Stock Research Checklist – Business Characteristics

Are you able to understand the Business Thoroughly? Is it a Simple Business?

What are the company products? How does the company generate revenue? How is the company market its goods and services? What is the competitive landscape of the business? Do you understand the business life cycle?

Companies that are involved in simple type of business tend to perform better in the long run. Business in the high tech industries where product life cycles are short, if they do not innovate the next product before end of its current cycle, it risk compromising its revenue and earnings.

We mentioned previously about business moat, there are two different types of businesses, one is difficult to replicate and other is a commodity type business. Hard to replicate business will have strong brand name, patents, and asset intensive which gives a competitive advantage. Commodity type business produce products with no difference from competitors's products. Commodity type business needs to be the lowest cost producer to fight the price war and it needs to be the largest size to demand best rates from its suppliers and distributors to compete on prices.

A non exciting industry can enjoy higher margin as lesser competition enters the arena and the company is able to build its market share over time, creating a moat to fend off later entrants. Not many entrepreneurs will like to enter non exciting industry. Young people like to run tech start ups rather than engage on a lumber business which can enjoy high margin.

Dirty type of business will not have new competitors entering the market will enjoy strong margin. For instance, waste management, cleaning services, and funeral business.

If the business has a chain of companies, is it successful in multiple locations before expanding nationally? IF you get into any of the successful chains in an initial period and hold the shares until they open for business across the nation, you can make tremendous amount of money. These types of national chain companies are available in retail companies.

Invest now

Invest Now

Most people wait until they are in their thirties, forties and fifties to start saving money. They realise that they are not getting any younger and will require additional money for retirement. The trouble is, by the time they realise they ought to be investing, they have lost valuable years when stocks could have helped them with their goals. Their money will have accumulated over the years through investing.

Instead, they spend what they have as if there is no tomorrow. Many expenses are inevitable, you name it, children to support, aging parents to support, doctor bills, enrichment fees for the children, insurance bills, household expenses, etc. If there is nothing much left over, there is not much they can do about it. But often enough, there is something left and they are not using them to invest. They use it to pay for fancy restaurants dinner and drinks or make the down payment on the fanciful car in the showroom.

Before they know it, they are heading into the sunset with pennies in their pockets. They have to squeeze themselves into a tight budget at the time they are supposed to enjoy life.

One of the best ways to avoid this fate is to begin saving money as early as possible, while you are living at home. When else are your expenses going to be this low? You have no children to feed and your parents are probably feeding you. If they don't make you pay the rent, so much the better, because if you have got a job you can sink the proceeds into investments that will pay off in the future.

Whether it is ten dollars a month, one hundred dollars a month or five hundred dollars a month, save whatever amount you can afford, on a regular basis.

We hope that young people will not fall into familiar trap of buying an expensive car. As soon as they land the first stable job, they become slaves to the car payments. A car robs you of free cash flow for investment, you will need to incur interest charges, road tax and fees (ERP in Singapore), insurance premiums, petrol and maintenance. So do not be deceived by the face value of the car at the showroom, there is alot of hidden cost and opportunity cost. For illustration, base on 2016 Singapore context, if you buy a car (say Toyota cost $100,000 with COE) for the next 10 years, you will have incur a total of approximate $160,000 for all miscellaneous cost mentioned earlier. Assume there is no scrap value here. $160,000 invested over the ten years, assuming $16,000 per annum with 5% (conservative) yield will amount to a considerable sum of money! Unless you can use the car to make money, then it will be a different consideration. We are looking at the numbers and not considering the intangible benefits which you derive from owning a car.

Putting Your Money to Work

Money is a great friend, once you send it off to work, it puts extra cash into your pocket without your having to lift a finger. If you invest $500 a year in stocks, the money gets a chance to do you a big favour while you are living your life. On average, you will double your money every seven to eight years if you leave it in stock. A lot of smart investors have learned to take advantage of this and they realize their capital is as important as their own labour.

If you start saving and investing early enough, you will get to a point where your money is supporting you. This is what most people hope for a chance to have financial independence where they are free to go places and do what they want, while their money stays home and goes to work. But it will never happen unless you get in the habit of saving and investing and putting aside a certain amount every month, at a young age.

The A-plus situation is when you are saving and investing a portion of your paycheck. The C-minus situation is when you are spending the whole thing. The F situation is where you are ringing up charges on your credit cards and running up a tab. Then that happens you are paying interest to somebody else, usually a credit card company. Instead of your money making money, the company's money is making money on you. The credit card companies love it when you buy things with the card and don't pay the entire bill straight away. They charge you a high interest as much as 24% which gives them a better return from your pocket then they could ever expect to get from the stock market. In other words, to a credit card company, you are a better investment than a stock.

