Stock Picking Strategies
Know your schedule
You need to commit to a period of time during which you leave those investments unchanged. A reasonable rate of return can only be expected with a long-term horizon.
When investments have a long time to appreciate, they are more likely to overcome the inevitable ups and downs of the stock market.
It might be possible to achieve a return in the short term, but this is unlikely. As legendary investor Warren Buffett puts it, “You cannot conceive a child in one month by carrying nine women.”
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The magic of makeup
Another important reason to leave your investment untouched for several years is to take advantage of complications.
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When people cite the “snowball effect,” they are talking about the power of makeup. When you start making money from the money your investments have already made, you are facing compound growth.
This is why people who start the investing game early in life can outperform a late beginner. They obtain the compound growth benefit over a longer period of time.
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Choose the appropriate asset classes
Asset allocation means dividing your investment into several types of investments, each of which represents a percentage of the whole.
For example, you can put half of your money in stocks and the other half in bonds. If you want a more diversified portfolio, you can expand beyond these two categories and include real estate investment funds (REITs), commodities, forex or international stocks.
To find the right allocation strategy for you, you need to understand your risk tolerance. If temporary losses keep you awake at night, focus on low-risk options like bonds. If you can weather setbacks in pursuit of strong long-term growth, look to stocks.
No decision either all or nothing. Even the most cautious investors should mingle with a few blue chip stocks or a stock index fund, knowing that those safe bonds will offset any losses. Even the bravest investors should add some bonds to temper the steep fall.
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Diversification rewards
Choosing between different asset classes is not just about managing risk. The biggest rewards come from diversification.
Nobel Prize winning economist Harry Markowitz referred to it as “the only free lunch in finance.” You will earn more if you diversify your portfolio.
Here’s an example of what Markowitz meant: An investment of $ 100 in the S&P 500 in 1970 had grown to $ 7,771 by the end of 2013. Investing the same amount over the same period in commodities (like the benchmark S&P GSCI index) would have made your money Grows to $ 4,829.
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Now, imagine that you adopt both strategies. If you had invested $ 50 in S&P 500 and another $ 50 in S&P GSCI, your total investment would have grown to $ 9,457 over the same period. This means your revenue would only have exceeded the S&P 500 portfolio by 20% and would be roughly twice the performance of the S&P GSCI.
The mixed approach works best.
Traditional and alternative assets
Most financial professionals broadly divide all investments into two classes, conventional assets and alternative assets.
Traditional assets include stocks, bonds, and cash. Cash is the cash in the bank, including savings accounts and certificates of deposit.
Alternative assets are everything else, including commodities, real estate, foreign currencies, arts, holdings, derivatives, venture capital, private insurance products, and private equity.
Most individual investors will find that a combination of stocks and bonds, plus a cash cushion, is ideal. Everything else requires very specialized knowledge. If you are an expert at antique porcelain, go for it. If not, you better stick to the basics.
Balancing stocks and bonds
If most investors can reach their targets with a mix of stocks and bonds, the final question is, how much should they choose from each category? Let history be a guide.
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If your goal is to achieve a higher return, and you can take the high risk, most stocks are the way to go. The truth is, total return on equity has historically been much higher than all other asset classes.
In his book Stocks for the Long Run, author Jeremy Siegel makes a strong case for designing a portfolio primarily made of stocks.
His logic: “For 210 years, I studied stock returns, the average real return on a widely diversified portfolio of stocks was 6.6 percent per year,” Siegel says.
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A risk-averse investor may be uncomfortable with even short-term volatility and chooses the relative safety of bonds, but the return will be lower. Siegel notes that “at the end of 2012, the yield on the nominal bond was about 2 percent.” The only way that bonds could deliver a real yield of 7.8 percent is if the CPI fell by about 6 percent annually over the next 30 years. However, a shrinkage of this magnitude has not been sustained by any country in the history of the world. ”
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What is the book value of the common share?
Book value per common share (or simply book value per share – BVPS) is a method of calculating the book value per share of a company based on the equity of the common shareholders in the company. A company’s book value is the difference between that company’s total assets and total liabilities, not its market share price.
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In the event of the dissolution of the company, the book value of each ordinary share indicates the remaining dollar value of the ordinary shareholders after all assets are liquidated and all debtors are paid.
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Understand the book value
The equation for the book value of a common share is:
Book value per ordinary share (formula below) is an accounting measure based on historical transactions:
What does BVPS tell you?
The book value of ordinary shares in the numerator reflects the original returns that the company receives from the issuance of ordinary shares, which are increased by profits or decreased due to losses, and decreased by dividends paid. Company share buybacks reduce the book value and the total number of common shares. Stock buybacks occur at current stock prices, which can lead to a significant reduction in the company’s book value per common stock. The number of common shares used in the denominator is usually the average number of diluted ordinary shares of the past year, which takes into account any additional shares other than the number of underlying shares that could arise from stock options, guarantees, preferred shares, and other convertible instruments.
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Example of BVPS
As a hypothetical example, suppose XYZ Manufacturing’s common stock balance is $ 10 million, and one million shares of common stock outstanding, which means that BVPS is ($ 10 million / 1 million shares), or $ 10 per share. If XYZ manages to generate higher profits and uses those profits to buy more assets or reduce liabilities, the company’s common stock increases. For example, if a company makes a profit of $ 500,000 and uses $ 200,000 of the profits to purchase the assets, the common stock increases along with the BVPS. On the other hand, if XYZ uses $ 300,000 in dividends to reduce liabilities, the common stock also increases.
