Valuing stocks involves four basic issues:
1) the characteristics of the
stock as a financial security
2) the financial and business prospects of the
issuer of the stock
3) the relative valuation of the particular stock versus
other stocks, and
4) the valuation of financial securities in general and the
stock market in particular.
"Stock pickers" focus on the
characteristics of the particular stock as a financial security and the
financial and business prospects of the particular issuer. They believe that
they should value the stock and analyze the prospects for the issuer independent
of market and economic changes. With their focus on individual securities, they
believe that they are "buying companies" that will prosper over a
longer period of time and reward investors because of their success. Value
investors try to buy "good companies at cheap prices" when these
companies are out of favour with other less disciplined and more faddish
investors. Growth investors strive to find companies with business strategies
and products that will allow them to achieve high levels of growth. Both value
and growth investors try to ignore the future path of the market or economy.
They are confident that the prospects for the individual securities they are
buying will overwhelm over factors and do not try to "time the market".
If they cannot find individual stocks that are attractive, they might leave some
monies in cash. This really reflects their ability to find attractive investment
ideas rather than a call on the market.
"Sector rotators" focus on the
relative valuation of a stock compared to other stocks and the overall prospects
for the stock market in general. They assess the relative valuation of
individual stocks and move between stocks and industry groups when they are
cheap by comparison using historical standards. They also assess the the overall
valuation of the market using aggregate data on earnings, price and other
historical accounting measures and compare these to historical norms. Another
valuation yardstick is a comparison to other financial assets, such as bonds and
money market securities. Much emphasis is given to the relative levels of bond
and money market yields and the market dividend yield. The stage of the economic
cycle is important, as stock industry groups have differential performance over
the course of a market and economic cycle. If their valuation measures suggest
that the market is expensive, they sell stocks and raise cash to defend their
portfolios from a potential market setback.
The average investment manager combines stock picking and sector rotation,
maintaining her portfolio reasonably similar to her index benchmark and other
managers. This type of manager will make industry and security "bets"
in their portfolio weightings, moving into defensive stocks and cash in
overvalued markets and weighting stocks and industries that are relatively
attractive.
FUNDAMENTAL VALUATION TECHNIQUES
Fundamental valuation of equity securities relies on financial analysis of
historical financial data and an assessment of the business prospects of an
issuer. The historical data demonstrates the "track record" of the
company and its management. The assessment of the business prospects of an
issuer involves a study of the conditions and environment under which a company
operates.
The financial analysis of the company examines trends in its profitably,
efficiency in employing capital, financial capability and other factors that the
analyst consideres important. These are assessed by calculating the applicable
financial ratios and patterns of sales and profit growth. Important ratios would
include: gross and net margin, sales and inventory turnover, financial and
operating leverage, interest coverage, current and quick ratios. Valuation
yardsticks would include price/earnings, book value per share, earnings yield,
dividend yield and return on equity.
A basic assessment of a company's business prospects includes a review of
all public information available on a company and third party research reports.
A more "in depth" review would include interviews of senior
management of the company, both telephone and in person, and even discussions of
the company's prospects with suppliers, regulators (where applicable) and even
competitors' personnel. |