By popular request, I re-publish this old article on stock market basics
Most people make fools of themselves in the stock market. Even most professionals invest like losers, constantly underperforming.
So, how can you avoid the worst newbie or pro mistakes?
All you need to do, to outperform stale index hugging mutual funds and schizofrenic panglossian/worrywart newbies is the following:
1. Check the present context intelligibly; ask yourself: “is it a fad or sustainable”
2. Imagine the future environment; the economy, profits, valuations, interest rates etc
Buy or sell accordingly.
THE HARDEST PART?
To wait, to hold off until you see an actual opportunity, to NOT buy or to NOT sell prematurely.
If you want a little more guidance to outperforming the market, here are…:
8 easy but essential checks you must perform before buying stocks (okay, maybe its 50 check points, but easy ones…)
Newbies typically invest too emotionally; they buy on a tip, because they “like” the company’s products, because they know somebody working there or because it is trending upward. They often buy stocks when they are relatively expensive, when the hype level is high, since that is when they hear about the company and they have a “good feeling”. Then they sell, cheaply, when the stock is trending downward, when the hype has faded and they have a bad feeling.
No matter what their time perspective is, 1 month, 1 year or 10 years, newbies tend to buy high and sell low, and then give up altogether and get out – disillusioned and fleeced like a newcomer to a poker table or poker site.
Professional portfolio managers at large institutions like mutual funds or pension funds play a completely different game. Their main objective is to keep their jobs or rather not lose their jobs.
Their performance is measured not in terms of absolute profits or returns but relative the market (a benchmark index) and their competitors. By “hugging” the benchmark, they make almost perfectly sure they underperform the market slightly (due to their fees and paid commissions), albeit never by much. As long as they don’t make a big mistake and underperform the market or their competitors by a lot, they get to keep their clients and their jobs – even if the market and their portfolio drop by 50%.
Any rational individual would be better off just buying the market average and holding the stocks forever than purchasing mutual funds, since you would then bypass most of the costs while still making market average returns. Unfortunately you would still have to ride out the big downturns, aka Bear Markets. However, if you are willing to do a little more work to avoid the worst mistakes, you could beat both the cowardly institutional investors and the uninformed masses.
Make these 8 simple checks before rushing into an investment on the stock market
IS THE STOCK CHEAP?
- Is the company absolutely cheap? If not, you are speculating on a bigger fool buying it from you even more expensively in the future. That’s gambling, not investing.
- Check valuation multiples. Assessing cheapness is material for a whole book in itself, but at least check P/E, P/B, EV/EBIT, P/FCF and P/S valuations for the coming 3 years. Anything above 10x EV/EBIT, 20x P/E and 2x P/S or 2x P/B, respectively, warrants a deeper evaluation. However, nota bene, just being cheap on these multiples, let’s say 1/3 of mentioned values, does not necessarily mean the stock warrants a buy recommendation.
- Is it relatively cheap? If not, why and how is that sustainable? If you skipped the absolute valuation recommendation, you should check whether the multiples are higher than several benchmarks:
- Is it cheaper than its own history? If not, what has changed to warrant a higher valuation now compared to before. If it is cheaper than before, is it actually cheaper or is there a reason?
- Are other similar companies even cheaper? Check the obvious industry peers (locally and globally) before buying the first stock you come across. Avoid proximity bias. If your company is cheaper, make sure the peers really are similar.
- Is it cheaper than the average market
ARE SALES AND MARGINS SUSTAINABLE ?
- Is the sales growth rate sustainable? Assume the market counts on recent trends to continue, but do you think that is likely? Compare the growth rate to
- its own recent history,
- to the average economy,
- to its industry peers. If differs significantly, why and for how long is that sustainable? What is unique, what is the competitive advantage that could explain continued outperformance?
- Are profit margins sustainable;
- vs. history?
- vs. peers?
- vs. the economy? Remember that if one company is making super profits it will attract competitors as well as could revolt some clients.
- Are tax rates stable and sustainable?
- Check historical range for the company, why does it vary?
- Compare paid tax level with actual official tax rates
- Do they have tax deductions? How long can they keep paying lower taxes?
- Is the official tax rate reliable? Natural resource companies, banks and other industries, or foreign companies in certain countries, often have to pay extra taxes if they make large profits, sometimes huge back taxes on many previous years. Beware if this has happened before or if the company is making super profits.
ARE RETURNS SUSTAINABLE ?
- Are economic returns sustainable for your company (Return On Equity, Return On Capital Employed)? If higher than
- or the economy, why and for how long do you expect it to continue? Why is it unique?
ARE CLIENTS AND DEMAND HEALTHY?
- Check trends in receivables; are they getting paid on time. Compare DSOs to
- historical range,
- to peers,
- to what might be reasonable (30 days, 60 days, 90 days,,, even longer?, why?). The trend is most important, since the market is already aware of the recent level, so
- check if DSOs are trending higher. Higher DSOs mean clients are delaying payment which is a bad sign. The company might be invoice stuffing, overselling or having to adjust sales practices to compensate for poor demand or poor clients. DSO=Days Sales Outstanding=Receivables/Sales*Days in period.
- Check cash flow conversion trends.
- Free cash flow/Sales,
- FCF/Earnings. If cash conversion is trending downward something is wrong with the business model or competition is heating up or the economy is weakening.
