In this article series by Karl Siegling, Cadence Capital Limited Managing Director and Portfolio Manager, we discuss several aspects of the investment process and how it actually works in practice.
The articles cover topics like market psychology and fundamental analysis, and they aim to provide the reader with a first-hand view of how financial theory stacks up in real world situations.
We encourage you to read this series and to visit our 54 Books To Read Before Buying Your First Stock, where you’ll find full-length titles we recommend as essential reading for interested investors.
Often in the investment industry we hear people say, “I am a fundamental investor” or “We only look at fundamentals”. This can be couched in many different ways, such as “We buy below fair value” and “We like to sell at fair value”. Such concepts at face value sound convincing. The one I especially like is, “We like to buy low and sell high”. It all sounds very logical.
More interesting, however, is what actually happens in a market when you involve a whole lot of animals, that is, human beings. Human beings experience emotions and often those emotions are stronger during periods of extreme share price movement.
In our previous article, Hope, fear and greed, we wrote about the extreme effects psychology can have on the share price of a stock and the market overall.
Once we accept that psychology can play a big role in the price of a stock we need to develop a way to deal with this fact.
For the purposes of this article, I am going to make the easy but fictitious assumption that using fundamental analysis, one can easily work out the value of a stock or the value that a stock should trade at over time.
This assumption makes the explanation of how to reconcile psychology and fundamentals easier to explain. In fact, calculating the value of a stock using fundamental analysis is very difficult, if not impossible.
Following on from our first two articles on investor behaviour and emotion, we briefly outline an oversimplified way of dealing with market and human behaviour.
We then dedicate a number of articles to how different investors actually arrive at “fundamental value,” “fair value,” “intrinsic value” and all the other methods or tools used that attempt to categorically arrive at a value for shares in any particular company.
After the first three articles on the behaviour and psychology of the market and stock investing, Karl Siegling looks at some of the traditional tools used by investors in assessing equity investments.
This is the first of our articles on fundamental analysis and we will focus on the price-to-earnings ratio (PE). The reason for focussing on this ratio first is that it is so widely quoted by the broking, investment banking and investment community.
Following our last article, 5 traps in using the PE metric, we are writing on possibly the second most misused ratio within the equities investment community — the dividend yield.
The Price to Earnings Growth (PEG) Ratio After having discussed the dangers of relying on a PE ratio and Dividend Yield, let’s turn to a number of ratios we do use frequently and pay more attention to.
We have discussed the psychology of the market, as well as a number of fundamental measures commonly used by the investment industry.This article discusses cash flow, which in our opinion, is the most important of all the fundamental measures. We will discuss operating cash flow and free cash flow separately.
We should start this by admitting from the outset that we can never do this topic justice in one article. Entire textbooks have been written on the topic — and even they miss large sections of important information.
It is fair to say that investors spend much more time looking at profit and loss statements than balance sheets, but that looking at balance sheets actually offers better insurance for finding potential problems within a business — these won’t necessarily be evident in a profit and loss statement.
Fundamental or technical research on a company that ignores the industry in which a company operates is like doing research “in a bubble”. As we always indicate in our presentations, we spend a lot of time visiting companies and visiting both listed and unlisted competitors in the industry sector.
History is littered with companies and sectors that at one stage would have been great investments but which wither, lose their way or become obsolete. Many people have dedicated their lives to trying to understand why some companies can adapt and be innovative while others cannot.
We spend a significant amount of time explaining to investors our process for entering and exiting investments. We call this process technical research.
The technical process for entering and exiting positions occurs once a stock has met our fundamental criteria and gives us a framework on how best to enter and exit a position.
Technical research is based largely on the “psychology of the market” or the “psychology of a particular stock”. The process is designed to eliminate as much emotion as possible from the investment process.
We’ve written extensively about how we deal with the psychology of markets. Whilst it is nearly universally accepted to buy cheap stocks and sell expensive stocks, this simple concept can prove difficult to implement.
We thought it might be useful to examine an example, Macquarie Group Limited (ASX: MQG), one of our larger positions, which was (at the time of writing) a fundamentally sound investment and combine this fundamental approach with the process we use to scale into and out of positions to ensure that we are adding to winning positions and reducing losing positions.