People are buying things when they don't have the cash to pay. Instant gratification, and shoppers pay a high price. They read the ads and go into different websites to find the best deal for a new toy (TV, shoes, watches, bags, etc) to save themselves a few bucks then charge it on credit card, when may end up costing them an extra few hundred. They do so willingly without thinking about it.

In the past, people felt great pride when they worked hard and made certain sacrifices in order to pay for something all at once. Don't allow yourself to get into the F situation. It is ok to pay interest on a house which may increase in price but not on cars, appliances, clothes or bags which are worth less and less as you use them.

Moats in Investing

Keeping Competitors Out

Warren Buffett says," A truly great business must have an enduring "moat" that protects excellent returns on invested capital.

A company needs to do something very well in order to grow their business profitably. A moat protects a business from its competitors. It is a durable competitive advantage which keeps competitors away from the company's customers. Pat Dorsey who used to head the Morningstar is a firm advocate of moat, he feels that it is better to pay more for something which is more durable from appliances to cars to houses, items which last longer will be more expensive. The same theory applies to stock investing.

Branding

Branding is one of the most important aspects of any business, large or small, retail or B2B. An effective brand strategy gives you a major edge in increasingly competitive markets. Branding helps to build mind shares in consumers which is defined as the amount of space the company occupies in customers' minds. Tiffany has a moat. People pay alot for the box when the jewelry will be cheaper somewhere else. Coca Cola has a strong branding, the brand value in 2015 is said to be worth $83.84 billion.

Cost a lot to switch

There is not much of a competitive advantage bank has over others, their products are similar. With internet banking, branch locations has lesser impact than before. However, consumers tend to stay with one bank for average six to seven years as it is troublesome to change banks. When switching cost is high, there is a moat. Previously, iphone users would not use android phones as it was difficult to copy their contact list over to other phone and the apps are different. That was a moat. However, with more intelligent phones entering the market, the moat of iphone is slowing eroded.

Network Effects

The more users of the product, the more they will enjoy the network effects. Think Facebook, Twitter and Youtube. It is very difficult for competitors to penetrate a network moat.

Low Cost Producers & Sheer Size

Walmart has a moat. With economies of scale, Walmart can sell its products cheaper than competitors, ask for longer credit terms from suppliers which improves the cashflow while getting paid immediately from the customers. Larger companies can cement their advantages and sustain returns for longer by been more efficient in SG&A than smaller companies.

Erosion of moat

Moat is not permanent, competitors will figure out a way to acquire market shares and erode the competitive advantage. Industry stability is another factor in determining the durability of the moat. Stable industries can create sustainable value creation whereas unstable industries present substantial competitive challenges and opportunities.

Conclusion

You need to look for companies with consistent strong growth of net profit margin, this will indicate that the company has a moat. Then you need to consider what sort of competitive advantage it has and how its competitors can erode this. You can also consider the entire supply chain and where the profits flow to. This will reinforce whether the company has true moat.

Low Interest Rates Dilemma

Low interest rates will create a dilemma. Will you accept a low return in order to protect your principal? Will you take on higher risk to achieve higher return?

Pay attention to costs

In a low interest environment, investing expenses will have a larger impact in eroding your gain. For example, a mutual fund with an expense ratio of 1% of net asset value each year which uses the expense for marketing and paying the employees. This 1% will have a big bite into your return if your return is only 3% than if the return is at 10%. At 10% of return, it is only 1% of your gain. At 3%, a third of your return goes to expenses. Prior to investing in a mutual fund, consider all fees and expenses as well as its risks which will be highlighted in the fund prospectus. Digest the fund prospectus because it is your money.

Real Return

If inflation is low, even when you are earning based on low interest rate, your real return will not suffer. Real return is what your money earns after taking inflation into account. Based on 2015 Singapore's inflation rate which is exceptionally low, the real return should produce the same return during high inflation years.

Own dividend paying stocks

You should not just buy highest yielding stocks for dividends alone because high yield stocks will have a certain level of risk. However, as part of portfolio management, you need to have some defenders which we will recommend the blue chip stocks with a yield of 4% and above.

Buy high-yield debt

High yield debt is also known as "junk" bonds. There is a reason why they are called junk because you are buying debts of companies which are on the brink of insolvency or with credit issues. You need a high return to justify for the high risk and bet that the companies can survive long enough to pay back your principal. Alternatively, you can consider owning a slice of this junk bond market through an ETF can serve good way to increase your dividend yield as part of your overall investment portfolio.

