the art of stock picking

Naikaj P. Bhobe | Building Sciences, Real Estate, Equities | [email protected]

USC Graduate Series Week 2 speaker: Naikaj P. Bhobe ! !Topic: The Art of Stock Picking!Date: 29 January 2014

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mailto:[email protected]


1) Types of Stock picking analysis: 1. Fundamental Analysis:

This is how star investors such as Warren Buffett operate. This is best suited for investors who look to wait 1-2 years in an investment. If you are not the patient type, this might not work the best for you. In addition to a good grasp of valuation techniques, a strong understanding of various ratios and their values is essential for this type of analysis. For this type of analysis, one must really understand the financials of the company, broader business trends as well as the long term prospects of the company. There are two variants of fundamental analysis.

1.1 Top-down analysis:

In this style, you first look at the global economic trends. You watch the macroeconomic indicators (currency movements, fiscal deficits, trade flows) and then drill into the specific market. If you had picked technology as your strong point, you want to understand how these macroeconomic indicators affect the various companies in this. See which company is positioned the best for the particular indicator (such as the weakening rupee or US Federal Reserve's quantitative easing). The best return is often found in companies that are not covered in mainstream media. If you can spend a lot of understanding those players not highlighted in the mainstream media, you are expected to make high make returns.

1.2 Bottom-up analysis

This is a lot tougher and hence can be quite rewarding if you do it right. Here you pick up a specific company (based on a screening software) and then analyze the heck out of it. You want to know the leaders, the businesses, the margins, the competitors and challenges. If you have a business background, this approach is best suited. This is the one used by Value investors like Warren Buffet etc. Some important factors you look into include:

1. Price to earnings ratio: This is an indicator of the returns you are getting for the investment you are putting. You can just invert the P/E ratio to get your annual "interest" rate. If you are investing in a company with a P/E of 20, your annual returns are just 1/20 or 5% (assuming the company doesn't grow).

2. Earnings growth: Good companies grow. You want to understand how fast is this company is growth into the future. This is where all magic lies. No one in the whole world has the right answer to this. You first look into its past earnings growth and may be use a pro forma analysis as per your assumptions.

3. Leadership: Are the leaders good? Are they trustworthy? How long have they been with the company? Whether it is a small company or big, you always want to invest in the leaders.

4. Clues to identify the future: Other clues you can look into for identifying future earnings are "Free Cash flow", product lineup and margin growth.

2. Technical Analysis

In this type of analysis, one does not care about the company at all. The traders just reduce a company into charts and identify which stock is having the momentum. Their reasoning is that there are plenty who do fundamental investing and you don't want to waste any more time with further analysis. The key to these people's analyses is looking for "smart money”. Thus, technical analysts follow the smart money and use a wide range of funny looking charts to get identify the smart money. They also look for "dumb money" to take contrarian approaches. Technical analysts are usually trend followers. They just care about the current stock trend.

3. Social Analysis

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This is an evolving field and uses the "wisdom of the crowds to identify the future market trends". It doesn't have an adoption anywhere closer to the other two types. Here you look at the stocks that are most talked about in social channels and identify the ones that have the strongest "Sentiment" going for it. You can also use social channels to identify if people "love" or "hate" the brand, the product & the company.

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2) On Stock Valuations:

!1. Valuing a Public Company- DCF method:

Valuing a company is an art rather than a hard science. It involves a lot of guesswork and speculation of future events.

1.1. Static Analysis:

This assumes the steady state of the company. Usually the Income statement represents the information for this type of analysis. In this case, we assume that the company will keep making profits at the current rate. Then using an appropriate discount rate (Cap rate in case of Real Estate Companies) we can get the current Value of the company. This is the easy part.

1.2. Dynamic Multiyear Analysis:

In this case, we predict the future cash flows of the company to determine the profits. We then add all the future profits, apply time discounting and find out what the company is currently worth. It is very straight forward. This main method used is called the Discounted Cash Flow (DCF). DCF is quite good for very stable companies such as electric power utilities that have little change or competition.

However, for most companies the future would be different from the present. The company could grow big (more revenues), become more profitable (in margins) or could lose out to the competition. We are dealing with a highly unpredictable system and thus simple math won't work. Various Micro and Macro economic factors need to be considered.

Appendices A and B is a representation of Static and Dynamic Analysis respectively (the Industry considered is the Real Estate Industry)

2. Methods we could use to predict the future (Pro Forma):

2.1. Financial Ratios:

Since valuing a single company is hard, we attempt to compare a company against its competitors and related industries. Some of the popular ratios are: P/E (Price by earnings), P/S (Price by sales) and P/B (Price by book value). They show the relative strength of the company against its past and against its competitors.

