Tuesday, October 21, 2008

Some investment opinons

Just had a chat with an old friend yesterday. We were discussing about different views on investing.

Just a little more info about this friend of mine. He was an engineering graduate and has been working for a few years now.However he has decided that his present job is not for him and would be changing to investment banking after his current job. His interest in the financial sector is also very strong, up to the extent that he wanted to change course in university, but due to practical reasons, he did not do it.

His investment philosophy is 'Think Business, not stock'. This is really true for the real value investor. You do not only need to look at financial reports of the company, but you would also have to fully understand the business and know how it operates. Going down to company to look at how it works and how the business look is also part of the process. For example, if you were to buy a stock of Eu Yan Sang, it would be best if you visit their branches and find out how they sell their goods, how they market themselves, how they make use of shop area etc.

In my opinion, though I feel that this should be the way investment firms do their analysis of any company, it is quite impossible for an individual to do this kind of in depth analysis on all the companies in the Singapore stock market.
Also, knowing how good the business is does not really mean that you can accurately give a 'market price' for the stock. Usually what the professional investment managers do is that they use a projected earnings model together with discounted cash flow to 'give' a price to the stock. One major flaw i realized about this is that the projected earning tend to vary quite some bit, depending on the market condition.

Giving a very simple example.

Lets say i know that the company earns $0.20 per stock per year. And i predict the PE ( price to earnings ratio) to be 10. Hence the 'market price' of the stock should be $2.

However, due to the economic downturn, with bad market sentiments, the PE ratio can suddenly be downgraded to say 6 times. And the investment managers with issue a new sell call, saying that the stocks is only worth 6 X $0.20 = $.120 . That is a 40% drop in stock price!

Of course this is a hypothetical stock, however many such cases do exist. In good times, stock pricing are extremely highly due to over projection of PE ratio and earnings. On the other hand, in bad times like now, people also tend to under project the earnings of a company suppressing the true value of the company.

Therefore in my opinion, even though you should 'think business, not stock' it is difficult for most people to achieve this highest level of stock investing philosophy. Hence the best way for the most of us would be to practice the use of FA(Fundamental analysis) and TA ( Technical Analysis).

FA: You look at the company report sheet and see how much profits they are marking and whether it is sustainable.Look at the PE ratio and compare it with other companies in the same sector and determine whether it is inflated. Looking at how they use their debts is also important. To go further in depth, you might want to look at their earnings/loss breakdown. Sometimes, even though a big profit is reported, it could be the company selling off their building in a one off event, and thus it would not happen in the following year.

TA: This is what I am focusing on right now. Though it is always said that whatever happens in the past does not necessary mean it will happen in future, I find that in the relatively short time frame, stocks do follow a general trend. There are many school of theory that supports this kind of analysis though there as as many that reject the idea.
One aspect that I could think off is that, big funds usually practice this. In fact, they use computers to execute buy/sell orders base on some set of rules. Usually these set of rules make use of TA, since FA doesn't change that fast in a short time. Hence when a market actually falls below certain trend line, these computers might actually get triggered to sell off all the fund's stock and cause a further drop in stock prices. You can say that this is something like a self fulfilling prophecy.

In all, investment values varies from people to people. But I think that a combination on FA and TA is essential to succeed. Knowing what company to buy depends on FA, however knowing when to buy is also as important, hence the need to know TA.

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