As an investor becomes more advanced, investment analysis becomes less of an exact science and more of an art. When looking at a possible investment, financial metrics sometimes contradict one another. A good investor will be able to know which factors to use in the analysis and which to discard. Often this leads to differing opinions on the investment as the facts used are at the discretion of the investor.
There are generally two schools of thought in investment analysis—fundamental and technical investing. Fundamental investing is analysis based on quantitative (profitability and earnings) and qualitative factors (brand, management team). Technical investing is conducting analysis based on behavior of the stock price. Fundamental investing is the more established and accepted investment approach in modern finance.
When conducting an analysis, it is essential to go beyond just the basic financials such as the P/E ratio or profitability. One needs to be aware of every single published metric on the asset as it is the more obscure ones that sometimes tell the real story. Some of the more quantitative metrics I use are the short ratio, analyst opinion, free cash flow and leverage.
Short ratio measures the amount of stock which is being sold short. The higher the short ratio, the more the public is betting for the company to fall—a warning sign for an investor. It is not to say admired companies have no one shorting them, it is common to see a 1-3% short ratio for healthy firms. Companies like Blackberry however, which is going through turmoil, is sitting at a significantly higher 12%.
The second metric—analyst opinion, is not used often enough. Research analysts are the experts in the industry for the sector they cover. Although an individual analyst can be wrong about a stock, it is ill-advised to go against the consensus opinion as their compensation is tied to how accurate they are. It is also important to pay attention to how the consensus opinion changes on an asset. If analysts are moving from a consensus “buy” towards “hold,” it is a clear warning signal for that investment and vice versa.
Cash positions are at the heart of good management and understanding them is a part of good investment strategy. Cash positions decide the flexibility of a company—whether it is flexibility for mergers with acquisitions (M&A) activity or allowing for increased capital expenditure. Companies with poor cash positions have no money for acquisitions or research and development (R&D). Companies in these positions tend to remain stagnant and are overtaken by firms with the resources to invest in the next big idea. Cash can also directly benefit investors in the form of dividends or stock buybacks.
Strong cash positions tend to go hand in hand with leverage, our final metric. Leverage is the amount of debt on a company’s balance sheet. High leverage is considered risky, but only to company’s who cannot support it. A sign of increased leverage, with the ability to support it, is a sign the company has increased appetite for risk—a good sign for investors. On the other hand, too much of it will eat up cash and is often a source of the debt spiral—issuing more long term debt to pay off the current debt.
Being a successful investor means knowing what not do as much as knowing what to do. There are many behaviors which plague fundamentally sound investors.
The first is holding onto stocks for too long. Often when stocks go up, investors who are holding those assets lose discipline in favor of greed. The thought process is “I will hold onto it for another day and make just a little more.” This thought process is irrational—greed should not control the investment process. For this reason, investors should set a price target for their investments in the event it goes up or down. Conversely, in the event an individual’s investment goes down, many times there is the hope that it will rebound and the losses will be recouped, when in fact the investor continues losing money. It is very difficult for an investor to admit they were wrong. In both cases the investment should be sold at the right time established at the beginning.
The second behavioral pitfall is hindsight bias. Hindsight bias occurs when an investor believes an investment to behave a certain way without a reason and if it turns out correct—retroactively applies. It as the reason for which the investment was originally made. Hindsight bias creates a false sense of confidence in inexperienced investors and when they finally decide to enter the stock market, they are not prepared for the reality.
Finally, a pitfall even seasoned investors fall into is not understanding the investment —whether it be the sector or the financial instrument itself. Option trading has become a very popular form of “high risk-high reward” investing. What they often forget is that the “quick buck” comes at the price of it being extremely risky—a swing of 90% of value is normal in option trading. Many have gone in expecting to replicate the results that top financiers enjoy, and have been overwhelmed because the financial instrument was beyond their understanding.
You will lose money in the stock market, everyone does. Inexperienced investors tend not to know why they make money and cannot control how much they lose. Creating a disciplined approach independent of emotions is the key to be successful. If you invest in companies you like or admire, that alone cannot be enough—the quantitative and qualitative factors have to support it. In contrast, experienced investors gain and lose money in a controlled manner—they are able to keep emotions out of it because they are work with facts. It is up to you whether you want to control the outcome or have it control you.
This article is the opinion of the author and is not shared by India Currents or any of its staff. All investors should conduct their independent analysis before taking any actions and should not make any decisions on the information provided in this article alone.
Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and is working in the technology industry as a financial analyst.