Investment Analysis: Your Essential Guide
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Why bother with investment analysis when you can buy an index and just be done with it?
If vastly superior investment returns are not enough enticement, stop reading, abdicate responsibility, and stick to the index!
On the other hand, if you are looking to build wealth and provide for your family, sound security analysis is the way to go. We’re going to help get you started.
Investment analysis is simple but not easy. It can seem overwhelming and make you feel like giving up. But capitulating and giving your money to someone else to invest can cost you more than you'd expect.
Small individual investors can beat the market and even gifted professionals. Providing the right investment approach is taken, and you cover all your bases when researching a company, you can make a fortune.
What Is Investment Analysis?
Investment analysis refers to evaluating investments such as stocks, bonds, or even property. The process involves researching, evaluating, and understanding an investment opportunity or industry to determine its value, future performance, and suitability for purchase. Investment analysis is also often referred to as security analysis, or financial analysis.
"Investment analysis is the study of financial securities for the purpose of successful investing."- Investment Analysis, Gareth D. Myles
The reason for sound security analysis is straightforward: Investors need to understand what they are investing in otherwise it is mere speculation or gambling, like playing slots at the casino. Warren Buffett refers to this as “greater fool” investing, where you hope there’s a fool greater than you to buy the security at a higher price.
If you understand the investment, you're less likely to make an expensive mistake. Having a clear goal and a strategy for analyzing an investment is key to creating a sound portfolio and ultimately achieving great returns.
Types and Methods of Investment Analysis
There are two general paths that you can take to assess an investment: bottom-up analysis and top-down analysis.
What is Bottom-up Analysis?
A bottom-up approach to investment analysis focuses on the financial analysis of individual stocks to understand its potential. Such research would include understanding what the company does, its valuation, the management's competency, pricing power, competitive advantage, and any other relevant criteria.
Bottom-up research excludes focusing on economic cycles and takes a microeconomic view rather than a macro view of the economy. It starts with the details of lots of small pictures and works up to a conclusion.
Some big proponents of this bottom-up method of analysis are Warren Buffett and Benjamin Graham. And although Mr. Buffett does not report to find investments through a top-down view, he certainly keeps an eye on the broader economy's bigger picture.
What is Top-down Analysis?
A top-down approach starts with analyzing the broader economy, markets, and industry trends. This then allows the investor to narrow down investment opportunities that will benefit from the macroeconomy trends. It starts with the big picture and works down.
Fundamental Vs Technical Analysis
There are several different investment analysis methods that an investor can undertake. As the title suggests, these include fundamental and technical analysis.
What is Fundamental Analysis?
Similarly to bottom-up analysis, fundamental analysis focuses on the financial health of the company. Fundamental investors look to find stocks that have been mispriced by Mr. Market and are trading at less than their intrinsic value. Financial metrics such as P/E, ROIC, ROE, ROA, debt to equity, and current ratios identify the company's financial soundness. This analysis also allows for an assessment of the competency of management and competitive advantage of the business.
What is Technical Analysis?
A technical analyst seeks to evaluate patterns in stock prices using computerized charts and graphs. There is little interest in the intrinsic value of a stock or the company; it is more about using patterns of price movements, trading signals, and charting to find potential trading ideas. Technical analysis is like reading the signs in the clouds, be navigating by the stars, or the daily horoscopes.
Understanding Investment Analysis
The purpose of security analysis is to conclude the likelihood that the investment will perform positively or in line with your expectations. An excellent way to think of the investment analysis process is to behave like an investigative journalist.
Dig into the company background, use web-based satellites to look at company properties, read employee comments, speak to former workers, review the annual reports, and listen to the investor calls. Phil Fisher would call this process scuttlebutt, and it was fundamental to his success.
A simple way to conduct a fundamental analysis is to compare an investment's performance and fundamental metrics to a benchmark such as the S&P 500 or industry sector. If metrics such as ROIC and ROA are better than the benchmark, then the company appears to be of better quality.
Another key to consider is finding a fair price to purchase the stock, the time horizon for the investment, and the role the investment is to play in your portfolio. Buffett states that the ideal holding period of a company is forever. With this mindset, however, you may not be getting the best returns that are on offer. To build a fortune, as Buffett did, net-nets are the way to go but more on this later.
Investment Analysis Process
An investor needs to have a robust investment process. Undertaking a strong analysis of potential investments is how you will make your investing strategy effective, accurate, actionable, and repeatable.
A Comprehensive Fundamental Investment Analysis Will Include…
A full and comprehensive analysis can seem daunting, and that's because it is. You are unlikely to know everything about a company, and it can seem an inefficient use of time unless you have a systematic process. Many investors undertake it on the assumption that the more you know, the more you will earn. But knowing something about a company does not make it a good investment.
To assist, here is a basic fundamental investment analysis template:
Company Basics: Name, location, exchange listing, business description, key management, date founded. The company basics are easy to find within the 10k or company annual report. At this point, if you can't understand what the company does by reading the business description, it may be outside of your circle of competence. If this is the case, you can put this into the too hard pile and move on. While it is essential to expand your knowledge, the company might be too complicated, but that's part of the investing process.