Invest in foreign stocks and bonds

Foreign companies and governments present the same credit issues and challenges. You need to analyse before parting your money. Speak to us if you require assistance to construct a suitable portfolio based on your risk appetite. All investing strategy will require you to measure your ability to suffer loss in a downturn. You need to question what are the factors which can blindside your judgement, taking into consideration low interest rates and rising inflation.

What should I do when the stock price drops?

What should I do when the stock price drops by 30%?

Knowledge is a very powerful tool. Investing requires knowledge and familiarity of the companies that you choose to plough your hard earned money into. This may be a good reason not to own too many stocks but invest within your circle of competence. You need to have a diversified portfolio but not beyond what you can handle.  For instance, I am visiting Breadtalk during breakfast, lunch and dinner to observe the crowd, the service level and menu. I will try to understand the price level and when they will increase price and give promotions to drive sales. You need to understand the companies you want to invest in thoroughly and its external factors such as competition and macro factors.

Know nothing about the company

I was having this chat with my mum this morning and questioned her why she bought InnoPac. I glanced through the Annual Report which was mailed to the house and immediately threw it aside. My mum explained back then there was a bull run and every single stocks had increased two to three folds and only this stock was like a few cents. Then they put their money into it and never see it grow past their initial investment. When I asked her what does the company do? What was the business behind the company? She just shrugged. Cheap does not mean the stock is good. My friend's girlfriend asked me whether she should buy penny stocks. I said," Unless you know the companies well, please don't throw away your money and buy ETF instead." As she is not into trading but want to invest thinking penny stocks are less pricey and can buy more of it with her monthly saving. I was burnt in the past with penny stocks and one of them was de-listed. It is in my portfolio to serve as a gentle reminder.

When the stock price is going up is not good enough reason to own the stock and keep it in the portfolio. Likewise, when the stock price is going down is not a reason to sell as well. In the short run, the market is a voting machine and in the long run, the market is a weighing machine. Firstly, you need to understand the business of the stock that you own.

Determine whether it is a good company

The company's success is related to the stock's price. It is imperative to focus on the long term and look at future earnings instead of historical earnings. You need to understand that profitable companies in today context may be future losers because new competitors will come into the market and erode their margin. Do you still remember Nokia handphone? It used to be very profitable until the smart phones came along. Apple replaced Nokia and dominate the market for a few good years. Apart from the business, you need to question what is the competitive advantage the company has over the competitors and whether the economic moat is deep and wide enough to fend off other competitors. With all these in mind, you just need to be patient and wait for the price to drop until it reaches a level with sufficient margin of safety. Then you just need to buy more of the company's shares. Margin of safety is important to protect you from unforeseen factors which blindsided your judgement.

Volatility in the market

Volatility is good for the market. After the meeting in Doha failed, the share price dropped and the very next day, the share price recovered. Stock market price movements are nothing to be concerned about. You should be happy when there is volatility in the market, especially when the stock price drops. Mr Market is presenting a discount to the price and it is a great opportunity to snap up this bargain.

Warren Buffett said: “Price fluctuations are there to provide opportunities to buy wisely when prices fall sharply. At other times you would do better to forget the market and pay attention to the operating results of companies."

You should not focus on the price but focus on the fundamental of the business. You should only sell the stock not when the price drops by 30% but when the company's business has deteriorated and it is an irreversible situation. You need to remember that you are a long term investor and not a short term trader. Seat back and collect dividend!

Cash Flow Statement

The Statement of Cash Flows

This statement shows the value created by the company based on how much cash generated year to year. This is the most important section of the financial statements. The cash flow statement strips away all the abstract, non cash items such as depreciation which you see on income statement and tells you how much actual cash the company has generated. The cash flow statement is divided into three portions: cash flows from operating activities, from investing activities and from financing activities.

1st Section - Cash flows from operating activities

Cash Flow from Operating Activities tells you how much cash the company generated from its business. This is the area to focus your attention on the cash generating power of business that we are most interested in.

Depreciation and Amortization

This is not a cash charge. So we need to add this back to net income.

Changes in Working Capital

If a company is owed more money by customers this year than it was last year, accounts receivable increase and cash flow decreases, if it owes more money to suppliers, accounts payable increase and so does cash flow. Finally if a firm pumps more money into inventory that does not sell, cash flow decreases. Inventory ties up capital.

One-Time Charges

This need to be added back when figuring cash flow (similar to depreciation, which is also noncash).

Net Cash Provided by Operating Activities

This is also known as operating cash flow, it is the result of adding or subtracting the previous items from net income. It doesn't replace net income but if you don't look at it in addition to net income, you are not getting the full picture.