ARE DEBTS UNDER CONTROL?
- Check debts:
- Check the debt/equity trend. If leverage is increasing, find out why.
- Contemplate the risks involved with rolling the debts in the future, if interest rates rise or if cash flow is poor. When do the loans reset or need to be rolled?
- Check debt covenants for highly leveraged companies, particularly in recessions.
- A typical covenant clause states a maximum debt/equity, debt /FCF or debt/EBITDA multiple before new conditions or interest rates apply.
CHECK TECHNICALS AND MARKET TRENDS
- Where is the general stock market going?
- If it’s expensive it might roll over and drag down your investments as well, unless they are very cheap or secure.
- How did your stock fare in earlier bear markets? How much did the stock fall. How much vs the market? Why would this time be different?
- Is the stock market trending upward or downward? The tide could lift or sink all boats. If the market is both expensive and trending downward you should have extremely good reasons to buy a particular stock. Do you? Do you really?
- Is the stock price above or below its own moving average (20 days, 50 days, 100 days, 200 days), Has MAV worked well for that stock historically? Which MAV had worked better, more consistently (100, 200)?
- What price range has the stock price moved in during the last 3 months, 6 months, 12 months, 3 years, 5 years? If your investment is based on a change in trend or range, why and how would that happen?
- Check the yield curve(s)
- Check the 10yr-2yr = government debt yield difference. A negative yield difference (“curve”) signals recession and can be a harbinger of poor profit growth. Nowadays this signal has been distorted by central bank manipulation.
- Check Junk bond yields vs. government yields.
- The higher the difference, the more risk avert the market is becoming. Professional junk bond investors care about not losing the entire principal, so they make sure to be the first to panic. When they sell their holdings they push yields higher. Higher-trending junk bond yield spreads indicate increasing risk aversion.
- Low absolute junk bond yields can signal extreme bullishness, e.g. if they are lower than average historical losses on similar debt instruments. This typically occur close to market peaks – and that’s a point where you want to avoid investing in stocks.
CHECK VARIOUS ECONOMIC VARIABLES
- Check the prices of commodities
- Check the price trends in oil, gold, soft commodities, commodity indices. What has happened when they behaved like that before? If they are really extreme it might be relevant for future growth or inflation – otherwise most often not.
- Check the state of inflation and central bank policy
- Is it high vs policy rates
- Is it trending higher
- What is the central bank likely to do the coming year – any reason to expect an unexpected hawkishness?
- Check economic indicators
- check coincident/lagging indicators – most economic indicators are complete bunk. However, taking what are considered coincident indicators and dividing them by the lagging indicators has given a rough estimate of future economic growth. Just remember that GDP growth and stock market returns have shown zero or even negative correlation historically.
- Check if the market has fallen – Past performance can carry informational value
- Buy more after negative market years (see strategies such as Quatro Stagione and Dogs of the Dow/World that will need its own post) – the market seldom falls for an entire calendar year. In any case, stocks are cheaper after a fall than after a rise. Buy after a sharp fall or after a particularly negative year for the market. Buy even more after two or three consecutive years of negative returns
- Is the investment reasonable in a general sense? Good company, good product, not hyped, is it producing real value or is it just a fad. Do you understand the product, what’s driving demand, what the competition is?
- Is the risk level appropriate for you? Can you afford to lose the money? How much of it? When would you be forced to sell to stop your losses. What might take the price there? Will you actually sell then or will you be locked in?
- What do you expect to gain from the investment, when will you sell and based on what?
- How do you picture the future environment for your investment?
- Imagine the state of the company, its industry and the economy 1-3 years from now
- Imagine the state of the stock market and investor preferences 1-3 years from now
- Imagine interest rates and valuation multiples 1-3 years from now
- Will there likely be a better time to buy in the coming 1-3 years, then wait for that. 2 years’ waiting in 2000 or 2007 would have saved you a decade of regret and worry
- What’s the warranted absolute fundamental value and what is the likely price range under certain circumstances and time periods
- Check the expected future return. Start point absolute valuation is EVERYTHING when it comes to expected returns
- Check previous price and valuation ranges. Trends, fads, interest rates, relative valuation etc can and regularly do push the actual price of a typical stock to extreme highs and lows vs the fundamental value. The historical range of stock price and valuation multiples serve as a rough guidance of the likely future range.
SUMMARY – “THANKS FOR NOTHING!”
“OK, thanks for nothing“, you might say. “That’s not 8 easy steps, Those are 50 cumbersome and difficult procedures” and then you didn’t even include how to actually perform absolute valuations.
So, let’s summarize and make it even simpler…
THE MAGIC TWO-STEP SPREZZATURIAN FORMULA FOR FANTASTIC INVESTMENT PERFORMANCE
- Check the present context. Does this seem like a good time to invest? If not, wait.
- Imagine the future environment or context. What will it look like when it’s time to sell? Better? Then buy today.
Just remember to check the present and imagine the future contexts in a thoughtful way, including relative and absolute valuation, earlier price ranges and likely future ranges, investor psychology and basic economic understanding about sustainability. The five most important questions you can ask yourself before investing are:
- Why do I expect things to change?
- Why would it be different this time?
- Why would the currently extreme situation continue?
- What has happened before in similar situations?
- Does anything need to change for the investment to produce the required/expected return?
So, get to it! Or do you need anything more to get started?