2.2. Strength of the Economy and Industry

If you are in a growing economy and growing industry, you can try to bake some of the growth projections into the company assuming that the market is big enough for the competitors to expand without impacting the analyzed company. This would involve a thorough study of all the macro economic factors and policies in the country as well as globally.

2.3. Strength and credibility of the Management

If the management is good & trustable and the business model is strong, you can expect them to move with the market and constantly grow the company.

2.4. Business Model

Is the company in the business that is undergoing a major disruption? Market discontinuities may greatly affect the projected performance of the company.

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Appendix A- Static Pro Forma 19,400 NET SQUARE FOOT OFFICE BUILDING, OLYMPIC SQUARE

Scheduled Gross Rent @ $26.22/sq.ft $508,800

Other Income4:

Parking Revenue $5088

Laundry Revenue $5088

Scheduled Gross Income (SGI) $518,976

Less: Vacancy/Bad Debt @ 3% of SGI5 $(15,569)

Effective Gross Income (EGI) $503,407

Less: Expenses

Management Fee @ 3% of EGI $(15,102)

Operating Expenses6 $(151,022)

Property Taxes $(52,500)

Total Expenses $(218,624)

Stabilized Net Operating Income (NOI) $284,783

Less: Annual Debt Service $(207,674)

Pre-Tax Net Cash Flow (NCF) $77,135

Estimated Market Value @ Cap rate of 5.5% $5,177,864

Equity and Debt Information Interest Rate: 4.00% (Annual)

Amortization Period: 30 years

Loan Amount: $3,624,505 (70% of Value) | Equity: 1,553,359

PMT: $17,304 (Monthly)

Balloon PMT8: $3,460,024 (Due at end of year 10)

Total Mortgage PMT: $5,536,496

Key Ratios Return on Cost= NOI/Market Value = 284,783/5,177,864= 5.5%

Pre-Tax Cash Flow Return (Cash on Cash Return) = NCF/Equity = 77,135/1,553,359= 5%

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Appendix B

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3) Stop Order and Limit Order:

!In practical Stock investing, these terms are very frequently used. The term has different meaning when you are buying the stock and when you are selling the stock.

!1. "Buy" Case:

1. Stop Value of x:

You will place a buy order if the stock value goes to x or above

2. Limit Value of x:

You will place a buy order if the stock value goes to x or below

!2. “Sell” Case:

2.1. Stop Value of x:

You will place a sell order if the stock value goes to x or below.

2.2. Limit Value of x

You will place a sell order if the stock value goes to x or above.

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4) Stock Indices:

!How is the Sensex Computed?

The Sensex is computed from the stock market prices of 30 of the biggest companies in the India (including ICICI Bank, Reliance, Infosys, Oil and Natural Gas Corporation (ONGC), India, TCS, State Bank, Tata Motors Limited, Maruti Suzuki India Limited). When the prices of the stocks of these top 30 companies go up by 1%, then the Sensex number goes up 1%. For instance, if the Sensex number was 10000 yesterday, then today's number will be 10100 if India's top 30 companies grow by 1%. In the same way, if India's top 30 companies drop by 1%, then Sensex would drop to 9900 from 10000.

Like most indices the Sensex was started with an arbitrary number 100 on Jan 1 1979. The number as such at any point of time is almost irrelevant. What is interesting is how much the number changes over a period of time. Thus, if Sensex grows from 10,000 to 15000 over a period of 1 year, it would mean that the wealth of Indian shareholders grew 50% in 1 year.

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5) Stock Valuation II:

