July 15, 2020
Understanding how to research stocks to add to your portfolio is the first step in generating great returns. Once perfecting your research methodology, it is time to apply this to your portfolio. In the first part of this mini-series, I talked about the basics of researching great companies and industries that can potentially yield great returns. In the second part of this series, I will be showing you how to apply your research in trading. I will guide you through an example using a made-up stock, in order to hopefully answer questions you may have.
To demonstrate how you can use your research skills in reality, I came up with an imaginary company that returned more than 250% year-to-date and its valuation is deemed either outrageous or undervalued. Let’s call the company Alfatauri Motors with the ticker “ATIM”. This is a great company to analyse, as it could be the center for controversy due to its valuation. The shares of the company have been on fire lately, and investors seem confused as to whether or not the company’s worth is fairly valued at $1,500 per share, or whether this might just be a case of FOMO, a case where investors are scared to miss out on a “gold rush”. 2020 has brought challenging times upon the global markets, having dropped more than 35% through March, whereas in a couple of months, the major equity indices have recouped all of their losses. So, we finally found our stock, but where do we begin?
When i first start researching a company, reading a chart will help with forming a strong basis for my analysis I look at a longer term chart, such as the five-year chart as well as a short-term chart such as the one-year chart and the six-month-chart as they tell us how recent events have affected the shares of the company. Looking at charts, one can observe the performance of each company and deduct some information deemed useful. Although past performance does not indicate future success, if you see a company that has been dropping for the past five years, it is most likely that there has to be some kind of substantial change within operations and/or management to turn the company around. If the chart shows an upward trend in the past five years, that also does not mean it is a perfect bet and you should go all-in. When deciding on what to invest in you have to take multiple factors into consideration (as i mentioned in the first part of this mini series). Great! So we have looked at the Alfatauri Motors chart and saw that in the past year the company has been on a roll. As informed investors, we know that this could have been because of technology advancements and great quarterly performances. Another factor is also key when looking at the company…
Investor sentiment! Investor sentiment shows us how optimistic or pessimistic investors are about the market, the economy or anything else. Investors have been putting huge faith into the imaginary company’s founder, whom we are going to call Kevin Corporate. In our imaginary world, he is often called the real life iron man and he has been a trailblazer when it comes to advancing humanity. As a personal opinion, I feel like that when it comes to analyzing a company, there are visionaries who have so much power over investors that can help share prices rise. Some examples of this from the real world are Elon Musk of Tesla and Steve Jobs of Apple.
Next, we will look beyond the charts and dive into fundamentals, following the path set out in part one of this mini-series. As I have mentioned, fundamental analysis is digging deep within a company’s financial statements and this is where we can find the most quantitative information to back our hypothesis for choosing a stock. A good way to start your fundamental analysis is by going to the investors relations page on the company’s website. There you will find quarterly reports in addition to annual reports. I like to look at both, as they contain different kinds of information. The annual reports or 10-K reports as experts call them, contain an annual recap of company performance, notes from management and plans for the future. Quarterly reports are short-term reports depicting a picture about the performance in a given quarter. These are also very relevant when choosing a company to invest in. I will look at the quarterly report for the sake of this analysis.
When it comes to Alfatauri Motors, one of the most critical parts of a quarterly or annual report is the number of units sold and delivered. This metric will be important for most car manufacturers. The reason why investors are keen on knowing these two numbers is because it shows how efficient the company is and how much demand there is for the products. The larger the growth in sales and deliveries, the more optimistic investors will be for the future of the company. Whenever the company exceeded delivery expectations, the stock price went higher.
Okay, so we have looked at the chart as well as some of the more important metrics when looking at Alfatauri Motors. The metrics that we should look for differs for each sector. For example, when analyzing banking stocks, you will be interested in the efficiency ratio and return on equity, or ROE. Of course, if you want to be thorough you can dive deeper in the three financial statements like I discussed in part 1.
Once you have looked at the quantitative side of research, you will have a basic idea of how the company is doing and where they are headed. This is the stage when you could start reading some of the analysis done by investment banks or even credit rating agencies. Why are these reports important? If you are reading this article, you are probably not a professional trader yet, so why not take some pointers from professional analysts. Within these reports you will find recommendations, price targets, analysis and much more. Of course, some parts have the usual financial jargon, but hey, it is a great source to expand your trading knowledge.
Hold on, you are almost there. You have found a potentially great stock. You have looked at the charts and scanned through their financial statements. You have observed what professional analysts think of the stock and you have also deducted your own opinion about the stock. The final step is actually buying the stock through your broker.
Furthermore, I wanted to share my personal thoughts on investing in a few sentences. When I first started out with trading, I thought stock picking would be a walk in the park. Well, let’s just say I learned the hard way. Diversification is very important. Creating a portfolio of stocks from different sectors is a better way to go as we limit our losses and increase our exposure to different industries. I will talk about diversification and portfolio creation in another article so stay tuned.
To continue our Portfolio-First Trading For Beginners mini-series, part 3 will be about fine-tuning and monitoring your investments.