Analyzing Companies

Just to drop some mental notes for reference.

When to use Price-Earnings (PE) ratio and when to use Price-Book (PB) ratio

Typically, use PB for banks, capital intensive, violatile, and cyclical industries. The rest PE will be more relevant. Of course, no harm looking at both, but need to know which is more relevant for the particular company.

Valuation

For conglomerates, use sum-of-the-parts valuation to get the fair value for the company.

Using the right tools

For range markets, use range tools like stochastic oscillator, RSI, bollinger bands.
For trend markets, use trending tools like MACD, moving averages, trendlines.

Indicators

VIX index to observe the volativity of the market.
M2 $ supply to observe the liquidity of the market.
Yield curve to observe the steepness of the curve (gradient) to observe the volativity of the market.

Stop Loss

Stop loss level should be adjusted only at significant price movements, else will end up activating the stop loss prematurely.

Other things to look out for

1. Insider trading transactions. Typically, if the management is buying in themselves, they are trying to signal that they are confident and bullish about their company.
2. Volume of the transactions. A low transaction stock could result in a liquity trap, whereby if you need to get back your $ fast, you will end up selling at a much lower price just to get a buyer.
3. Owners of the company. Find out about their style, whether they are here for the long haul (eg. GIC, Temasek, Capital Group), or out to make a quick buck.
4. Seasonality of the company stock. Some company stock tend to go up during certain months of the year. Most of the time it is the cyclical effect of their earnings, or the dividends.

Subtle stuff from Annual Reports

Some items from Annual Reports that are often passed over, but warrants some scrutiny.

1) Amount of tax that the company pays as a percentage of their earnings before tax
If the percentage is less than those typically levied by the country, do not be too happy and think that the company is good at managing their taxes! On the contrary, this could (not always, but could) be a tell-tale sign that the earnings reported in the Income Statement is overstated. Thus actual tax paid to the taxman is lesser. This info can be found in the Income Statement and Cashflow Statement.

2) Depreciation Policy
Look at how lax or conservative their depreciation policy is. For example, a conservative company may depreciate their plants over say, 10 years. While another company may depreciate it over 30 years. The one that depreciate over a longer period, may be able to report a higher earnings figures since the depreciation expenses are lower (spreaded over a longer period), even though both may have the same revenue and other cost expenses. This information can be found under the Financial Notes section of the Annual Report.

3) Financial Commitments and Obligations
These may include items like operating leases. For account purposes, if an event is deemed likely to happen, it will have to be accounted in the Balance Sheet. If an event is deemed 50%-50% of happening, then it will be reflected under the Financial Notes section of the Annual Report. However, sometimes a event that is bound to happen, such as a commitment for a long term lease which is not paid up yet, ends up in the financial notes. Such commitment has to be paid for eventually, and may rank in situ with a interest-free debt.

Useful Sites

Added a section on the right panel on useful sites that can help in analysing stocks. Do take a look.

I particularly like reuters. Create an account and set up your own dashboard. Create a watchlist of all the companies that you are interested in so that you can track their news easily.

What you need to know about Price Earning Ratio

The concept of Price Earning (PE) ratio should be pretty well-known by now. PE Ratio is the no. of times you are paying for every $1 that the company earns. For example, if Apple earns $10 per share, and the stock price is trading at $100, then the PE is simply 100/10 = 10. So you will be paying $10 for every $1 that Apply earns if you buy the stock now. From another perspective, it will take Apple 10 years to earn what you paid for the stock.

However, PE ratio, if not analyzed in the right context, will end up as a misleading number, and simply, just a number.

2 key scenario drives PE ratio.

I need a higher return NOW

why do i need a higher return now?

1) Inflation is going up. I need a higher return to offset the inflation loss in the value of $.
2) Tax is going up. Again, I need a higher return.
3) Risk of the company is high. High risk = high return expected.

In the above situations, I will only be willing to pay a lower PE, so that I will increase my chance of realising a higher return (think buy low sell high).

I can make do with a higher return in FUTURE

Again, why?

1) Return on Equity (ROE) of the company is high. Thus every $ re-invested by the company in terms of capital expenditure (thus lowering the earnings) should reap higher earnings in future.
2) Growth of the company is high. Again, I will be hoping for higher earnings in future.

In such situations, I will be willing to pay a higher PE now, so that I may get to enjoy higher earnings in future (think buy high sell higher).

Summary

Inflation up, PE should be lower
Tax up, PE should be lower
Risk up, PE should be lower

ROE up, PE can be higher
Growth up, PE can be higher

US banks continue to fail

From business times today.

No. of banks failed -
2009 to-date: 100
2008: 25
2003-2007: 10

When banks fail, other banks took over their accounts and customers. However, many a times the banks that took over will exercise greater caution towards the failed banks' customers, either refusing further credits, or make the loans more expensive.

This in turn, will result in a credit seize that we just experienced a few months back.

We can only hope that the credit seize had not been significant. Else, we will see more companies failing, and unemployment rate increasing. Not good at all.

Leverage & Degree of Thinking

If we can understand how much leverage a market has, we will have a better understanding of how the market will move given a pricing momentum.

A market could be leveraged in many ways - margin accounts, warrants, options, futures, CDOs, derivatives, etc. The more a market has of such vehicles, the more leveraged it is.

A higher leveraged market will have higher degree of thinking. Degree of thinking can simply be explained as how many iteration that you think the rest of the world will behave. Eg. If you think that the world will sell a particular stock at $10, you may want to sell at $9 to avoid getting caught in the selling frenzy. However, if you think that many people will come to this same conclusion, you may decide to sell at $8. Again, if you think that quite a number of people will come to this conclusion and sell at $8, you will probably sell at $7. The more cycles you think (and thus arrived at an ever smaller $ value), the higher the degree of thinking.

A sophisticated and matured market has a higher degree of thinking. Conversely, a developing or young market will likely have a lower degree of thinking.

Leverage, together with degree of thinking, could be the major explanation why the seemingly irrational behaviour that we had observed during this financial crissis, is actually rational.

When the prices started to come down, those leveraged players (eg margin players) would be pressured to sell (eg. margin call). Thus they will start selling to ease the pressure. Observers who see this selling, will predict that more margins will be triggered as the price comes down and thus conclude that more selling will be on the way, and they too, start selling. Thus selling begets selling and that is what we get in this financial crissis.

So what results in the reversal? Again, leverage (actually the lack of) and degree of thinking. As players become less leveraged, they will be more willing to take risk and even take up some leverage again. And as people started to think that the market will bottom, at say STI 800, the degree of thinking effect comes into play. Some will be willing to enter at a higher level, say 1000. Others coming to this conclusion (that people will be willing to enter at 1000), will start entering at 1200. And there you have it. Simple?

The tough part is getting a feel of how much leverage and degree of thinking is in the market...

Demand and Supply

Just attended a talk recently and was given this concept which I find interesting:
- Stocks behaving like luxury goods.

On top is a normal goods demand and supply curve.

On the bottom, I had drawn in the luxury goods demand curve. Recap economics 101, a luxury goods has higher demands at higher price, and when prices come down, people perceived it to be of lower-class and stop buying them, thus reducing demand.

Think about stocks like Wilmar. How fitting this luxury concept on such stocks. Most blue chips have this behaviour too.