By Simon Guzowski, Senior Analyst at investment research house, wise-owl.com
Wednesday 6th June 2007
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However, while it is good to understand all of these trends, what is most important is a companyís individual merits. The right company can do well and outperform even when the market or that companyís sector faces tough times. Focusing on individual companies first before looking at the broader environment is called Ďbottom upí stock selection.
Bottom Up Stock Selection Made Easy!
Analysing a company can seem daunting at first, however when you break it down to a step-by-step process, itís not actually all that difficult! Itís a skill that can be developed with practice and some good old fashioned elbow grease of the intellectual kind.
Before we recommend a company we always make sure it meets a set criteria - what we call the Ďwise-owl.com checklistí. Put simply, we are looking for companies with good management, a reasonable valuation, share price drivers, good business partners, and a technical buy signal.
What sits at the very core of this process is the assumption that high quality stocks will typically outperform lower quality stocks over the longer term. These gains will also be safer and may not necessarily come from the big name or blue chip stocks we often hear about.
This is arguably the most important factor to look at in a potential investment, and the smaller a company gets, the more important management becomes. Now unless youíve got a very deep hip pocket and potentially going to invest a very large sum of money, most management teams will not be in a hurry to meet you and let you analyse them first hand. Fortunately this isnít a big problem, as you can usually find the information required through public sources such as company websites, annual reports and the internet.
There are two critical things to look out for. One, does management have the relevant experience, and two, do they have a good track record? Mining companies are a great example of this right now. Many of the smaller miners lack management teams with relevant experience. A gold exploration company needs people on the management team who have explored for gold before. Youíd be surprised at how many small to mid cap companies can be ruled out on something this simple.
If the management team has not only explored for gold before, but has been behind some big discoveries in the past, then this box on your checklist deserves a tick and you could be onto a winner.
This is probably what scares most people away from fundamental analysis. If you havenít been exposed to valuation methods before this isnít something you can exactly pick up overnight. There are rules of thumb however that can get you over the line.
PE ratios are probably the most widely used indication of value. A PE ratio is simply the companyís share price divided by its earnings- It gives you a good idea of how much youíre your paying for the companyís earnings power. The question to ask is: Is a companyís PE above or below that of its peers, and is this discount or premium justified? Donít necessarily go for a share just because it has a lower PE and looks cheap. Quality companies often trade at a premium to their peers and can be worth the extra cost. As with many things, you get what you pay for.
Another rule of thumb you can use with a PE is to compare it to a companyís growth rate. If you think a company can grow earnings faster than its PE ratio, then it could be good value. For example if a company is going to keep growing at 20% per annum, you would expect it to trade on a PE of about 20 which could be considered fair value. If it was trading below a PE of 20, then it would be considered good value, maybe even cheap.
Share Price Drivers
You must understand whatís driving the share price of the company youíre looking at investing in. In the case of an upstart biotech, itís probably the blue sky potential of their technology. In the case of a large bank, it could be earnings stability and growth potential. In the former case you will be relying on sentiment towards your stock or sector, which could change very quickly. In the latter case, itís more likely to be a predictable and steady ride. Whatís best will boil down to your tolerance for potentially wild swings in the share price and risk.
How many times have you been told Ďbirds of a feather gather togetherí? The partners a company can attract reveals a lot. If a company is aligned with high quality, reputable business partners or clients, then itís more than likely a quality company itself with a market leading product or an exciting proposition. If on the other hand the company hasnít been able to attract any reputable partners, or worse, it has disreputable partners, then tread with more caution!
Strategic investors are also something you can look at. You may not be an expert in oil exploration, but BHP is; so if BHP is a large shareholder in a small oil exploration company or Pfizer has a stake in a small biotech, youíll be able to sleep a little better at night. Of course this isnít failsafe in itself; however it does reduce your risk and increase your chances of success.
Charting or Technical Analysis
Technical analysis or Ďchartingí as itís more affectionately known has more than its fair share of both supporters and critics. To cut a long story short, charting is widely used by short term traders who use it as a tool to Ďtimeí short term trades. It is also useful for long term investors as it can help identify the best time to buy into or sell out of a position. Charting is as much art as it is science, so not everyone is able to put the theory into practice.
Charting can also be a great way of confirming or disproving your fundamental analysis. Should you be looking at a company which stacks up fundamentally through all you research, yet it has traded in a long term downtrend for many years now, then there is probably something your analysis has missed. Or even if your analysis is right, if the market doesnít like the stock and its price keeps on falling youíre not going to be laughing all the way to the bank as your stock falls below your buying price!
On the other hand, if a stock has a steady bullish uptrend without too many hiccups the company is likely to boast strong fundamentals and support from other investors. Stocks with respected management teams and good track records of past success often display a great chart as well.
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Wise-owl.com is one of Australia's leading independent investment research houses. We empower all levels of investors and traders with education, advice, actionable strategies and risk management techniques. Our investment philosophy is based on a combination of quantitative, fundamental and technical analysis that has been proven over the years to produce very consistent and powerful returns. At wise-owl.com, we empower our members to take control of their investment destiny.
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