By Aaron Dunn
There are many individuals that buy and sell stocks on a routine basis. But the fact that someone buys and sells stocks does not make them an intelligent investor. Far too often individuals make important investment decisions not based on facts and fundamentals but on emotional factors, like the unsupported hope of a big gain. Unfortunately, far too little effort is put into actually understanding the how the stock market works and how an individual stock is going to generate the required return.
Part of the reason that individual investors put too little effort into training themselves to be good stock pickers is because there is a common belief that acquiring the requisite skills is too time consuming or technically demanding. And yes, not everybody is going to achieve the heights of great stock pickers like Warren Buffet. But the good news is that we don’t have to. Without being an expert, there are some very basic principles that anyone can apply to substantially reduce their risk and increase their odds of success, or at the very least better question their financial advisor. Understanding just three concepts, profitability, financial position, and valuation, can help most individuals start their transition from being an emotional and hopeful speculator to intelligent and calculated investor.
The first thing that an intelligent investor needs to understand is that when buying a stock you are purchasing a piece of an underlying business (albeit a very small piece). It is true that as a stock investor you do not have control over the business like you would your own private enterprise. However, this level of control is no different than what an investor receives when purchasing a minority interest in any private company. Although you may not have control over the management, the return on your investment will still ultimately depend upon the success of the underlying business and the cash flow it produces.
This brings us to an important question. Why does a business exist? Why do owners innovate, invest their hard earned capital, and take on risk? The question is simple as is the answer. A business exists to make money; to earn a profit. Simple yes…but unfortunately this concept is all too often lost on investors. The actions of most retail investors would actually imply otherwise. A surprisingly high percentage of publicly-traded companies on the stock market have never generated a dime of positive cash flow in their histories and have no immediate prospects of doing so. This is particularly common in junior issuer market which is where retail investors commonly flock in hopes of big gains. We would not consider the purchase of shares in such a company to be a real investment. On the contrary, we would consider this activity to be speculation.
The best question any investor can ask when being touted a company is, “does the business make money?” Not revenue, not expected profits at some point in the future, not a gain on the sale of a mineral exploration property or obscure high-tech patent, but actual cash flow from existing operations. This is by no means where there investment analysis process ends but it is absolutely where the process begins. Of course, I’m sure most people can provide more than one of example of a company that was not making money and either grew into profits or was eventually acquired by a larger entity at a gain to shareholders. This certainly happens and by no means does lack of profitability today preclude the company from being profitable in the future. However, purchasing stock in a company pre-cash flow substantially increases the risk of the investment. Whether it is a technology, mineral property, or developing product, most investors (including professionals) will not have technical ability specific to that industry to analyze whether or not the assets will be commercially feasible or saleable to a highly sophisticated third party. The transition from early stage to profitable operations is fraught with risk on many levels. Simply by confining your pool of potential investments to profitable businesses you substantially reduce the risk of incurring a permanent loss of capital.
> FINANCIAL POSITION
When we talk about a company’s financial position, we are referring to the mix of assets and liabilities (debt) and how this impacts risk. Let’s take a look at two fictional people that make similar incomes but are in widely different financial situations. Jim likes to spend lavishly and live beyond his means. As a result he is heavily in debt, has very little equity in his largest asset (his home), and has next to no cash savings. John has made more responsible and realistic lifestyle choices. As a result, he has focused more attention on paying down his debt, leaving him with substantial equity in his largest asset (his home) and a very comfortable stockpile of cash savings put aside for a rainy day. It is pretty easy to see which of these individuals is in a better financial position. But how does this relate to the risk level of a stock?
Booms and busts in the economy are inevitable. When times are good there is a human tendency to think they will always be that way. Plans (which include spending habits) are too often made in absence of an understanding of the full economic cycle. This is done in business as well in the lives of individuals. Typically full economic cycles take years to complete, but other smaller cycles occur as well. Very commonly we see more frequent cycles take place in individual industries, companies or geographic regions. The success a company (or individual) has in navigating through these cycles is largely dependent on their financial position.
