When I brought up the idea of investing with my friends who don't work in the financial industry, they always assume that only professionals can make good investments because it is a "hard" thing to do. However, the reality is that making good investments, particularly in stocks market, does not require extensive data analysis or financial knowledge.
In this article I will introduce a brief framework and some simple tips to help you pick stocks. I hope this article will help you to start your stock investment journey.
Framework
Select Sectors
Look at the economic cycle
Cyclical sectors VS Defensive sectors
Use your experience
Check industry indices and think long-term
Select companies
Determine your investment style
Check important financial ratios
Rank companies and make decisions
LOOK AT THE ECONOMIC CYCLE
The global economy has been up and down throughout history and the cycle will continue. An economy cycle has five phases – recovery, early expansion, late expansion, slowdown, and recession.
When the economy is growing strongly, people often have more money and are willing to spend it. People might travel, buy new cars, and shop at luxury retailers. The aerospace and travel industries see profits rise during this time. But when the economy enters a recession phase, people tend to tighten their belts and give up those luxury stuff, but they still need to eat, drink, and maintain their healthcare. Therefore, during a bad time, the food and healthcare sectors won't be significantly impacted.
As a result, after identifying the economic stage we are in, we should categorise sectors into two groups: defensive and cyclical.
CYCLICAL SECTORS VS DEFENSIVE SECTORS
Cyclical sectors are likely to be affected by economic cycles, so they have higher volatility and are expected to produce higher returns during periods of economic strength. Defensive sectors are stable and held up well in downturns. Here’s a list of cyclical and defensive industries.
Since we are going through global recession, defensive sectors are safer choices to invest.
USE YOUR EXPERIENCE
Warren Buffett once said: “Don’t invest what you don’t understand.” If you are new to investing, it is best to use your experience and look into the industries you are familiar with. For example, if you are a restaurant manager, you are probably aware of the daily cash flows in the restaurant and the situation of your rivals and can therefore determine whether it is a good time to invest in the restaurant industry.
CHECK INDUSTRY INDICES AND THINK THE LONG-TERM TREND
Usually, I would pick 5 sectors and analyse their S&P indices annual returns for 10 years to understand the historical trends. In my upcoming posts, I'll go into more detail about trend analysis, but in general, I favour industries with steady growing trends.
Then, think about the long-term trend and anticipate future needs and changes. We can start with two big themes – technology and climate change. Will ChatGPT replace financial advisors in the future? Do we really need driverless cars? Will electric cars market continue growing?
DETERMINE YOUR INVESTMENT STYLE
First, you need to think about two questions. “Are you willing to take more risk?” “Are you able to take more risk?”
For me, I’m willing to take higher risk if I can get higher return and I’m able to, because I’m still very young and don't yet have to take care of kids or my parents. All I need to do is to make sure I have enough money to pay rents and essentials. I would therefore invest more in small-cap companies that have sustainable growth. However, if you hate risk, you should invest large-cap companies with great dividends.
After figuring out your risk appetite, you should focus on some specific ratios in companies’ financial reports.
CHECK IMPORTANT FINANCIAL RATIOS
Don't be afraid if you have no prior knowledge of fundamental analysis. All you have to do in this case is look at some ratios.
If you are a beginner, I suggest you start with low-risk stocks. I listed some important ratios that you should check before making decisions. (This is for beginners. Fundamental analysis is much more complicated than this, I'll write another article to discuss it.)
Companies with a low price-to-earnings ratio (P/E) are often considered to be value stocks. It means they are undervalued because their stock prices trade lower relative to their earnings.
Earnings per share (EPS) is a company's net profit divided by the number of common shares it has outstanding.
A higher EPS indicates greater value because investors will pay more for a company's shares if they think the company has higher profits relative to its share price.
A low debt-to-equity ratio means the equity of the company's shareholders is bigger, and it does not require any money to finance its business and operations for growth. In simple words, a company having more owned capital than borrowed capital generally has a low debt-to-equity ratio, which also means low risk.
The quick ratio is an indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term.
RANK COMPANIES AND MAKE DECISIONS
So far, we have already decided on the industries in which to invest. Now, we rank the companies in these sectors based on the financial ratios we looked at to pick stocks with solid fundamentals.
I hope this article is helpful, and I'll post my personal investment analysis on this blog, including equity and industry analysis. I also want to learn from you. Please contact me on blog or leave a comment if you want to discuss any investment ideas or analysis suggestions. Now, it’s time to pick stocks for yourself!!!
Very informative and simple to understand