My Investment Method

Active investing in the stock market involves the process of picking and analyzing companies. While it may be more time consuming than the passive method of investing, to me, the lessons learnt and joy derived far outweighs my time spent. Furthermore, being a retail investor, there is a chance to outperform the benchmark annualized return of 7%, and hence I have adopted active investing (in particular value investing).

From my investment journey and mistakes, I have adopted a framework of investment analysis which consists of two components - quantitative and qualitative. The quantitative factors are straightforward and involves the use of financial ratios which are taught in finance classes taught by schools or Investopdia. Some criteria to seek out undervalued companies are:

i) Low P/E ratio companies with positive cash flow generated

ii) Low P/B ratio companies - Companies with a low price to book ratio indicates there is a sufficient margin of safety when investing. For example, a company with a P/B ratio of 0.5 means that if you will be investing $0.50 for $1 worth of its reported assets. In addition, another ratio we will use is the Net Tangible ratio which is similar to the P/B ratio but eliminates intangible assets such as goodwill.

iii) Companies with dividend yield - While it is not a necessary requirement, it is good to have 

iv) Companies which do not have high level of debts (Debt to Asset ratio must be less than 0.6) - Personally I do not like companies which employ a large amount of debt to finance their operations. However, one listed company called "Starhub" is the exception to this rule.

v) Avoid companies whose controlling shareholder owns more than 50% and contributes more than 50% revenue or expense

Computing this financial ratios is easy and the information can be obtained online and computed on Excel. However that is not all there is to value investing. Financial ratios are only part of the story and mostly gauges the past performance of a company. When we invest, we are making a bet on the future worth of our investment and that is where the qualitative component of investing comes in - to peer into the crystal ball to see what the future holds.

Qualitative factors

Besides analyzing purely from numbers, it is important to judge what the future holds. This is where we have to make our own judgement if there is indeed a mispricing of the company. Lets consider an example. 

Company A is an oil company that has reported an earning of $1 per share for this year. It trades at $10 per at a P/E of 10. The P/E of 10 is the historical average price of Company A. However due to a sudden turn of event  that adversely affects the company's profits, the negative sentiments results in the sell down of share price. The table below illustrate the financial situation.

With company A now selling at a much lower P/E and P/B ratio, it seems Company A is now cheaper and is a bargain. However, we will have to ask if there is any justification behind the sell down of the share price. We will have to ask:

i) Will the earnings of Company A fall as much as the share price (20% reduction for this case)?

ii) Is this event only a temporary dent to the company's earning and how long will it take to return to its pre earning level of $1? 

iii) Is the company able to weather this bad episode with its balance sheet?

The above list of questions are not exhaustive and will differ for different companies due to the industries and business model they are in. In addition, a fall in share price price can be attributed to factors beyond the company's control such as a shift in government policy or acts of god (e.g. tightening of foreign labour quota or the 2011 Thai Flooding which affected car and hard disk manufacturers)

To summarize, while quantitative analysis is simple, the qualitative aspect of investment analysis is not. It requires a measurable amount of analysis, knowledge and time (less than a day to understand one company). This is so that one is adequately proficient to understand the company's operations  and make the decision to invest. 

Given that much analysis and financial knowledge is required on one's part to invest, it is tempting to stay out of the stock market. However, with the passion and interest to make one's money work harder, investing on your own can be fun. Besides that, you may discover interesting facts. Did you know: Giant, Cold Storage, Guardian and the 7-11 stores in Singapore are in fact operated under the same company called Dairy Farm Group?

Leave it to the experts 

For those who still feel investing on your own will take up too much time or have no interest to pursue it, do not worry. Moving forward, I will share how we can leave it to the experts to help achieve decent returns on the stock market.