An introduction to stock research

A week or two ago, I found myself in JCube, the Jurong East mall that had suffered in the past year because of competition from nearby malls.

JCube is notable for its ice-skating rink on the third floor and cinema on its fourth floor. Apart from these two places, the two floors are usually quiet. Shops that opened there have come and gone.

Yet one on the fourth floor stood out. I noticed long queues by the Kentucky Fried Chicken (KFC) outlet. They, obviously, didn't have a problem with visitors.

I wasn't planning to do research on KFC, but seeing those lines piqued my interest. As it happens, a month ago, I wrote about Yum! Brands, the US-listed company that owns Pizza Hut, KFC and Taco Bell.

Beginner investors are better off looking at stocks like Yum with an established international presence, brand name and business model, rather than small and medium-sized enterprises (SMEs) more vulnerable to sentiment swings, the article said.

I found myself wondering if Yum is more profitable than the average restaurant.

We will use Yum as an example in this iteration of our annual series of articles on financial statements and investing.

Today, we will discuss the process of stock-picking and doing basic research.

A starting point: Large-cap

The process of figuring out what to invest in can be very arbitrary.

Most investors just go by what they hear or read. They look at some indicators, and decide whether to buy. Some even skip the indicators and assessment part and go straight to the buying.

This is a shame, especially in a world with easily accessible information.

Ideally, investors should think about their approach to investing and how rigorous the process is.

Which industry sectors do they prefer? Which geographies? What kind of currency and market risk are they willing to take? What size should the companies be?

Some of these questions can be more easily answered than others.

For example, as a beginner investor, I might feel safer investing in large-capitalisation, or large-cap companies. This term commonly refers to companies that are valued by the market to be above US$10 billion.

These companies tend to be international businesses which have been around for decades. Many are extremely strong financially and are at very little risk of collapsing even when a global financial crisis or global economic downturn hits.

While not all large-cap businesses possess substantial multinational operations and happen to be financially strong, the opposite generally applies: these kinds of stable businesses tend to be large-cap.

So we use "large-cap" as a starting point. It's far easier to screen for companies using quantitative rather than qualitative criteria.

Currently, in Singapore, there are only 10 companies that might fit the large-cap bill according to our strict definition: Singtel, the three banks, the Jardine-related stocks, Wilmar International and Thai Beverage.

In the US, there are some 470, as at last Wednesday. Yum is one of them.

Thus, a Singapore-based beginner investor who wants to invest only in large-cap stocks might also want to look at US stocks to get more choice, provided he or she is willing to take the risk of holding US dollars which should not be underestimated.

Top-down versus bottom-up

You need to think about what sectors you are comfortable investing in. This ties into strategy and risk tolerance.

If you want to sleep soundly at night, you might want to avoid commodity-related stocks. This is because commodity prices are notoriously volatile. The fate of your investment could be held hostage to the actions taken by speculators and traders.

Every sector has a different set of risks. Based on your investment or professional experience, you might want to decide which sector you are comfortable with. Or you might want to diversify. An investment banker might not want to buy financial stocks even though he is well-versed in them, as a market crash might affect both his career and his stocks.

Whatever you do, you are slicing and dicing the universe of the some-70,000 unique listed companies out there into smaller, digestible pieces.

What makes investing fascinating is that there are innumerable ways of deciding what works for you, and no easy answer on what works. Broadly speaking, there are two methods of getting to individual stocks: Top-down versus bottom-up.

Both methods might lead to the same endgame, which is to pick stocks that are likely to offer superior returns based on an investment thesis.

The top-down method refers to starting from the macroeconomic or industry level before narrowing down to a group of promising individual stocks, without necessarily examining every single stock.

For example, you can take a view that low interest rates are likely to benefit property stocks over other types of stocks such as, say, banks. The hypothesis is the cost of borrowing to build large buildings has come down significantly, which benefits borrowers but hurts lenders. At the same time, low risk-free rates generally boost asset valuations.

So you have determined property stocks are likely to do well. Then you try to identify the best such stocks in the world - performing a bottom-up analysis on each of them - and then invest in a few given the right valuation.

Or you might just want to invest in a fund holding on to a diversified mix of property plays, meaning that your initial top-down analysis will be enough.

Another top-down strategy could start from you compiling statistics on which industries have the highest revenue growth rates, and investing in those, presumably because your top-down analysis finds that industries that grow fast offer superior stock returns.

In examining industries, you will need to understand the competitive trends shaping them, what draws new customers, what keeps costs low or causes them to rise, and what technological or regulatory developments would shape the profitability of industry players up ahead.

The bottom-up search

Bottom-up stockpicking is used loosely by analysts to just mean analysing individual stocks carefully.

In essence, you go through the financials, arrange to meet key managers, check in on consumers and suppliers, all to try to understand the company better.

Then you project the company's earnings and come up with a valuation. You compare the company's valuation with what is being offered by the market, and initiate a position if the market value falls below your own idea of what the company is worth.

However, bottom-up stockpicking can also refer to the idea that stocks with certain kinds of characteristics will outperform regardless of the macroeconomic environment.

You get a taste of this when the fund you've invested in is down, and the fund manager shrugs, pointing out that his "superior bottom-up stockpicking approach" will pay off in the long run.

The classic stock arrived at through bottom-up stockpicking has high earnings growth, strong free cash flow and low debt.

For at least 20 years, funds around the world have been trying to exploit the returns offered by stocks with certain bottom-up characteristics.

One famous study on US stocks published in the early 1990s found that stocks with low price-to-book ratios, and smaller-cap stocks, could get investors additional returns over time. The model developed from there was known as the Fama-French three factor model.

Following the study, other "factors" have been identified as researchers sought to figure out whether any other characteristics could result in higher returns.

For example, an investor practising this "factor investing" might pull up lists of:

  • value stocks, which are stocks typically trading at low earnings or price- to-book ratios;
  • quality stocks, which are stocks that offer high profitability, return on equity or return on capital ratios;
  • small-cap stocks, which are essentially small and medium enterprises (SMEs) under-researched by the analyst community, and are more illiquid, but with the potential for higher returns should funds take notice; low-volatility stocks, which are so-called "low-beta" stocks that historically do not move as much as the broad market;
  • momentum stocks, which are stocks that have outperformed the market recently and might continue that outperformance. You can start with a top-down question and end up with a bottom-up screen.

For example, you might predict a macroeconomic environment with volatile currency and commodity price swings, a top-down view. Which stocks will do well?

It might very well be low-volatility stocks, possibly because investors appreciate the stability of the earnings stream that they offer.

Then you go through stocks with these low-volatility characteristics and decide, after analysing each and every one of them, which are more cheaply valued that you can buy.

Sounds like a lot of work? It certainly is!

Ultimately, to be serious about investing requires a lot of reading and information-processing.

After all, you are up against the entire asset management industry, and whole teams of analysts hired to perform the abovementioned top-down and bottom-up analyses.

But one edge you have is that you are not beholden to panicked investors demanding that you sell at a low.

Hopefully, you can take a longer-term view.

Being small also has the advantage of being nimble. If you decide that a stock is worth buying, you can buy it immediately, instead of having to go through a committee or a decision-making chain.

In the large-cap world, the retail investor also has a small edge in the sense that the trades you make are not likely to move prices.

We will discuss financial statements in the next article, embarking on a little bottom-up analysis of Yum.

This article was first published on March 14, 2016.
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