July 13, 2020
As a stock trader starting out, whether you plan to make some extra cash on the side or build a portfolio for your retirement, one of the most important questions that you have to ask yourself is which stocks to add to your portfolio. This could be an intimidating question at first, as there are a little over 32,000 public companies globally and around 3,600 listed companies on US stock exchanges. So where do you start this journey? Which companies will be the most successful? Why is one company better than the other?
These are some of the questions you will or have already asked yourself before submitting that first trade. There are numerous strategies and research methodologies out there that have made many people successful. You will find people talking about top-down analysis, bottom-up analysis, value investing, growth investing, and several other jargon that you might not understand at first. No worries. In this article we will hold your hand to navigate through the exciting steps to find stocks that could potentially be successful, while you formulate your own research methodologies and strategies.
Usually when you have no idea what stock to look at, the best path is to research an industry in order to find a sector that will outperform. Starting your research from a macroeconomic perspective and then working down to an individual company’s financials is called a top-down analysis which is a great way to find stocks you have not heard of or thought of to put in your portfolio. With this approach you will also avoid or limit attention bias, which means that most retail traders concentrate on stocks that they hear in the news or on companies that they know. This limits your success potential as there are so many companies out there that we might not even consider investing in just because we are not familiar with them.
Analyzing industries or sectors can be very lengthy and tiresome, but as a retail trader, you have so much information available on a daily basis that you don’t have to do it yourself. With the number of new investors growing on an annual basis, news sources start to shift their focus to sharing financial analyses on media outlets that you read daily, and these analyses are done by professional investors so that when you decide to invest, you don’t have to go through the research process. A quick Google search can also tell you what the largest investment institutions think as great sectors for the future. Once you find the sector that you think will outperform, you might start researching companies within that sector. The next step in your research process might be fundamental analysis.
When looking for stocks to add to your portfolio, fundamental analysis is a great way to see if a company is financially stable, whether it has a good growth potential or if it is socially conscious as ESG investing has become a trend nowadays. So what is fundamental analysis? Fundamental analysis is a research method where you take a deeper look at a company’s financials and business model. Sounds intimidating doesn’t it? Most retail traders are not accountants or business people, and this article is not for investment professionals either, but for the everyday Joe who wants to plan for the future. So let’s dive into this mysterious concept.
As I discussed above, fundamental analysis is about taking a hard look at the company’s financial statements and looking at the ratios and change throughout the years. What if you are not a finance person and have no clue what a financial statement is? The most basic things that you will look at are the revenues, bottom line, overall growth, and cash flows. Why? These four concepts will tell you how sales are and how much costs are, while you will also be able to see how fast the company is growing. Cash flows are important when talking about paying off debt that a company might have or when we look at solvency and liquidity.
Most people know what revenues are and could seem uninteresting, but for the basic analysis of the income statement, revenues are important. When you look at a financial statement, you don’t just look at one year’s data. You compare it to past data so that you can observe the growth trend. While seeing steady growth in revenue might be a good sign, this does not mean that the company you picked is a clear winner. In order to find a winning stock, you have to observe multiple factors, of which one is revenues. Steady growth is always a positive, but even if there was a substantial drop in revenues, we might be able to deduce an educated guess about why the drop happened. The more we analyze financial statements, the better we will get at understanding the connections between the three financial statements, as well as connecting financials to management and other factors.
The bottom line or net income is revenues minus costs, interest, depreciation, taxes, and other expenses. The higher the profitability the better, as it means the company’s financials are stable and sales are high compared to costs. When talking about net income you can find ratios such as the net profit margin which is an important percentage when measuring profitability. A good profit margin varies by industry. Companies such as Snap Inc, Uber, and Pinterest are making a loss, but many investors still love these companies. Why is that? Investors see a favorable long-term potential and path to future profitability so they are willing to take a loss in the short-run.
The financial summary shown above is from Tesla’s quarterly report. Looking at this snapshot you can deduce quite a few things. Total revenues have been increasing year-over-year which is a good sign, although net income has been fluctuating, but this can be attributed to several factors which are talked about within the report. It is always good practice to read the quarterly and annual reports of the company as they talk about the challenges that they face during the time period.
How do you know if the financial performance of the company is good? Growth is a key factor in determining if a company is doing better year by year as we compare financial performance to past data. A good growth level is also dependent on the sector or industry we look at. Usually tech companies have a higher growth rate than mature companies, such as utilities or telecommunications. We can look at growth in almost all rows of the financial statements. When a company releases its quarterly report, you will often hear consensus figures. These consensus forecasts are carried out by investment professionals and if a company does not reach the growth level expected by analysts, the stock is likely to drop and vice versa.
If you look at a cash flow statement you might get confused, as I did when I first saw one. A cash flow statement shows the cash movements within a company and how the balance sheet and the income statement affect cash movement within the company. The cash flow statement is great to analyze the liquidity of a company. We will look at cash flows from operations, as this is the amount of money that a company generates from its business operations. From this, we will deduct cash flows from investing and cash flows from financing to get free cash flow (FCF). FCF is the amount available to distribute to shareholders or to reinvest in the company. From the cash flow statement, we can also calculate if a company has enough resources to pay off short-term debt, which is key when assessing financial health.
Of course, other than these four factors there are various others we can take a look at, calculate different ratios from, and do very complicated calculations with in order to figure out if a company is worth investing in. Besides analyzing the industry and the company’s financials, reading the news can also be a huge factor. New contracts, new products or new approvals can skyrocket a stock price as well as can plummet it if the news is negative. On the chart below, you can see how Moderna’s (MRNA) stock price jumped after the first quarter results in May. It jumped an astonishing 364% (!) in just 11 days, because of the quarterly performance.
Moderna share price after quarterly performance report
I believe that the most important idea of this article that I would like to get across is that investing is not a casino. It is a process of quantitative and qualitative techniques, if carried out properly, resulting in favorable returns. In the short-term, stocks can be all over the place and you might think that your analysis was wrong. In the long-run though, if you believe in your analysis and you did your homework, you can find success.
In the next article within the Portfolio-First Trading for Beginners series, I will discuss how to apply these research techniques within your own portfolio and how you can minimize risk by doing research efficiently.