5. Active Investing: Investment Analysis
In the previous section of our program, we divided the bodies of knowledge which we believe investors should have into four categories:
• Asset allocation/portfolio construction.
• Macroeconomic analysis (understanding workings of economy)
• Company analysis (understanding how to analyze companies and industries)
• Stock analysis (understanding valuation of company stock)
We have already discussed general asset allocation and portfolio construction guidelines in the previous sections – 2.2 “Introduction to Asset Allocation” and 4.2 “Asset Allocation Revisited”. Towards the end of our program, we will build further on these two sections with more thoughts on portfolio management.
In the remainder of this section, we want to give you an overview of the remaining three topics: macroeconomic analysis, company analysis and stock analysis. After the overview provided in this section, the program will discuss each of these areas in even further detail to equip you with the tools you need.
5.2. Macroeconomic Analysis
Macroeconomic analysis encompasses three aspects: 1) an understanding of the basic terminology used to describe the modern economy, 2) an understanding of the relationships between different parts of the economy and 3) an understanding of how different aspects of the modern economy can impact the performance of your investments.
As far as terminology goes, we will attempt to convey an understanding of the following terms: 1) unemployment, 2) interest rates, 3) inflation, 4) money supply, 5) trade balances, 6) GDP growth, 7) investment, 8) consumption, 9) national budget deficit/surplus and 10) consumer confidence.
As far as economic relationships go, we will try to show the following links: 1) unemployment and inflation, 2) inflation and interest rates, 3) inflation and money supply, 5) investment and savings, 8) taxes and national deficit/surplus, 9) consumption, investment and GDP growth, and 10) factors which influence the balance of trade.
Regarding how the real economy impacts investments, we will try to show general principles as the following: 1) how interest rates affect bond and stock prices, 2) how currencies are impacted by interest rates, inflation, budget deficits and trade balances and 3) GDP growth and stock prices.
5.3. Company Analysis
Company analysis encompasses the following: 1) qualitative analysis of the company and 2) financial analysis of the company. Both of these are important although those who are comfortable with numbers may feel more comfortable with financial analysis while those more comfortable thinking analytically may enjoy qualitative analysis.
We would break qualitative company analysis down into three sub-categories: 1) industry analysis and 2) company analysis and competitive position within the industry.
We would break financial analysis down into two sub-categories: 1) reading company financial statements and 2) estimating a company’s future earnings potential.
5.4. Stock Analysis
By stock analysis, we really mean valuation – that is, determining the value of a share of stock in a company. At the end of the day, we hope that through investing, we are purchasing shares of good companies that are worth more than what we pay for them and avoiding the purchase of shares that are worth less than what we pay for them. To do this, we must have some way of determining what we think a company is worth. This is valuation.
Here, we believe it is very important to make the point that although valuation often involves numbers – i.e. either an actual or estimated share price – an investor should not be misled into thinking the numbers used in valuation are especially precise. Accurate valuation involves making estimates about the future prospects of a company. These estimates are just that – estimates. As a result, the precision of numbers used to evaluate the future of a company can not be considered very high. They are used as guidelines to distill our thinking into a format that can help us to make decisions about whether a stock is more likely to perform well or to disappoint in the future.
As with company analysis itself, we would therefore split stock analysis into two sub-categories: 1) qualitative valuation and 2) quantitative valuation. As with company analysis, one of these is more analytical and the other is more numerical. As with company analysis, both are important.
We would break down qualitative valuation into the following pieces: 1) improving/deteriorating trends and inflection points, 2) market expectations and 3) scenario analysis.
We will cover the following aspects of quantitative valuation: 1) discounted cash flow, 2) ratio analysis and 3) yield analysis and 4) expected value.