Novice Traders and Value Investing

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Novices and Value Investing

Q.: Can you give me ideas on how to research stocks?

A: You first hear mention of a company from a friend's tip or newspaper article or newsletter - how do you go on researching it? Research comes in all different forms, whether looking at in-depth financial company reports, studying the company history, checking historical data, or, a more practical approach to fundamental analysis. For instance, I know of a friend in Australia who wanted to buy some building stock, so he found a couple of companies that made bricks, bought some bricks and cement from them and made a couple of small walls in his backyard. He looked at the quality of the bricks, inspected the quality of service, the price, the clarity of the instructions on the cement mix etc...and bought the company he felt was the best - without even looking at common denominators such as net debt, EPS, director holdings or any of that stuff. Made a good profit too! My point is, trading or investing can be as hard or as easy as you want, it can even be fun.

Usually, however, the first place to start your research is to check-out recent company announcements which should include the latest financial reports. Most CFD providers offer access to a searchable Reuters or Dow Jones real-time news feed and this together with director stock dealings and future-looking analysts expected earnings estimates should prove invaluable. Functionality to chart a share price performance and compare it to other companies in the same sector should also prove useful. In most cases the share price will already have built the expected numbers, but sometimes the financial reports can create big movements. A good way to study share price movement is to monitor just a few stocks and become familiar with them, in due course, you'll understand the price movements better and you'll be able to spot good trades more easily.

However, here you also need to consider the general picture of the economy i.e. the fundamentals of the economy taken in context. If, for example, the earnings for Company ABC are 25% higher than last year, then you must also compare the economic conditions of last year and this year to fully understand the real value of the increase. For instance, care needs to be taken on the corporate earnings announcements being released if there has been considerable cost-cutting, inventory reductions or lowered expectations. Thus, the most valuable numbers are the revenue figures, cash flow, strength of the balance sheet and liquidity of the stock (are you able to buy and sell shares easily?).

Whatever stocks you invest in, do your homework, don't expect to retire next year, and good luck!

Q.: What is Value Investing?

A: Value - To my mind is a correct strategy - find companies that exhibit value in whatever characteristic(s) you like and buy them cheap. For some this is PER, some cash flow, others Tangible book value and of course for income seekers there's the High Yield variety.

However, don't forget that the valuation of any asset is a relative concept. First of all one cannot value an asset by itself as the valuation of an asset is constantly changing and may depend on external factors. For instance suppose I was offered property for GBP100,000 and it had an annual rental toll of GBP10,000 then that property is offering me a 10% rental yield. In isolation this doesn't tell you much. If bank deposits rates are also 10% then the attraction of that property as an investment is not so great after all. But what if interest rates decline to 5%? Well suddenly the rent on that property is more attractive. Of course, in reality, any such decline in interest rates would (in theory at least) start to push up property prices - investors would seek out such properties until the prices rose sufficiently to lower the rental yield to near interest rates of 5%. The corollary, of course, is that rising interest rates act as a depressant on asset values. So although understanding valuation is important but this taking into consideration the relative valuation.

So while accepting the valuation of the aggregate market as it is you should concentrate on buying a portfolio of stocks that offer, in aggregate, better value than the overall market.

Q.: But why do you believe Value can work?

A: This is a key question and oddly enough someone on a bulletin board recently made me think a bit more about it. First, I think we have to consider 'What is the market?' To me 'the market' is 'moment in time' supply and demand. I think it's the 'moment in time' bit term bit that's key - anyone who's been watching level 2 for a bit can surely testify to this.

I've seen share prices jump 5-10% on bid rumours and indeed often in the auctions you can get bargains where there's a big seller or buyer in the market at that 'moment in time'. Indeed, I've made a fair of money out of these situations - it ain't rocket science just pure price driven by demand.

Remembering that the general idea for stock pricing at any given time (especially for a Market Maker driven stock) is to meet demand and offer supply. I believe it is that simple. So for one taking a longer term view with no need to be so short term about it value has huge strengths. So to sum up the principle I think 'the market' can get it wrong and often does.

Q.: I'm looking to trade companies that are undervalued but fundamentally sound? How do I track such companies?

A: The first thing to do before evaluating a company's technicals is to make sure that the global markets are moving in the correct direction. Which sectors are outperfoming? Which industries are constantly in the news? Which industries are likely to benefit most as the economy moves further into recovery mode? Knowing the answers to these questions will give you a starting point. Once you have established this you need to be able to digest a company's technicals i.e. interpreting such terms as Price/Earnings, Profit Margin, Quarterly Revenue Growth (yoy), Total Cash, Total Debt and Operating Cash Flow as well as Levered Free Cash Flow. This representation of financial information will provide you with an insight of a company's balance sheet.

In some cases you will find cases of companies that appear to be fundamentally sound but whose share price is still underperforming; it could be that you're missing something from the balance sheet or the company has simply not attracted institutional interest. In such cases understanding financial information, such as a stock's Beta, 52-week High/Low, Moving Averages, Average Volume Traded, Shares Outstanding and in Float and Crest Loan Data (which indicates shorting interest) can go a long way. Personally I prefer companies with healthy balance sheets that have experienced consistent year-over-year quarterly growth, lots of operational cash flow and healthy doses of cash on hand. Volume information is also important as weak volume implies wild swings in volatility.

Q.: What is best: using technical analysis or fundamental analysis to formulate a trade plan?

A: Technical analysis focuses exclusively on the study of market action while fundamental analysis focuses on the underlying economic forces of supply and demand that cause prices to move up or down or stay the same. The reality is that both technical analysis and fundamental analysis are important and can be used together when formulating a trading strategy. Technical analysis and charting is actually interesting as theoretically the graph should depict the underlying fundamentals, they are intrinsically linked; as market price tends to lead the known fundamentals. The general principle of technical analysis is that prices tend to fall to points of support, settle and move back up or fall further and rise until they hit resistance and often fall back before continuing their upward journey.