The difference between the market value of the share and the book value of the share
The market value per share is the company’s current share price, and it reflects the value that market participants are willing to pay for their regular share. Book value per share is calculated using historical costs, but market value per share is a forward-looking measure that takes into account the firm’s future earnings strength. With increases in the company’s estimated profitability, projected growth, and soundness of its business, the market value per share grows higher. Material differences arise between the book value per share and the market value per share due to the ways in which accounting principles classify certain transactions.
For example, consider a company’s brand value, which was created through a series of marketing campaigns. US Generally Accepted Accounting Principles (GAAP) require marketing costs to be spent promptly, which reduces the book value per share.1 However, if the advertising efforts enhance the company’s product image, the company can charge premium rates and create brand value. Market demand may lead to an increase in the share price, which creates a large discrepancy between the market and the book values per share.
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The difference between book value of common stock and net asset value (NAV)
Whereas, BVPS considers the residual equity per share of the company’s shares, net asset value, or NAV, to be the value per share computed for a mutual fund, exchange-traded fund, or ETF. For any of these investments, the net asset value is calculated by dividing the total value of all fund securities by the total number of fund shares outstanding. NAV is created daily for mutual funds. A number of analysts consider total annual return to be a better and more accurate measure of mutual fund performance, but net asset value is still used as an easy-to-use interim valuation tool.
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BVPS limits
Because the book value per share only takes into account book value, it fails to incorporate other intangible factors that may increase the market value of the company’s shares, even upon liquidation. For example, high-tech banks or software companies often have very little tangible assets in relation to their intellectual property and human capital (workforce). These intangible assets will not always be taken into account in the book value calculation.
Understanding Fundamentals
In business and economics, fundamentals represent the primary characteristics and financial data necessary to determine the stability and health of an asset. This data can include macroeconomic, or large-scale factors, and microeconomic, or small-scale factors to set a value on securities or businesses.
Analysts and investors examine these fundamentals to develop an estimate as to whether the underlying asset is considered a worthwhile investment, and if there is fair valuation in the market. For businesses, information such as profitability, revenue, assets, liabilities, and growth potential are considered fundamentals. Through the use of fundamental analysis, you may calculate a company’s financial ratios to determine the feasibility of the investment.
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While fundamentals are most often considered factors that relate to particular businesses or securities, national economies, and their currencies also have a set of fundamentals that can be analyzed. For example, interest rates, gross domestic product (GDP) growth, trade balance surplus/deficits, and inflation levels are some factors that are considered to be fundamentals of a nation’s value.
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Macroeconomic and Microeconomic Fundamentals
Macroeconomic fundamentals are topics that affect an economy at-large, including statistics regarding unemployment, supply and demand, growth, and inflation, as well as considerations for monetary or fiscal policy and international trade. These categories can be applied to the analysis of a large-scale economy as a whole or can be related to individual business activity to make changes based on macroeconomic influences. Large scale, macroeconomic fundamentals are also part of the top-down analysis of individual companies.
Microeconomic fundamentals focus on the activities within smaller segments of the economy, such as a particular market or sector. This small-scale focus can include issues of supply and demand within the specified segment, labor, and both consumer and firm theories. Consumer theory investigates how people spend within their particular budget restraints. The theory of the firm states that a business exists and makes decisions to earn profits.
Fundamentals in Business
By looking at the economics of a business, including the overall management and the financial statements, investors are looking at a company’s fundamentals. Not only do these data points show the health of the business, but they also indicate the probability of further growth. A company with little debt and sufficient cash is considered to have strong fundamentals.
Strong fundamentals suggest that a business has a viable framework or financial structure. Conversely, those with weak fundamentals may have issues in the areas of debt obligation management, cost control, or overall organizational management. A business with strong fundamentals may be more likely to survive adverse events, like economic recessions or depressions, than one with weaker fundamentals. Also, strength may indicate less risk should an investor consider purchasing securities associated with the businesses mentioned.
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Fundamental Analysis
Investors and financial analysts are interested in evaluating the fundamentals of a company to compare its economic position relative to its industry peers, to the broader market, or to itself over time. Fundamental analysis involves digging deep into a company’s financial statements to extract its profit and growth potential, relative riskiness, and to ultimately decide if its shares are over, under, or fairly valued in the market.
Often fundamental analysis involves computing and analyzing ratios to make apples-to-apples comparisons. Some common fundamental analysis ratios are listed below.
The debt-to-equity ratio (DE) measures how a company is financing its operations.
The quick ratio measures the company’s ability to meet its short-term obligations.
The degree of financial leverage (DFL) measures the stability or volatility of the earnings per share (EPS).
The price-to-earnings (P/E) ratio compares investment to earnings dollars.
The DuPont analysis looks at return on equity (ROE) by looking at asset use efficiency, operating efficiency, and financial leverage.
Fundamental analysis should be carried out with a holistic approach, utilizing several ratios and including a bottom-up as well as a top-down analysis to come to specific conclusions and actions.
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Real World Example
In the fourth quarter of 2018, according to Market Watch, large-cap tech companies Microsoft and Apple had similar market caps for the first time since 2010. Although the two companies had similar market caps of about $850 billion, they had very different fundamentals. For example, Microsoft was trading at 45X earnings while Apple was trading at 15X earnings.1