How does one value a stock?One of the most important terms in stock valuation is Earnings per Share (EPS). It is the profits of the company divided by number of shares outstanding in the pen market. For instance, Apple has $41 billion in profits and about 950 million shares, giving an EPS of about 41000/950 = $44/share. Thus, if you own a share of Apple, you are entitled to 44 bucks of Apple’s profits this year. Calculating Share price: To evaluate how much you need to pay for that 1 Apple stock you need to do a simple addition of all the earnings you will get Stock Price = EPS in Year 1 + EPS in Year 2 +... Now, you know that a dollar earned 10 years from now is not the same as a dollar earned now. Because, there is an interest rate i involved and money you get in 10 years is less worthy than the money you have now. Thus, you need to adjust that formulae. Stock Price = ((EPS in Year 1)/1+i)+ (EPS in Year 2/(1+i)^2) +... Now, there is a whole bunch of math involved (starting from the compound interest formula) and for the sake of simplicity, I will get you to the final results and reduce the stock price to two cases: 1. In case of a mature company that doesn't grow: Stock price = EPS/Interest rate The expected Interest rate is relatively easy to calculate and depends on how risky the company is, how risky the market is and the current long term interest rate of government bonds. For many mature utility companies this interest rate comes to about 10%. Thus, utility companies that doesn't grow much is generally traded at about 10-15 times the EPS. (insert in the formula above). The stock prices of these companies are very smooth and change only when there is a change in long term interest rates, the risk profile of the company (can change when hurricanes such as Sandy hits) or when market risk changes (for instance 2008 financial crisis). But on a regular day, not much action here. Let us move to the second category of shares: 2. For a growing company: Stock price = EPS of next year / (interest rate - expected growth rate of the company)Let us use a simple example. If you assume Apple's next year EPS will be $48, the expected interest rate for such a risky company at 15% and an expected annual growth rate at 5%, you will get: $48/(15%-5%) or $48/10% or $480 as the ideal stock price for the company. Where did I get this magical 5% number?Getting the growth inputs:Now, we need to find the growth rate of the company and figure out what the company will earn in the next year, the following year and so on. This is not an exact science and no one has a perfect answer to this question. This is why we need stock markets. Collectively, we all pool our intelligence to figure out the future growth of the company and thereby its current price. To do this collective prediction, we constantly get new inputs and project that to future. For instance, if the

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company management gets hotshot new engineers, then we predict the future will be bright. What are the other news that investors typically use:

1. Periodic financial results of the company that gives us a view into the company;s workings and its financial position

2. Periodic results of similar companies that helps us guess this company;s results. Thus, when Apple sneezes everyone else catches a cold.

3. Changes in the sector. If a new report comes that people are more inclined to using mobile phones, we predict growth of these companies will be high.

4. Changes in the broader market.

5. Changes in the international economy

6. Market Estimation: In short, we try to use every possible information to guess the future growth of the company, plug that into our formula and find out the stock price. For instance, if Apple comes out a report saying people are buying less of iPads, we might ding Samsung too as we believe their Galaxy Tabs will sell less too. Estimating growth rate is an art rather than a science, and is collectively done by millions of humans in a place called the stock market. Since, we need to constantly adjust the growth rate based on new information, stock prices constantly fluctuate. !

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6) 3 classes of Investments:

1. Stocks (owning a part of a company)

2. Bonds (loaning a company money)

3. Commodities (holding the rights to a physical good).

Unless you are a smart trader, stick to only the first 2 classes of investment. Also, when someone tries to sell you a Forex account don’t walk, run. (Unlike stocks, which are quite strongly regulated in favour of investors thanks to the SEC, Forex has very weak protection for common traders as CFTC is usually very non-aggressive in going after scam-my brokers). !!!!!!!!!!!!!!!!!!!!!!!

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7) What is short selling:

Short selling means you borrow a stock from a broker, sell the stock (at a high price), buy the stock back (at a low price) and return the stock back to the broker (along with an interest). It is a good strategy, when you know that a stock is over-valued and is due for a correction.

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8) Asset Valuation:

How do you value real assets like cars, real estate and ships etc?

An asset is any item that can be converted to cash at a future time. This is really important to understand before you attempt to value something. First let us try to see two main types of tangible assets.

1. Depreciable Assets

Cars, ships, machinery, buildings are called depreciable assets. The value of these items decreases over time (unless the item has legacy value tied to its history). For instance, as soon as you take the car out of the showroom, the value of the car goes down by 10% or more.

2. Non-depreciable assets

These are items whose value doesn't drop normally with time. For instance, land is non-depreciable.

How do you value an asset?

1. Potential Cash flows: When you own an asset, you can see it in terms of cash flow. For instance, if you rent out your home, you get a monthly rent and instead of a one-time payment, the cash "flows" over a period of time. You add the value of all these individual cash flows (and then apply the interest rate to discount the value of future cash flows) to get the present value of asset. This is widely used by businesses.

2. Value to a potential buyer. An asset might be of less value to you, but might be quite useful to others. For instance, you might be owning a small shop in the centre of a downtown that might be making $1000/month. However, a commercial centre could use that area to build something of huge value. Then, you have to value the asset based on what is the worth of the end product to the buyer.

3. Replacement cost: If you are owning a machinery to produce a product and want to value the machinery, you can look at what it would cost to pay for something that would produce the same amount product. A new machinery to do the same stuff might cost quite low and that means the value of asset drops quite low (think of your phone's value after a new version of the same phone comes). Or you might be able to avoid using the machinery and hire two humans instead. Insurance companies typically use this method of valuation.

4. Comparable assets: When you are buying a piece of land, you compare it to other pieces of land in neighbouring areas. If people are buying $100/sq.ft for a comparable land in the next street, you can consider the price of your piece of land to be $100/sq. ft. If you don't find a direct comparable, find the closest (say something in the neighbouring area) and then account for the potential benefits & disadvantages of your piece of land. This method is widely used in real estate industry.

