Sunday 26 March 2017

The Investigative Approach to Stock Investments

There are a couple of quantitative methods for analysing stocks, such as the Dividend Discount Model (DDM). A lot of people use them for stock analysis and investment as they are relatively simple to use and do not require qualitative analysis of the business strategies, competitive environment, corporate governance, etc. For a very long time, I was also a keen user of such methods, looking at only earnings, dividends, cashflows, debts, book value, etc. to identify value stocks. Such an approach has served me well in the past. However, there are times when this approach turned up value traps whose stock price keeps on declining. Over the past 2 years, I have gradually moved away from such quantitative analysis.

Let us use the DDM as an example of the quantitative approach. A simple form of the DDM is:

where P    = Intrinsic value of stock
           D1  = Dividend for the next financial year
           r     = required rate of return
           g    = perpetuate rate of growth in dividends

It is simple to use, as there are only 4 parameters to estimate. A lot of times, in the absence of qualitative analysis, these parameters are estimated from past performance. However, past performance do not necessarily represent future performance. An example of this is Starhub. Since 2010, Starhub has been paying a constant dividend of 20 cents every year. The dividend has been so regular that it is commonly assumed that the 20-cent dividend will continue every year. Last month, Starhub dropped a bombshell by announcing that the dividend will be cut from 20 cents to 16 cents in FY2017. This is the perils of looking just at the financial numbers and extrapolating past performance into the future.

An alternative approach to stock investment is to carry out a qualitative analysis of the company and the industry it is in. One of the best known techniques in this approach is the scuttlebutt technique, which is made famous by Philip A. Fisher in his book "Common Stocks and Uncommon Profits". For the past 8 weeks, I have attempted the use of such an investigative approach in the analysis of telco stocks, looking at the business strategies, competitive environment, (my own) customer experience and industry trends. My skills are still rudimentary compared to the scuttlebutt technique, but the investigative approach does provide a glimpse of where the business is heading rather than extrapolating from past performance.

It is tough work reading through and comparing all the telco price plans, financial results, annual reports, industry statistics and trends, technology news, etc. But the end result is a better understanding of the prospects and risks of the company and whether the money can be safely invested in it. 

So far, 2 industry analyses have been completed, namely, Oil & Gas and Telcos. I hope to complete more industry analyses in time to come.

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