Foreword from ShareInvestor

This article Getting Started On Stocks by Cai Haoxiang was first published in The Business Times on 30 Dec 2013 and is reproduced in this blog in its entirety.

CAI HAOXIANG sums up the investing topics of this space in 2013

LAST WEEK, we discussed personal finance. Learning how to  set financial goals, manage your spending and build up saving habits is only one  side of the coin. To get the best returns, one has to invest time and effort into analysing businesses.

A disciplined approach to  understanding publicly-listed companies, industries and trading patterns can reap rewards for the market participant. Here are some tips that have appeared  in this space in 2013.

There are two ways of investing in a company: buying a stake in it, or lending money to it. The second  way assures investors of a fixed amount of interest every year. The first offers  greater rewards in exchange for greater risk.

Companies issue shares to raise money from investors by giving them partial ownership. Investors do not get interest from the money they give but participate in the growth of the business. If the company is successful at making money, it can reward shareholders by distributing dividends. But if the company fails, shareholders bear the brunt. They are the last in the queue to get anything as company assets are sold off to pay lenders first.

Shares are traded on the stock market. To buy them, one needs to approach an intermediary called a broker and set up a trading account, as well as a securities account with the Central Depository, or CDP for short. Trading can be done online, through the phone, or mobile apps. Dont trade too much as commissions on each trade will eat into your returns.

The 30-company Straits Times Index (STI) is one of the first things beginner investors should get to know. The index contains the largest and most liquid stocks on the Singapore market, including familiar names in the property, financial, industrial and services space. The STI is a way to gauge the mood of market players and a benchmark which you can compare your own performance against. One can also buy a basket of all the stocks in the STI through a vehicle called the exchange-traded fund, or ETF. Buying an ETF can be a cost-effective way of having a stake in the market, without having to worry about whether an individual company would be dragged down by an unforeseen event.

An ETF exemplifies the important concept of diversification, the intuitive idea of not having all your eggs in one basket. In financial terms, having more than one company in a portfolio reduces the risk of the portfolio having dramatic movements in price. Diversification also reduces the risk that your investments will be wiped out by a single catastrophe. Diversification works best when investments are not correlated with each other. Invest in companies across industries, sectors or countries, and  even across asset classes like stocks, bonds, and property.

On the flip side, overdiversifying could mean that the performance of your top stock would be dragged down by others below. Given limited capital, there is no point getting everything that sounds good. Making smart, concentrated bets gets you better returns.

Hunting For T he Right Company

Beginner investors tend to rely on the latest stock tips from the experts, listen to market rumours, or subscribe to the latest initial public offering. These are not sensible ways to go about selecting stocks.

There are two general approaches professional investors use: top-down and bottom-up investing. The two approaches can be combined.

To do top-down investing, analysts think about the broad issues affecting the economy and try to identify sectors or industries that will benefit. Then, companies are identified within the sector. For example, amid an ageing population, demand for healthcare facilities and assistive technologies like hearing aids, wheelchairs and robots could rise. Companies that are involved in supplying goods and services that meet these needs could benefit. Increasing digitisation of the world, growth in Asean and Asian economies and the resulting increase in infrastructure and middle-class consumer demand, and urbanisation are also commonly cited as trends.

To analyse industries, a classic methodology used is one developed by Harvard Business School professor Michael Porter called the five forces: the threat of entrants, the intensity of rivalry between established players, the threat of substitute products, the bargaining power of customers and the bargaining power of suppliers. Significant profits can be reaped from industries where there is little competition and companies can charge a high price for their products and services without worrying about other stakeholders.

Global brands like Coca-Cola and Pepsi, credit card companies Visa and Mastercard, and giant oil companies like ExxonMobil and Shell are cited as examples of companies that have this strong economic moat due to their significant pricing power, and the barriers to entry to their industries that competitors face.

To do bottom-up analysis, investors examine financial ratios to find promising companies with strong balance sheets, low debt, steady cash flow, and growing earnings. They can screen stocks that have such characteristics using financial software like Bloomberg. The do-it-yourself investor can check out the Singapore Exchange website to obtain a list of stocks traded there, and compile numbers from Bloomberg, Yahoo Finance and company financial reports, before doing a screen.

