not announce their existence. Investors have to look out for them. Accurate stock valuation is a complex process. While uncovering the signs that point to valuable opportunities, investors need to have a clear understanding of the company and stay mindful of psychological blunders.
Stock investors would do reasonably well if they learn from the past, understand the present and think in the future. Understanding why we invest in these companies, having clear quantitative criteria for buying or selling, diversifying and overcoming our biases would be helpful. Undoubtedly, good analytical skills, patience and sound judgement are important to successful stock investing. But one learns also from bad experiences! Equity investing is a lifelong apprenticeship.
Drivers of stock prices
Stock prices can be affected by many macro and company-specific factors. Macro factors include changes in regulations, economic conditions, political climate, industry competition, and behaviours of overseas financial markets. Asset classes (eg stocks, bonds) change in their perceived values and they perform differently at various phases of the business cycle.
Company-specific matters such as business prospects, dividend policy, management track record, product innovations, changing consumer tastes, management-labour relations and other company developments all influence stock price movements. Sometimes, changes in research analysts' stock recommendations would also cause share price volatility.
The goal is to make informed forecasts and a valuation judgement on the attractiveness of a stock/company. A starting point to measure a company's worth would be its financial statements. Among the key information analysed would be a company's earnings power, debt ratio, management quality, business model and relative share price performance.
Different valuation methods can be applied to determine the fair value of stocks. These valuation techniques may include cash flow discounting, and widely-used ratios such as price-to-earnings ratio (P/E), price-to-cash flow ratio (P/CF), price-to-book value (P/BV), and enterprise value to earnings before interest, taxes, depreciation and amortisation (EV/EBITDA). An investor or analyst may use a combination of valuation methods to arrive at a range of fair value for a stock. Even though models are quantitative, they rely on subjective inputs. Hence, one needs a clear understanding of the firm and its business.
Investors use these valuation methods and ratios to help them screen stocks. Typically, investors prefer stocks that are considered under-valued - that is, the current share price is trading below the stock's fair value, derived by applying the equity valuation methods. If the stock is trading above its fair value, it is over-valued. For over-valued stocks, investors may want to avoid or sell them until the stocks fall back to more attractive levels.
Some investors also learn from other successful investors such as Benjamin Graham, Warren Buffett, John Neff, Peter Lynch, John Templeton, Mark Mobius and many others. They get insights on how these investment gurus think and assess opportunities. Investors hope to understand their investment philosophies, and learn from their successes, trading styles and strategies. For instance, Benjamin Graham laid out the principles of 'value-oriented investment' - the use of fundamentals - in guiding the valuation of stocks. Many investors also follow Warren Buffett's investment strategy of discipline, patience and value.
Stock picking
The basic stock price is the fundamental value based on tangible assets in a company. As assets become increasingly intangible, there is a so-called 'weightless price' which is the price based on qualitative and intangible assets such as business connections, management expertise and human intellectual capital.
Stocks in different sectors have diverse operational and financial characteristics. They also produce different performances at various stages of the economic cycle. Stocks in the cyclical sectors such as auto, leisure, tourism and property, are the best performers during economic expansion. Stocks in defensive sectors like utilities, healthcare and food staples are steady performers regardless of how the economy behaves. When the economy slows, investors tend to seek refuge in defensive sectors and stocks. Recognising that various sectors perform diversely during different economic phases, stock investors would rotate or switch among the sectors/stocks.
Financial markets are driven by investors' expectations. The aggregate decisions of individual human beings are manifested through financial market and stock price movements. Human beings, however, are not always rational. Greed and fear are commonly known to influence our investment decisions and cause wild swings in stock prices. Investors are prone to be extremely optimistic at the top of the market when prices are high and very pessimistic at the bottom when prices are low.
History is replete with examples of financial market bubbles such as the Tulip craze, South Sea Company bubble, Japanese Stock Market and Dotcom mania. Charles Mackay's book, 'Extraordinary Popular Delusions and the Madness of Crowds' depicted how greed and fear led to speculative human behaviours and the bursting of bubbles in the last few centuries. The human element in investment decision-making introduces a 'psychological price' that is influenced by market pressures and irrationality.
Conclusion
To discover undervalued stocks before other investors do is the objective of most market savvy investors. However, undervalued stocks or companies do not announce their existence. Investors have to look out for them. Accurate stock valuation is a complex process. While uncovering the signs that point to valuable opportunities, investors need to have a clear understanding of the company and stay mindful of psychological blunders.
Stock investors would do reasonably well if they learn from the past, understand the present and think in the future. Understanding why we invest in these companies, having clear quantitative criteria for buying or selling, diversifying and overcoming our biases would be helpful. Undoubtedly, good analytical skills, patience and sound judgement are important to successful stock investing. But one learns also from bad experiences! Equity investing is a lifelong apprenticeship.
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2 comments:
I have a web site where I give advise on penny stocks and stocks under five dollars. I have many years of experience with these type of stocks. If their is anyone that is interested in these type of stocks you can check out my web site by just clicking my name. I would like to take a moment to talk about low price stocks not classic penny stocks or stocks under one dollar the term most people most often think of when the word penny stock is used. The single most important thing that investors must realize about low price stocks or stocks under five dollars is this’ their are companies of really decent quality trading under five dollars’ but for every one company trading under five dollars that is of decent quality their are maybe ten of poor quality. So the really big difference between those investors that are tremendously successfull when it comes to investing in low price stocks and those investors that lose enormous amounts of money investing in stocks under five dollars’ is having a great deal of knowledge and experience when it comes to low price stocks’ or having a total lack of knowledge and experience when it comes to low price stocks. Finding quality stocks under five dollars requires a lot more research than finding a decent stock above ten dollars.
Nice post
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