Strategies for investing in stocks
Which stock is best for investment?
Small Cap stocks are best for investment if you are looking for share price growth. It's easier for a small company to double or triple in size than for a big company to grow by 5% or 10%. If you invest in Small Cap stocks your investments will grow. To view Under the Radar Report’s latest stock recommendations for investment, please click here.
What are the best strategies for investing in stocks?
It's important for ASX investors to get their bearings on the best strategies for investing in stocks. Below, we outline seven strategies for ASX investors to determine which stocks to invest in. For our latest investment strategies, please click here.
Seven strategies for investing in stocks
These are Under the Radar Report's seven strategies for investing in stocks
1. Cash is King
How much cash/debt compared to last year?
Changes to working capital?
Net investment expenditure?
What is the company doing with its excess cash?
The big effect that COVID-19 has had is to expose the vulnerability of companies’ balance sheets. Put another way, they didn’t have enough cash and debt facilities to weather bad conditions. A virus that was unknown at this time last year has produced really, really bad conditions. Consequently, many were forced to raise equity to compensate for the cash burn they’ve experienced, or simply opportunistically raised. On the other hand, some of our favourite companies have taken the opportunity to grow their businesses organically, raising debt through existing facilities.
In the coming weeks we’ll be able to see whether individual companies have more, or less, cash or net debt than the previous year and half year. While this is a simple question to answer, the reasons behind changes in the cash position can be extremely complicated and relate to the aforementioned capital raisings.
What has been the impact of COVID-19 on cash flow and has management successfully constrained capital expenditure? What does this mean for the sustainability of growth? At the big end of town, the bigger a company’s debt the bigger the problem for the banks. This isn’t the case for Small Caps where the bank’s profitability isn’t much affected. But it is important when there is debt to understand its terms and when it needs to be renewed. If free cash fl ow is not going towards debt reduction, something will have to give. Whether a request for more funds from shareholders is done on good terms or bad will largely depend on the reason given for those funds, which in turn relies on underlying fundamentals – the interaction between the profit and loss; the cash flow statement and the balance sheet.
2. Sales Growth
Is the company growing sales?
Why are those sales growing – volume or price rises?
If it isn’t, what is driving earnings growth?
Sales growth will be more interesting because of the COVID-19 related disruption. What we want to see is a resumption of sales growth. If a company doesn’t have a prospect of growing its top line year on year, the key is identifying how it can grow. If it is growing sales, the key is to quantify the factors behind this. In a service business, this may be achieved through more efficient operation, or by an increase in staff or infrastructure. In a manufacturing business revenue increases should be achieved from either increased volumes or higher selling prices. Management’s commentary on the sources of growth should be clear and unambiguous.
3. Margins Matter
The higher the gross margin, the bigger the impact from lower sales.
What are the company’s input costs?
What is the proportion of fixed costs to overall costs?
What is the level of government support and how long can this last?
This is a period in which losses may have blown out. How much have these costs been contained by government handouts such as JobKeeper, is one key. For Small Caps we suspect it won’t be as big an issue as for the big end of town and at the other end of the spectrum, small business. The question is the extent to which the company is reverting to profitability, if at all. This comes back to sales: the factors behind it and the cost structures associated with it should be reflected in both gross profit margins and net profit margins. Gross margins should expand when prices are rising faster than the input costs that go into creating the products and services.
Underpinning this is our eternal search for operating leverage, as a company’s sales and margins should be growing, and the fixed operating costs of the infrastructure and corporate assets necessary to deliver the outcomes should reduce as a proportion of sales over time, increasing net margins. Margins matter. The goal should be to understand what are the factors behind changes in margins and whether these are likely to be sustained or increased.
4. Be wary of what’s “Underlying”
Headline profits versus the so-called underlying?
What has the company declared to be exceptional or one off in prior periods versus in the current period?
What are the effect of accounting changes?
These results are going to require some creativity and then some from investors trying to work out maintainable profits. We are always trying to work out what the real business is doing, but companies make life very difficult and some are definitely worse than others. Expenses companies put above the line (costs incurred in making the product/providing the service i.e. cost of goods sold (COGS)) versus those below (relating to operating the business) will need to be scrutinised carefully. The company will claim that some above and below the line costs are exceptional items.
Red flags are often hidden in the exceptional items, which the company considers not part of its normal operations, or one-off in nature. Examples include gains and losses on asset sales, restructuring costs, as well as write-offs of intangible items when a board has reviewed the cash flows from those assets and decided that they are insufficient to support the assets’ carrying values in the accounts. This will be a particularly important factor in the coming results season.
Companies exclude these items to come up with their “underlying earnings”, which is meant to reflect the performance of their ongoing operations. This is an issue when these one offs recur from one result to the next. Outside of us ignoring management’s
5. Outlook Comments
What is the tone of the outlook comments?
Is the company looking to make acquisitions?
Does the company have a track record of underestimating or overestimating future profit growth?
The outlook comment has never been more important because the numbers will be so hard to read. What we’ll be looking for, which will be in short supply, are specific numbers that the company is expecting to deliver or report, but also the tone and information about investment plans and strategic direction which the outlook should deliver. Beyond this, how well has the company adapted to the COVID-19 world and can this continue if no vaccine is found.
Company reports need to be read with a healthy dose of scepticism. The annual report should be read. This can be somewhat tedious, but as an audited document, this is an important constraint on management’s ability to delude itself and investors.
6. Share price reactions
The market has been on a wild ride during the pandemic, but each stock price chart tells a different story. Subscribers are sometimes surprised by the reaction of share prices to market moving news like results and prospects. This is a variation of the old adage to buy the rumour and sell the news, which has worked very well through this crisis. The stock market is always looking for growth, and accelerating growth at that. Decelerating growth will often cause a big problem for growth stocks, because valuations are based on higher growth for longer. The bottom line is to avoid owning too many stocks that are so expensive that they are vulnerable to any disappointment of other investors’ expectations
Ultimately, management’s confidence is reflected in the dividend declared. If a dividend was declared and not paid, that used to be an absolutely terminal act. Think of the Queensland based financial services company MFS. Its stock was going gangbusters until early in 2008 when it fell 70% in one day after it announced that a previously declared dividend would not be paid and that an enormous rights issue was coming. MFS went into administration within weeks.
But no more. Almost every company in that 3 to 4 week period from the beginning of March had to pull their payments at the last minute. Now that the uncertainty has lifted, some businesses are doing better than expected, and especially where management has a large shareholding, there has been a natural tendency to resume dividend pay-outs sooner rather than later. Some have paid in late FY20, some in early FY21. But dividend payment behaviour in this environment may be different. If management want a free pass on paying a relatively high dividend, and to go for growth by increasing investment from earnings, now would be a good time. We’ll explore dividends further as companies report.
click here for your 14-day free trial and to access this week's best stocks to buy.