Thursday, February 21, 2008

How To Make Money In Stocks Part 1: Back to the Basics 5 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
An idea for this series of articles (this will probably be a long one) came from a few readers who wrote to me asking about the exact issue described by the title. I thought it might be useful to do a few writeups on some general strategies to employ. No gaurantees of course.

Each of these strategies, like so many other things in life, would work when executed well but might fail when improperly done. Also, they might be mutually conflicting, so it's important to keep an open mind. For example, I can tell you trade aggressively in one article, and to be patient for value to emerge in another article. It can be confusing; the right thing to do often comes from experience and gut instinct, and the worst thing is to be paralysed by confusion like a deer in the headlights. Indeed, what I often do is to mix-and-match, but always keeping an eye on the balance between fundamentals, sentiment and valuation, as well as constantly scouring for alternative better stocks to plough into.

The title is similar to that of William O'Neill's book; however I can think of no other way to name it. I cannot profess to have made copious amounts of money off stocks but a crystallisation of my experiences and philosophies over the years would nonetheless be useful for future reference.

It is no coincidence that the first strategy is titled Back To The Basics. So many books have been written on this, that I shall not elaborate on how fundamentals drive share prices, how earnings are all-important, etc etc. Everybody probably knows this to death, thanks to Warren Buffett's real-life example.

But really, everybody knows this, how many people practise this? There are many who simply give up on interpreting the fundamentals and understanding industry dynamics, the demand and supply balance (or lack of), the competition, the company financial specifics ---- and resort to price-volume charts exclusively to predict the future. I have never said charts are completely useless --- after all a perspective of price history and buying interest is given by charts --- but technicals without fundamentals forms an incomplete framework for decision-making.

Understanding the fundamentals is actually not that difficult. If one is prepared to focus on the fundamentals, he can already cut down a lot of time diverted to learning chart-reading, for example. The key thing is making the most of your limited time doing something that really can make a difference to your investing effectiveness. And the key thing to fundamentals is understanding the industry, from upstream to downstream, the entire value chain, and where your particular company lies along the value chain, what chance does it have of maintaining its niche or competitiveness vis-a-vis competitors through good times and bad. Find the one or two indicators that best characterise the company's performance. For example, for palm oil stocks, it will be palm oil prices; for hotels, it will be tourism growth and REVPAR growth (read it up); for upstream oil stocks, it will be oil prices; for refining stocks, it will be refining margins; for shipbuilding stocks, it will be steel prices. If one gets the understanding and the indicators-to-watch part right, he'll be halfway done on the fundamentals aspect already, without having to labour through the financials which should take care of themselves (though it'll be good to analyse them too).

Back to the basics also means an understanding of what a share actually means to the holder. A piece of the business, yes, but the key thing is: what does it actually mean? What good is a share unless it brings one tangible benefits, which means tangible cashflow, which means dividends or other distributions. Going back to basics means understanding the valuation models of a stock, which always stresses dividends or cashflow. Assessing the sustainability and growth potential of this cashflow, together with the willingness of the majority owners to share this with the minority holders, is what investing is all about. Based on this, one can actually already filter down to a useful list of stocks that can commit to growing and paying out good dividends.

The key reason why mastering the basics is so important is that it provides a margin of safety. This is not the margin of safety as defined by Ben Graham; rather, it is the conviction and patience that an understanding of the business imparts to the investor. He can not only be relatively insulated from price volatility so long as he knows the core business is intact, but more importantly, he will know what to look out for if he suspects the price volatility indicates an underlying decay in fundamentals. He can then take active action to track and possibly exit the stock. Forming investment decisions based on price movements without fundamentals understanding is like driving a car watching the traffic ahead of oneself but without a map of the neighbourhood or any idea of his final destination.

The thing about fundamentals is: it can be very difficult to pick up from a standing start. There are many things in life that are difficult to do, and yet worth doing. For a start, read all the IPO prospectuses you can find on various industries for their description of the business and the industry. Read all the business magazines you can get your hands on. Find some books that actually discuss dynamics of various industries (eg. "The Five Rules for Successful Stock Investing"). That would take some dedication but at the end of the day it is something nobody can take away from you, and it becomes your competitive advantage. It is also the reason why I am willing to share so much of my experiences with readers while knowing that it is difficult to replicate all this knowledge in them without them putting a lot of hard work themselves in building up their own mental frameworks.




Blogger Derek said...

Hi Daniel,

I couldn't agree with you more. The mind can be easily influenced. Hence it is important to first decide what you want and then develop your strategy.


2/23/2008 7:25 AM  
Anonymous Anonymous said...


It's always refreshing to read your blog each time there's an update. Wish you update it more often... sorry to make you sweat!

By the way, what's REVPAR?


2/24/2008 12:52 AM  
Blogger DanielXX said...

Hi Derek & Anon:
Understanding how the professionals think will add to your trading/investment advantage!

To Anon: REVPAR is a performance metric to measure average revenue per hotel room. See my writeup on this:

3/01/2008 3:12 AM  
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