Common financial ratios include the price to earnings (PE) multiple, the price to book ratio, gross profit margins, return on equity, and the debt-to-equity ratio. These ratios can give investors a sense of whether the company is fundamentally strong. Ratios with price in them can provide an idea of whether the company might be undervalued or overvalued by the market.

But misunderstanding and misusing these ratios is worse than not knowing them at all. Investors should know how the ratios are calculated, how they can be manipulated by management, or how they can mislead. For example, a company trading at a low historical PE multiple  might not necessarily be undervalued if its earnings fall dramatically in the next few quarters, causing the PE ratio to shoot from its current low number given the current price.

Understanding Financial S tatements

Learning how to read and analyse financial statements is crucial for they are one of the best ways for investors to make sense of a business. There are three main types of financial statements to get to know: the income statement, the balance sheet and the cash flow statement.

The income statement, otherwise known as the profit and loss statement, sums up how much money the company made for its shareholders, or net profit. Net profit is arrived at after a series of steps deducting costs of raw materials (cost of sales) from sales (revenue) to get an interim measure called gross profit, and then adding other income from investments and such, deducting other expenses like wage and office costs (administrative expenses), advertisement, marketing and distribution costs (distribution and selling expenses), and taxes paid to the government. What is left in the net is money due to business owners.

Why is the income statement important? Net profit, otherwise known as the bottom line, is the first figure investors and analysts look at to see if the company is making an increasing amount of money or not. This figure can be manipulated, but that is another story.

The balance sheet gives the investor a quick sense of how financially strong a company is in terms of what it owns and what it owes. It is so called because what the company owns, its assets, is supported by what it has to repay other people, its liabilities, and what is due to business owners, its equity. The accounting equation to remember here is Assets = Liabilities + Equity.

To use a personal analogy, you may own a HDB flat, and the flats total value is part of your assets. Cash savings in the bank are assets too. But you dont have enough to pay for the flat outright, so you borrow from the bank to fund your purchase. Borrowings fall under the liability side of the equation. Deduct liabilities from assets, and what you are left with is your equity.

Similarly, a companys assets include its property and factory space, as well as the money that other people promised to pay it but have not done so (receivables). Bank loans, and what it promised to pay other people but have not done so (payables), all come under its liabilities. What is left is shareholders equity.

Why is the balance sheet important? Through it, investors can identify warning signs not immediately apparent in the income statement. The most obvious is how much debt the company holds. If it is  constantly borrowing to invest in mega projects that do not seem to pay off, the company will collapse one day under the weight of interest payments to creditors. If a large amount of receivables (what others owe the company) build up on the books, one can also ask if these debts will be repaid or if the company is faking its sales. If the company has too much cash sitting around and no obvious plans, investors can also ask if it is better that the money be returned to them.

Finally, the cash flow statement records the ebb and flow of cash through a company over a period of time. This refers to actual cash, and not promises made on paper that are reflected in the previous two statements. Hence, it provides a nitty-gritty picture of the circulation system of a firm. Through the statement, an investor can see how much money that came in from a companys day-to-day operations (cash flows from operations), how much then flowed out to investments in new factories, new equipment and the like (cash flows from investing), and how much came in or flowed out in terms of money borrowed from banks or interest repayments (cash flows from financing). The result is the net increase in cash and cash equivalents.

The cash flow statement is important because it tells investors what is happening on the ground. A key indicatorinvestors can track is called free cash flow, roughly calculated by deducting purchases of property, plant and equipment from cash flows from operations. Positive free cash flow is a healthy sign because the companys assets are generating more money than what is needed to maintain them. Negative free cash flow is fine when the company is investing heavily into its projects, but a prolonged period of negative free cash flow throws doubts on the ability of the company to generate returns for shareholders.

In addition to the financial statements, investors also need to scrutinise the notes attached to them in the annual report to learn additional details.

To sum up, investing can reap the participant long-term rewards, but an understanding of business, finance and accounting is essential. Next year, we will delve further into some of these topics. We will also cover issues like dividends, earnings quality, financial statement manipulation, as well as do more analysis on various companies and industries.