Monday, June 15, 2020

Thought Process On Picking Your First Stock

I've had countless queries in the past and a couple of emails recently from readers who are interested to start investing and one of the commonly asked questions is ways to pick the correct stock to invest.

The first stock purchase for an investor is always intriguing. 

The emotions when you first purchase your stock are filled with mystery, excitement, fear and then there's always the risk and reward. Many will soon get addicted to it and then will proceed with the next second and third purchase and so on.

It's incredibly difficult to answer this short question to any investors who are asking as there's legitimately no right or wrong answer. Nevertheless, I'll try to provide some framework guidance which hopefully can be productive and useful to any investors who's starting to venture out on their own.



Step 1: Organize a list of companies in your respective region that are big market cap

Your very first step as a beginner should always be looking at the bigger market cap in your respective region.

This means looking at the likes of blue chip companies such as Singtel, DBS, OCBC, Sembcorp and SIA in your STI index if you are looking at the Singapore market. In the US market, you will get a list of acquainted well-known companies such as Apple, Boeing, Facebook, Starbucks, Visa and many more.

Don't buy them yet at this point because there's many rotten apples hidden in the fundamental of these companies, even for blue chips.

At this point, all you want to do is to get a grasp understanding of:

  • What is their business model?
  • What products do they sell?
  • What competitive advantage do they have over their competitors?
  • How much market share have they acquired?
  • Management capability and their historical financial performance

Most, if not all of these information, are easily available in the annual reports or financial statement of the company where typically management would provide operational quantitative updates on how they are doing or coping with the situation.

All you really need to do at this point is just to spend some time gathering the information and writing some notes down and that's it. No action should be taken yet at this point because the information you have is public, which means anyone else will have the same information as you do so that's not really helping you to gain any advantage.

You may also want to segregate the list of companies that are appearing in your newsfeed or newspaper because not all the time they are good. The fact that you read in the newspapers that people are queueing up at McDonald's does not immediately qualify them to be a good stock. 

Always be selective when reading and takes information with a pinch of salt. This way, you will have more questions than answers which is good because it leads you to explore more on your questions.

Step 2: Areas of Competency

Your areas of competency is your competitive advantage over the next other person that you have a lead on.

This lead can be achieved through years of working in the industry and getting to know-how the inside operations of how certain things might work in detail. For example, if you are in procurement, you would know how aggressive your competitors are pricing in their bids for the tender or if you are working in supply chain logistics company, you would better understand the details on transit times, delivery performance, freight claims and customs requirement.

Thus, when you select companies that are in your areas of competency, you are able to value-add your experience to the companies you are prospecting and make better informed decisions from there.

Step 3: Consistently Strong Gross Margins

We haven't really looked at the financials of the company until this point.

Once you select the ideal companies of your choice after step 2, you have to start looking at the financials of the company.

One of the financial metrics that I usually pay close attention to is the company's gross profit margins.

Companies that are able to consistently generate strong gross margins are usually indication that the products or services the company provides are superior and highly valued by its end user which allows the company to scale up for more market share.

Consumers pay a premium for company's products and services because they are superior in many senses which may include design, quality, reliability and uniqueness. Some firms may have also competitive advantage in its supply chain and thus are able to drive increasing gross profit margins over time.

There are certain industries such as consumer staples or constructions that will be struggling with low margins because of the evolving nature of the industry itself. I would want to avoid these companies for now because the industry may be in the transition phase and may take a while to see fruition.

Step 4: Companies Are Not Loaded With Too Much Cash or Debt

While it is quite obvious that companies with too much debts are not natural selection, companies that are hoarding too much cash are not an ideal choice either because it means the company is not allocating enough to grow the business It may also be the case that the company is at saturation point thus management has no options to grow the business any further and sit on the cash.

On this, a quick dirty way of checking is through analysing the company's profitability using the Dupont analysis.

The Dupont analysis is a financial ratio based on the return on equity ratio that is used to analyse a company's ability to increase its return on equity. From this breakdown, not only does an investor is able to recognize the company's profit margins, but he is also able to deduce if that profit margins are coming in from an effective way of using leverage to boost its margins.

The Dupont expression is a function of the profit margin, total asset turnover and equity multiplier.

Step 5: Valuation

The last step is probably the hardest to deduce because it is an art to be able to deduce the right valuation of the company.

The most commonly used method to value a typical company is through a price to earnings ratio, which is simply taking the share price divided by the earnings (excluding any one-off). It is usually very seldom that you see a company trading at below 10x PE ratio and if it does it is usually in an industry where it is in a very competitive space. Don't get into the trap thinking that it is a value buy just because it is trading very cheap on the market.

The higher the company's moat, the higher the market tends to price in the valuation so a good overall benchmark is to look at their historical and competitor's valuation and see where they stand at.

Conclusion

This is not a hard proof and only way of looking at companies.

There are probably a thousand and one ways one could have select companies that they decide to ultimately purchase into the portfolio. For example, the cashflow is another important aspect of a company's financial statement but I figured this would be a little intermediate for beginners.

Nevertheless, I hope these framework will provide the very basic guidelines that as beginners you are able to start the ball rolling.

As always, the market is and will always be there so there is no need to FOMO on companies that you think you might have missed. It is always better to err on the caution and miss the gain than having put your hard earned money and earn that loss in the long run.

Thanks for reading.

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13 comments:

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  2. Hi Brian

    Thanks so much for sharing your thought process.

    On Step 4 and particularly companies with too much cash, I am interested to have your thoughts on how you distinguish between cash-rich companies that have reached a saturation point and those who might simply have fiscal prudence to tide through unpredicable times like now. For example, Valuetronics has a cash hoard of over SG$200m and with no debt, yet is able to deliver a superior ROE without any loan assistance. What are your views on such companies? Thanks.

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    Replies
    1. Hi Ming Jie

      Yeah that's a good question.

      Cash is an obvious drag to the ROE for companies that generate plenty of free cash flow but yet do not allocate or distribute back the cash as much, hence cashpile will grow bigger. If the ROE can sustain throughout the years, it means that the company is generating higher roa through its asset generating ability which is a good thing.

      For me I think I'd tend to side with the rule that companies with cashpile must either have a minimum of 50% payout ratio as dividend policy or they must demonstrate an intent to use the cashpile in the next 3 years. Generally, I don't believe in holding super long term because there's a lot of variables that might erode unless you are moat companies like the obvious Google, Microsoft, Apple.

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