Where is the Fun Without Being Mental?
Originally published on February 1, 2017
What’s the first thing that comes to your mind when you think of a Wall Street Investment Analyst? Is it alcohol, drugs, and stealing money from the working class citizens? If you are like some of my Dad’s friends, you might think all the people on the street are just some cocky kids who have never worked a real day in their life. You also might think if you were to stick your money in the market it will get stolen from you by these money hungry savages. Well, anonymous friend’s of my Dad, time to set the scene for you a little bit. When you walk into a casino in Vegas you don’t expect to walk out a winner (if you know basic probability). Why? Because you know the “house” is against you. The games are set up to allow you to have an optimal amount of fun while slowly draining your pockets like a leech drains blood. The stock market is not like that. The stock market is designed to give you a chance at partial ownership of any publicly owned company throughout the world. Outside of bubbles and crashes, which you still have control of when to buy and sell your shares, you have control over one main thing when it comes to your investing. Research. You see, asset management companies and their analysts become rich because each investment analyst has gone to school for years to learn how to do research. These analysts also have the advantage of covering two to three stocks for their entire job. These guys are not out drinking and doing drugs, they are finding the best possible information on their respective companies. They are modeling their company’s financial statements, talking to people within the companies they are researching, and writing research reports on their findings. They are not worried about taking money from you, they do it automatically if you are on the other side of their bets without doing your research! However, as long as you have a day job and do not have a Bloomberg Terminal in front of you for the entirety of every trading day then you can never reasonably expect to be better than the pros on a consistent basis (if you are please manage my money). However, we can narrow the gap a little bit, welcome to research school!
Ideally, this will be a series because there is way too much information to fit into one article. I am going to start with the basics because, well, I’m in control? Feels nice. Anyways, we are going to focus on bottom-up research in this article. Which means we are not going to focus on the macroeconomic perspective of investing (we DON’T care about Dow 20k), we only care about how the heck to research an individual company.
Imagine you just made your first thousand dollars from suddenly finding an efficient way to put yourself through college (a respectable way). Obviously, you are really happy because you get to open up a brokerage account, but you have no idea where to start or how to invest. What is the first thing you should look for to find a company that might be below its intrinsic value? If you said the price of the company, then you are wrong. The first thing we should look at is the price-to-earnings ratio, or the P/E ratio. This ratio will tell us the price in relation to the earnings. Generally, we are looking for P/E ratios that are below the industry average. It is extremely important to compare all your research to relative benchmarks because analysis means very little in a vacuum (without comparison). Even with a comparison, this ratio is just a first screener, anything in the 10-20 range for most industries is a healthy amount. Below 5 might mean some red flags in other areas of the company and above 25 might mean the price is inflated based on investor sentiment. The earnings part of the price-to-earnings ratio is how much money a company is making per share of their stock. Therefore, if a company, let’s name this company Value Inc., has 1 million outstanding shares and they are earning $5 million in profit, then they have earnings per share of $5. Taking it one step further, if the price of Value Inc. is $50 per share, then guess what their P/E ratio is. That’s right! They have a P/E ratio of 10, which would mean this company passes our first screen of investing. You might ask, “Why would I want a stock with a lower price relative to its earnings”. Good question. Ultimately, the price-to-earnings ratio tells you how much you will have to pay for the earnings. If we reduce the fraction to how much you have to pay for $1 worth of earnings, then in Value Inc.’s case you are paying $10 for $1 worth of earnings. A better question is, “Why would you want to pay more”?
Now that we have screened though stocks based on their P/E ratio we need to take the screening another step further. Next were going to look at the PEG ratio, or price-to-earnings/projected future growth. This ratio will look at the consensus projected growth of the company over the next 5 years by analysts, which of course will not be perfect, but this consensus is what we are going to have to work with unless we want to make our own financial model. We have already decided that we want a company that resides within the 10-20 range for a P/E ratio. Value Inc. has a P/E ratio of 10, perfect.
Now, we are dividing this P/E ratio by its projected growth percentage, which means we are looking for a company with a low PEG ratio, ideally below 1. We want a company that has a reasonable price in relation to its earnings, and we want the company that is projected to grow fast in the future. Sounds logical right? In our scenario we are giving Value Inc. a projected 5-year growth rate of 20% per year, what is its PEG ratio? If you said .5 then you are right! This means that our PEG ratio= (($50 per share/$5 earnings per share)/20% projected growth rate). This is a great start to finding our value of the company, but it is not infallible. Remember, the earnings part of the price-to-earnings ratio is normally plugged in from the previous 12 months and the growth rate is projected into the future. Which means the earnings portion is not guaranteed to reflect the future, and the growth rate could be flat out wrong. Therefore, it is important that we take these ratios with a grain of salt.
Another area that we can look at to find an undervalued company is at their economic moat. An economic moat is going to protect a company the same way that a real moat would protect a castle. It is describing how much of a competitive advantage and how much control a company has over its respective market. On the flip side, it is also describing how hard it would be for new competitors to enter a market and be able to compete with an established company in that respective market (i.e. when investing in an established company we would like to see the barriers to entry be high for new companies to enter). There are 3 types of economic moats. Wide, narrow, and none. I will leave “none” out of the picture because it is self-explanatory.
An economic moat is not scientific. It is a subjective look at the position of a company in relation to their market. A simple way to find out what type of economic moat a company has is to ask yourself “Can the consumers just switch to another company without any issue or would it be tough for the consumer to leave?” If it would be tough then the company probably has a wide economic moat, if consumers would not think twice before switching then there probably is not an economic moat (would it be hard to switch from using any apple products if you are already a customer? Exactly).
Ideally, from a risk perspective, we would always like our companies to have a wide economic moat (think like a wide moat around a castle providing more protection). However, we might not always find the best returns from investing in these types of companies because they are normally well established at that stage and have little room for growth. Therefore, a great, although a riskier option, is to find a company with a narrow economic moat. Look for a company that has a product or service that has the potential to one day help a company develop a wide economic moat. The benefit to using metrics like the P/E and PEG ratios are that we can make investments with a greater potential for return with confidence. Of course, if you are more comfortable throwing your money into an index fund and riding the ups and downs of the market there is nothing wrong with that, many people have been successful that way (probably less stress too). On the other hand, if you decide that you want the opportunity to successfully invest in stocks then there is a due diligence that must be conducted. You do not want to be the person complaining in 30 years that the stock market is rigged simply because you didn’t take the time to learn it, do you?