A problem with fundamental analysis is that it doesn't give you the exact levels entry/exit levels, neither does it tell you when it would be best to open a hedging position to protect against a fluctuating market. So entering an equity cfd trade basing yourself on fundamentals only is not practical as yield and Price/Earnings ratios can remain unchanged for months (if not years). In these cases the fundamentals may change only due to corporate actions such as the company announcing a trading update or a director disposing of shares - however trading equity contracts for difference on such announcements is a risky strategy as market sentiment can be stronger than the fundamentals of the corporate newsflow. So it is usually a safer strategy to combine both technicals and fundamental analysis. For instance results released when a stock is in an positive trend can signal a great opportunity to go long as the uptrend implies that the fundamental update would be greeted by the market. On the other hand, bearish data released released into negative sentiment, as would be the case if the stock were in a downtrend or had just broken support can provide an ideal indication of a possible short.

So you can use fundamentals to decide whether to go long or short on an equity cfd trade and technical analysis to determine entry and exit points and the level at which to place a stop loss. Do keep in mind, however that technicals are usually more important for shorter holding periods while fundamentals are more important when considering longer timeframes. This is because fundamentals can persist for quite a long time but technicals can change completely if key levels of support or resistance are breached.

Once I heard an experienced trader say that it matters little whether one finds a stock using fundamentals or technical analysis (although it would be wise to use both), so long as one always checks the other side before taking the trade/investing. I think he was spot-on. You can't fight a downtrend so why try...better to wait for the downtrend to end. Equally, no point in heaving into a share which is blatantly on the verge of breaking some covenant or other. Earlier this year, having used fundamentals to build a good watchlist, all I had to do was take the trades as they came up on my technical analysis scans...sounds simple huh. And now I am using my technical analysis scans to exit the trades but at times I have had to reverse the exit and go back in because the pull-backs have been shallow. I have no problem with that and I shall stick to my plan because in 2008, when all around me were losing money, I was safely out of trouble.

Q.: How long does it take the average person to learn how to trade well?

A: This is really a relative question because it depends on the individual and each one of us learns differently, however invariably learning to trade will require substantial time, solid commitment and focus. Learning to trade also depends on a number of variables some of which are outside our control. We can do our best to control the variables we control and this helps to create success (well, that coupled with that little bit of good fortune!) . Success is, however, not just about making good choices but also about avoiding the bad choices and when opportunity presents alternatives, make no mistake the choice you make will help decide the final outcome. Some traders will call this luck but no matter what they call it, the outcome is determined from the decisions you make. The question, is, are you able to make good choice when the variables you don't have control upon present you with opportunities? I believe that one has mastered trading when he's able to make good profits on a consistent basis and the number of good choices outnumber the number of bad choices.

Q.: Should I trade intraday or end-of-day or both?

A: Whether you choose to trade intraday or end-of-day is not important IF you have a system. What is important is that you stick to just one strategy until you find your feet. Dabbling with intraday trading and end-of-day trading at the same time for instance can be dangerous. When I started trading the index my equity trades immediately suffered so I dropped them and made considerable progress. I gradually got back into both and made a good call in January to close my equities near the top. Nearly all those gains were lost last week on the dead cat bounce (bear trap). The reason why the two don't mix is really quite simple. If you trade end of day (EOD) you will quite likely see a different trend to those who are trading a different timeframe. If you trade intraday you will be seeing different trend directions depending on what time frame you are trading. So an uptrend on end of day could be a downtrend on the one hour chart and an uptrend on the five minute chart. Using multi-timeframes as per Elder is useful to identify consistent trend direction but trying to trade different timeframes at the same time often in different directions confuses the emotions imo. Another issue is that risk: reward will be completely different as will money management. They will also mess up your emotions and discipline.

Q.: But how difficult is day trading? How long does it take to be successful?

A: Day trading is easy. Profiting from it is the tricky part. I have tried it myself and find that I lose as much as I gain, plus it is too stressful for me, not to mention it is very boring just staring at the screen. So, day trading is not for me. I swing instead. Yeah, baby, yeah. It suits my personality. You need to try them to be able decide which trading style (day, swing or position) suits you.

Length of time for successful retail traders: I've heard anything from 6 months to 2 years.

Q.: What do you think about swing trading?

A: Response by Henry, expert chartist. The thing to remember with swing trades is that they are not always available. They tend to come in gluts at the end of a major index (say FTSE) pull back. Other times the pull back of an individual stock can look good but it may be because there is good reason for the fall in price such as a profit warning or a director selling. You must check the fundamentals are still sound and there is no bad news before trading.

Why I like these swing trades is because they are so simple. Just one moving average and buy the up day candle crossover then use a down day candle crossover as your stop:

Swing Trading

Nothing works all the time so imo swing trading is best done on the most liquid larger cap stocks with tight spreads with profit hopes for 5-10% per trade. Even decent smaller companies can be more difficult to short term swing trade. It would have been hard to make much out of RHL:

Smaller companies can be more difficult to short term swing trade

Q.: What is risk appetite and risk aversion?

A: Higher risk usually implies either bigger gains or bigger losses. Risk appetite suggests you are looking for risk to try and maximize your gains.

Risk aversion is the reluctance of a person to accept a trade with an uncertain payoff rather than another trade with a more probable, but possibly lower, expected payoff. For example, a risk-averse investor might opt to put his/her money into a bank account with a low but locked-in interest rate, rather than into a stock that is likely to have higher returns, but also comes with the risk of becoming worthless.

 ...Continues here - Successful Traders versus Losers