Important Variables

1. Economic life. A car might be designed to run 200,000 miles and that is the economic life of the car. Beyond this period, you might be spending more to keep the asset alive. The longer the life of a asset, the higher its value. For instance, Honda Civic tends to retain its value longer than most other cars due to its longer economic life.

2. Extent of usage. If the asset is well maintained, then the valuation is higher.

3. Maintenance and holding costs. If you are holding an old ship, you need to consider the cost of keeping the ship on the dock.

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4. Economic trends. If you are holding a valuable drill bit for drilling oil, it would be pretty valuable now. When there is no exploration, the same asset would be of very less value.

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5) Why are book values lower than market values for many companies?

There are many possible scenarios:

1. Market is not trusting the book. There are many Chinese and other emerging market companies that are trading less than the book. But, depending on the rigor of the auditing process, the book value might not be great indicator. World has too many cooked, inflated books.

2. The value of assets are dropping substantially. The value of your assets are depreciated based on a fixed depreciating schedule and might not reflect the market reality. What if you had a toxic leak on your prime real estate two days ago? The value of the real estate would have plummeted, while the book value might still show a sterling value.

3. Changes in business is pushing you out of the reckoning. Let us say we are in 1900 and you have a massive plant for producing horse carriages. Your plant could be state of the art and would be valuable a lot in the book. But, smart traders in the market would have guessed that your days in business are numbered.

4. Terrible management. What if you had a psychopathic CEO who is trying to go on stupid path and has a control over the board? Even with great assets, the stockholders would want to quit.

At present, 980 stocks in the US had book value higher than the market value of the company.

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6) What are preferred stock and why do some analysts want apple to issue them?

Preferred stock is a type of debt that provides a higher rate of return than a bond but more riskier. There is a common joke that Preferred Stocks are neither stocks nor preferred by public. ;-) Essentially a preferred stock has:

1. No voting rights unlike the common stocks. With common stocks, you are a part-owner of the company.

2. Preferred stocks usually have a high dividend (much higher than either stocks or bonds).

3. If a company is bankrupt, preferred stocks are given a higher preference over common stock for the assets of the company.

4. Preferred stocks are not traded usually and thus have very little potential to appreciate in value.

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7) What can Beta tell us about a security?

The beta coefficient in finance is a measure of the volatility (market risk) of a stock or portfolio, correlated to the entire financial market. The financial market is represented by indices such as the S&P 500 or Dow Jones. Beta measures systematic risk, and will give you an idea of the sensitivity of the stock share price. Beta also gives you an idea of how a stock will react to swings in the market. Beta coefficient plays a key role in CAPM (Capital Asset Pricing Model). CAPM allows you to determine the relationship between the risk and return of securities (stocks or bonds), and is represented graphically by the Security Market Line (SML). CAPM: ra = rfr + β(rm - rfr)β = betara = expected stock return rfr = risk free raterm = expected market return

Beta is calculated using regression analysis. βi = Cov(ri, rm)/ Var(rm)Cov = Covariance Var = Variance ri = market returnrm = market returnHere is a great tutorial on how to calculate beta using excel: How to Calculate a Beta So, what can beta tell you about market risk?When β=0: movement of the security (stock, bond, etc.) is uncorrelated with the movement of market. When β<0: Security moves in opposite direction of market (remember the market is represented by an index such as the S&P 500). Systematic risk is below average. When β=1: security moves proportionally (same amount and direction) with the market. When β>1: systematic risk of security is above average. The security moves in the same direction as the market (proportionally), but not the same amount (moves more). When 0<β<1: security moves in the same direction as the market, but moves slightly less than market. Systematic risk is below average.

What happens in an Exchange? Let's say you want to buy 100 shares of Apple Inc. Here is how the process goes through.

1. You first login to your broker's application and place an order specifying the price you are willing to pay for Apple's stock. Your account must be already setup with your bank account etc.

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http://faculty.babson.edu/academic/Beta/CalculateBeta.htm


2. The broker first tries to see if any other client of theirs wants to sell Apple stocks at that price. If yes, the broker matches the orders and transfers the shares electronically.

3. If not, the orders goes through the exchange. The exchange connects with all brokers & financial institutions where others are selling stocks simultaneously.

4. Bigger stocks like Apple will have assigned specialists to make sure the stock moves up/down in smooth manner. They have an inventory of stocks that they can use to wiggle out short term changes in demand. Thus, you will find 100 shares of Apple if you are willing the pay the market price, even if no one else is selling a stock of Apple.

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