2nd Section - Cash Flow from Investing Activities

This section involves acquiring or disposing PP&E, corporate acquisitions and any sales or purchases of investments.

Capital Expenditures

This figure represents money spent on items that last a long time such as PP&E, basically anything needed to keep the business running and growing at its current rate. Operating cash flow minus capital expenditures equals free cash flow, or the amount of cash the company generates after investing in its business.

Investments Proceeds

Companies often take some of their excess cash and invest it in bonds or stocks in an effort to get a better return than basic saving account. This number tells us how much money the company has made or lost on such investments.

Final Section - Cash Flow from Financing Activities

Financing activities include any transactions with the company's owners or creditors.

Dividends Paid

This is the money spent on dividend.

Issuance/Purchase of Common Stock

This is important number to look because it indicates how a company is financing its activities. Rapidly growing companies often issue large amount of new stocks which can dilute the value of existing shares but gives cash for expansion. Slower but more mature companies that generate a lot of free cash flow tend to buy back significant amounts of own stocks though companies that issue many stock options to their employees also buy back stock to minimize dilution. You need to be wary of companies that grant their employees with options and then spend corporate cash on repurchases are essentially selling shares to their employees at low prices and buying it back on the open market at much higher prices at the expense of shareholders.

Issuance/Repayments of Debt

This number tells you whether the company has borrowed money or repaid money it previously borrowed.

Income Statement

The Income Statement

The Income Statement explains how much money the company is making or losing.

Revenue

Revenue also known as sales is how much money the company has brought in during a quarter or a year. Larger companies sometimes break down revenues on the income statement according to business sector, geographic region or products versus services. You will need to understand how revenue is been recognized in the financial statements, companies can record revenues at different times depending on business they are in.

Cost of Sales

Otherwise known as Cost of Goods Sold, represents the expense involved in creating revenue such as labor costs, raw materials or whole price of goods. Large companies combine manufacturing with services sometimes break down this number into cost of goods sold and cost of services.

Gross Profit

It is not a number on Income Statement but can be derived by revenue minus cost of sales. Once you have gross profit, you can calculate gross margin which is gross profit as a percentage of revenue. A more differentiated product or services will have a higher gross margin than its competitors.

Selling, General, and Administrative Expenses (SG&A)

This is known as operating expenses which includes items such as marketing, administrative salaries and research & development. If you see a forecast in decrease in SG&A, the company may be reducing headcounts. To analyse efficiency of a firm, you can look at SG&A as a percentage of revenues, a lower percentage of operating expenses relative to sales mean a tighter and cost effectiveness. You need to compare the company with the nearest competitors.

Depreciation and Amortization

When a company buys an asset intended to last a long time, such as a new building or a piece of machinery, it charges a portion of the cost of that asset on its income statement over a series of years. It is always included in the cash flow statement, you can look there to see how much a company's net income was affected by non-cash charges such as depreciation.

Nonrecurring Charges/Gains

This is the area where companies put all one time charges or gains that is not the norm such as cost of closing a factory or gain from selling a business. It is preferred not to have this section in the Income Statement.

Operating Income

This number is equal to revenue minus cost of sales and all operating expenses. It represents the profit the company made from its actual operations, as opposed to interest income and one-time gains. Companies often include nonrecurring expenses in figuring operating income, and you have to add back one-time charges. Operating income excludes one time items as well as income from non-operational sources such as investments, you can use it calculate operating margin which is  comparable across companies and industries.

Interest Income/ Expense

Sometimes Interest Income and Interest Expense are listed separately and sometimes they are combined into net interest income. In either case, this number represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns. You can get some insight into the financial health of a firm by looking at its earnings before interest and taxes relative to its interest expense which is called an interest coverage ratio.

Net Income

This number represents company's profit after all expenses have been paid and it is the number most companies highlight in quarterly earnings. Net income can be distorted by one-time charges and investment income.

Number of Shares (Basic and Diluted)

This figure is the number of shares used in calculating earnings per share, it represents the average number of shares outstanding during the reporting period. Basic shares include only actual shares of the stock. Diluted shares include securities that could potentially be converted into shares of stock such as stock options and convertible bonds. Given the amount of granting of stock options that occurred over past years, it is the diluted number that you will want to look at because you want to know the degree to which your stake in the firm could potentially be shrunk or diluted if all those option holders converted their options into shares.

Earnings per Share (Basic and Diluted)

This number represents net income divided by number of shares. You need to look at cash flow and many other factors when considering EPS. This number does not represent all of the corporate financial performance.