Going back to our example of Jim and John…how would these two fair in the event that the economy contracted? Let’s say both of them were to experience an income decline of 15% as a result of a recession. Jim has a very high debt load and high debt payments. The bank doesn’t care if he is making less money. With less income, Jim cannot make his debt payments and provide for his family. If he cannot reduce spending sufficiently, then he will have to either sell his house or declare bankruptcy. John on the other hand is still doing pretty well. He is making less money but is still more than covering expenses and debt servicing. He is under less stress and actually noticed an opportunity in the downturn. He noticed that a lot of people are in the same situation as Jim and are being forced to sell their homes. The result is that asset prices are temporarily depressed and he is seeing some fantastic deals. With lots of equity in his home and a supply of cash on the sidelines, John knows that he will have little problems capitalizing on one of these opportunities.
Businesses work very much the same as people. Everything else being equal, companies with higher debt loads relative to assets and cash flows are at greater risk of deterioration in challenging economic times. Companies with reasonable levels of debt (or better yet no debt and loads of cash) are far better positioned to both survive and capitalize when the economic environment takes a turn for the worse.
Value is arguably the most important concept that investors need to understand. Yet in spite of its importance, it is largely disregarded in the decision making process. Value is more than just a concept. Value is what we get relative to what we pay. All of us have heard the urban legends about how some person went to a garage sale and purchased a old painting or relic for a few dollars that turned out to be worth a small fortune (unbeknown to the buyer or seller at the time). This is a classic value transaction…when the asset you bought is worth significantly more than what you paid.
The beauty of the stock market is that it is highly cyclical, volatile and often inefficient. The recent past has been a case study on investor emotion and how it can cause abrupt swings in stock prices. Although in the long-term stock prices will tend to follow the intrinsic value of the underlying business, in the short-term, prices can fluctuate wildly around this value. We have seen this cycle repeated throughout history. What it means to investors is that there are times when stocks can be purchased at less than the intrinsic value of the business and there are times when they can be sold for more than the intrinsic value of the business.
The trick is determining when a company is under or overvalued and this is not necessarily an easy thing to do. One method that is commonly used in valuation analysis is to look at the stock price as a multiple of the earnings (or cash flow). So if a company trades at a price of $5.00 and generates $1.00 per share in earnings, then their price-to-earnings (or P/E) multiple is 5 times ($5 share price divided by $1 of earnings). Everything else being equal, a company with a lower P/E multiple would be more attractively valued. But to complicate the situation, everything is not usually equal. Different companies have varying levels of financial and operating risk and all of this should be reflected in the valuation. For example, a company in a risky industry with volatile earnings may trade with a P/E multiple of three times whereas a company in a less risky industry with more certain earnings may trade with a P/E multiple of 15 times. Comparing these two valuations is like comparing apples to oranges. Where valuation becomes more applicable is when we compare similar companies in the same industry. Investors should be aware if an individual company is trading at a substantially higher valuation than its peers in the industry, or if an industry is trading at a substantially higher valuation than its historical average. This may or may not be justified by current fundamentals but the investor must always question and understand why the valuation is so expensive before making a purchase.
Clearly this type of analysis can become very complicated but we don’t need to be experts to apply the basic concepts. A recent example of how basic valuation can help investors can be found in the infamous IPO of Facebook. The company IPO’d in mid-May at a price of $38.00 per share. Within the first day of trading the share price precipitously dropped and by the time that this article was written the shares were down nearly 50% in a matter of months. So what happened? How could such a renowned company and highly anticipated IPO have been such a disappointment? The answer is valuation. When we look beyond the hype of Facebook and into the fundamentals, the company was actually only expected to earn about $0.43 per share in income for the year. That equated to a P/E multiple at 88 times at the IPO ($38 share price / $0.43 earnings). To put that into perspective, two other iconic technology brands, Apple and Google, were at the time trading at P/E multiples of about 14 times and 18 times earnings, respectively. IPO investors allowed themselves to be persuaded as a result of the potential behind the Facebook brand. But did Facebook really have five to six times the potential of Apple and Google? Now the market is saying no and IPO investors are highly disenfranchised. But the reality is that every individual is ultimately responsible for the decisions he or she makes. Had the IPO investors utilized this very simple and relatively easy to apply concept of valuation, they may have seen beyond the hype and better protected their capital. •
Aaron Dunn is an Equity Analyst with KeyStone Financial specializing in dividend and income stock investment analysis. KeyStone is a financial advisory firm that provides retail clients with independent BUY/SELL research on publicly-traded income and growth companies listed on Canadian and US exchanges. Information on KeyStone’s investment advisory service can be found at www.incomestockreport.com and www.keystocks.com