Securities issued: All classes of common stock, number of shares of each, rights of each issue, buybacks & new issuance, whether the company is planning on issuing new shares in the future. This can be a great way to identify if management is shareholder orientated. Are they issuing shares when the company is undervalued, destroying shareholder value? This can indicate poor management and capital allocation practices, something to be mindful of.
Financial position: Debt to equity, current ratio, quick ratio, interest coverage, off-balance sheet liabilities, and fundamental solvency. Debt kills! Or, more specifically, too much debt and insolvencies can force a company into bankruptcy. It is vital to be confident of the company's financial position one way or another before investing.
Operating performance: Change in revenue, profit, and margins over a period of years. Also, what is the quality of earnings? What are the company's trends? Is the company stable and predictable? Or is it difficult to tell where the company is heading one year to the next? Depending on your investment style, predictability can be critical for future success. Understanding how the company makes money is a crucial element, or if they are not, why are they not? Are they reinvesting all earnings to help fund growth? Is this the right thing to do? Is the return on the invested capital covering the cost?
Business strategy: What niche does the firm hope to occupy, and how? Also, are there any competitive barriers that will allow for long term profits? Has the company changed its strategy recently? Has this been successful? Why the change? If not, is the business strategy working to increase shareholder value over time?
Industry/market outlook: Projections for the firm's industry and competitive pressures or innovations that would derail the business. Could the company withstand a global event or recession? If so, how?
Valuation: A fair value that a knowledgeable business person would place on the business. You can conduct such a valuation through a discounted cash flow model (DCF), earnings multiples, or net asset value assessment. Each method has its advantages and disadvantages, but the future is inherently uncertain. Conducting a valuation on the unknown where several assumptions have to be made can provide inaccuracies and false valuations; such is the dilemma of a DCF. Nonetheless, buying below the calculated intrinsic value of the business is essential. The price you pay matters in investing; while you can pay up for growth, doing so blindly can lead to poor returns.
Spending countless hours researching will not be an optimal use of time unless it's put to efficient service with a structured approach. It is still best to focus on the must-know rather than be all-knowing. Concentrate on the salient points will help reduce your error rate and time spent.
A Radically Simplified Approach to Good Analysis
If the above sounds like a lot of work, that’s because it is. There’s a reason why professional analysts are hired to produce good investment assessments. It’s both time consuming and takes a substantial amount of work.
The small investor is better off leveraging their small portfolio size, and adopting one of a handful of strategies that can be done part time at home in their den, and produce great results. These are often referred to as mechanical investing strategies, and the particular strategy that we’ve opted for is known as net net stock investing.
Mechanical strategies allow you to give up a significant amount of the detailed research listed above in favour of focusing on a handful of criteria, and broad diversification. An individual working on a mechanical strategy from home can cut down on roughly half of the work needed to produce a solid piece of research. Of course, it’s always great to get help to reduce your workload even more.
One way to do this is through a community and research platform such a Net Net Hunter. By joining Net Net Hunter, you get direct access to a significant amount of information gathered on how to invest using a net net strategy - which was Benjamin Graham's favorite strategy. You also get high-quality stock research, shortlists of the best net net stock opportunities, access to our Inner Circle Community Forum, Inner Circle Advice emails, our Inner Circle Newsletter, and our Inner Circle Resource Center.
While knowledge is a key necessity, the Shortlist and community interaction of any platform really helps you cut down on the amount of work you need to do. A shortlist is a pool of stocks arrived at by painstakingly filtering out poor quality candidates so members can focus their time on the best options available. Rather than comb through 1000 net net stocks by hand each month, this work is done for members so that they are presented with the best 40 or 50 to pick from.
But, the first step in the investment process is always to build your knowledge. By building proficiency over time, you can act decisively and with conviction when required. It is also essential to know that perfection is not needed and unlikely to be found. Sometimes it's best to make a decision even if it is not the "perfect" investment providing it meets your core investment criteria. A great place to start is the Net Net Hunter Core 7 Scorecard.
The Net Net Hunter Approach To Screening and Identifying Stocks For Analysis
Identifying investment opportunities is an essential part of the process. It plays a crucial role in achieving a profitable portfolio. With classic value investing such as net nets, it is critical to base the selections on well thought out factors.
The selection factors that have become the Net Net Hunter screen's backbone have been academically and practically validated to boost investment returns. Here we screen for the highest returning net net stocks.
Let us briefly run through the investing analysis criteria we use before then running through a real-world example. This will provide a good overview of how analysis works with mechanical investing.
For a mechanical approach to work, there must be a set of core criteria. Criteria which any potential investment must pass to be worthy of further analysis. Here we have an initially 7 must have qualities which are as follows:
- Not Chinese - Past frauds have occurred with Chinese Net Nets so are best avoided. We select companies with reliable financials so exclude Chinese companies or companies operating in China to avoid the increased possibility of fraud.
- Low Price to NCAV - The cheaper a stock is purchased, the better the returns potentially on offer.
- Low Debt-to-Equity - Debt can kill an investment, a company without any debt can’t go bankrupt.
- Adequate Past Earnings - A temporary event or setback that is able to be overcome is a must. We do not want a company that is just getting by, otherwise it may never become rerated. The goal is to buy companies that have had the ability to earn a decent profit in the past with the hope that it can do so again in the future.
- Past Price Above NCAV - If a company has not traded above its NCAV in recent history, it may stay that way indefinitely.
- Existing Operations or Liquidation - We avoid companies that don't have operating businesses to make sure we are buying a once profitable business to turn around. We exclude companies without operations or that have minimal sales
- Not Selling Shares - We don’t like companies that are selling shares below fair value since it signals that the company is desperate for cash due to operational weaknesses or management’s disregard for shareholders.
While a company must meet all of the above core criteria, the following ranking criteria are great to have. The more criteria the stock passes the stronger the investment case.
Quantitative Ranking Criteria
- Small Market Cap - Smaller firms outperform their larger counterparts. If large institutional investors can but don’t want to buy these companies, it's likely for good reason. The investment threshold is more than $1million but less than $100million.
- Large Current Ratio - A Large Current Ratio protects you from insolvency. The current ratio measures the ability of a company to cover its short-term liabilities with its current assets. By large we mean a ratio of at least 1.5x and above.
- Low Price to Net Cash - Net cash is simply cash and equivalents less all obligations prior to the common. Having net cash is always a positive since the value of cash is certain, strengthening the quality of assets on the firm’s balance sheet. Furthermore, cash gives the company operating and reinvestment flexibility.
Qualitative Ranking Criteria
- Financial/regulated/ADR/Real Estate/closed fund - Unless you understand this type of investment and they are within your circle of competence they are best avoided.
- Company is Buying Back Stock - Buying back stocks when cheap is a great sign of effective capital allocation and management. A further bonus is the increasing the NCAV per share.
- Burn Rate - If a company is burning through its NCAV it won't be long until there is nothing less of the company. A burn rate of less than - 25% annually is preferable.
- Catalyst - Ideally there will be an event or reason why shareholder value will soon be unlocked. If not an internal catalyst such as a new revenue on the horizon then an external one such as an activist investing alongside you will work.
- Insider Ownership - Skin in the game aligns management with the interests of the shareholders. Those responsible for the success of the company should have a major financial stake in the success of the company — having put their own money on the line shows their faith in the company.
- Major/Minor Insider Buys Vs. Sells - Insider buying signals that the management view the stock as being undervalued and as above, aligns the people running the company with shareholders. Be on the lookout for a token gesture of buying though. The share purchases should be significant in relation to the net worth of the purchaser. It is also important to keep an eye on insiders selling, they may be legitimate reasons for selling, buying a new house or paying for a divorce, but it could be a sign of trouble ahead.
If you want a more detailed discussion of some of these items, click to visit the NCAV Investment Scorecard.
Real-World Example of Investment Analysis
Let's run through an example of how to conduct an initial investment assessment. An exciting example found by the Net Net Hunter raw screen was Albemarle & Bond Holdings - a British company traded on the London Stock Exchange. Albemarle & Bond operated pawn shops in the UK. Its main business was gold.
The company's stock was cheap -- dirt cheap. As opposed to the minimum 1/3rd discount needed to consider the investment, Albemarle & Bond was priced at just 20% of NCAV -- a massive 80% discount to intrinsic value.
The company passed on 6 out of the 7 core criteria set out above but failed on the low debt to equity requirement. Albemarle & Bond had a debt to equity ratio of 70%, so they had significant debts. Firms should have little to no debt to be considered acceptable, with a debt to equity ratio under 25%.
If failing one of the core criteria was not enough, Albemarle & Bond failed almost all of the remaining key considerations. The company did not have a large current ratio, nor did it have a large amount of cash on hand, and the NCAV was eroding more than was comfortable.
Although, in some instances, it can be acceptable to provide a bit more flexibility when analyzing a company, it is essential to remember that the criteria are there to adhere to the only two rules in investing.
"Rule No. 1: Never lose money. Rule No. 2: Don't forget rule No. 1". - Warren Buffett, Adam Smith's Money World: How to Pick Stocks & Get Rich, PBS (1985).
As you may have anticipated, based upon our assessment above, things didn't work out well for Albemarle & Bond. Shortly after the initial analysis, the company filed for bankruptcy and practically wiped out its investors. The lesson here is simple, have an initial investment framework, and stick within the rules defined. Otherwise, you will end up breaking Warren Buffett's golden rule of investing.
The Bottom Line
Investment analysis is critical for the individual investor when assessing a potential investment. Without an investment process, you are likely just to be throwing a dart or picking random stocks based upon speculation or media hype.
You can undertake numerous types of analysis, but here a solid bottom-up fundamental approach is considered preferable. Using an investment assessment method can help you make a better and more educated decision, ultimately leading to a profitable portfolio. And, taking a mechanical approach can make things much easier.
If you’re a small private investor and want to start building your net net portfolio and investment process, it’d be worth your while to download Your Essential Guide to Net Net Investing, with more tips to stock your portfolio with the highest quality net nets worldwide.
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