Trading Strategy

This section is concerned with the actual share trading strategy, focusing on how to pick a stock, when to buy and when to sell, ultimately with the view to being successful in your trades.

Fundamental Analysis

We talked about the main indicators determining the fundamental situation of a particular company. Fundamental analysis takes into account much more factors than the Earnings per Share and Price/Earnings ratio discussed in Market Forces. Fundamental analysis is the starting point for any share trading strategy. It has such prominence in my own method as it ultimately determines the intrinsic value of the company, i.e. what a company is worth. The intrinsic value of a company is worked out by adding together all the profit that the company will make in the future and discounting the figure due to the fact that £1 will not equal £1 in a year’s time, hence the need to readjust for currency changes. So when (sometimes in an accusatory fashion), companies are said only to be interested in profit, it really is the case. Profits determine how much a company is worth and if the current price of the company (seen in its share price) is lower than the actual worth of a company, the share price is clearly a buy. It takes some maths to work out the value of a company. It also takes predictions about a company’s future profits which are educated guesses (based on statistical data analysis called Discounted Cash Flow Analysis) at what the company expects to gain in terms of profit in the future. Much more can be said on this, but in order to give a more general overview, time and space do not serve to give long explanations about what can be done to ascertain the actual intrinsic value of a company. The point is that there is the inevitable need to study the company, do the hard-work of finding out if a company is undervalued. Because the objective is that if a company is undervalued, the fundamental data will eventually ring loud in the corridors of the stock market and investment banks, institutional traders and private investors will eventually buy the stock.

There is more than just crunching numbers to determining a company’s true value and whether it is a suitable company in which to invest. More general questions about the company can be raised to give you a clearer idea of whether it will make a profit in the future and whether the share price will rise as a result. The main starting point would be to ask questions about the management i.e. who are they, were have they come from, what have they shown in their past to warrant a confident investment, where are they professing and demonstrating in their management philosophy to be taking the company in the future. A company is only ever going to be as good as its managers and if the management team, structure and historical success of these people is impressive, the company warrants a closer look.

What is the company actually doing? This can be overlooked at being a bit obvious, but without asking the question, you could be looking at a company with great future prospects (inevitably hyped up prospects) and in reality the company is trying to sell ice to Eskimos. Not all instances are that obvious or indeed that illogical but the question needs to be asked.  The classic example of this is the dotcom boom which eventually crashed. Most investors had no idea why the dotcom companies were making the money they did. But it did not matter, ‘they were in ‘IT’ and ‘the Web’ and stuff like that. It’s modern technology that will revolutionise the world so we must invest‘, etc. Warren Buffet, someone to whom I shall refer again and again, was not taken in by the herd mentality that was throwing its money at anything technological. He did not understand it, could not see where its intrinsic value lay and was criticised by the industry for not investing. Many millions upon millions of dollars was lost when the dotcom bubble burst, but Warren Buffet did not lose a penny and he was justified afterwards for not investing as the true intrinsic value of the IT industry eventually revealed itself for what it was, overly bought.

What industry, or what competition the company faces is also another important question to ask. For example, the steel industry started to suffer in 2007 in Europe particularly. Look at Salzgitter’s (a German steel making company) chart for an example. Salzgitter’s history has been nothing but impressive, the graph would suggest that over the previous 5 years, in spite of difficult times coming in the world economy in 2000 and again in 2002, Salzgitter’s share price did nothing but grow. The P/E ratio remained at a very attractive level too, not risky but not an overly priced company either. All in all a very worthy company to invest in, so it seemed. However on a wider economic front (those technical factors that can have an effect on share price), the steel industry in China was having a major affect on European steel companies as China was able to sell steel at significantly lower prices than it’s competitors. So in spite of Salzgitter’s apparent appeal as a suitable investment, wider factors namely the steel industry in China was suggesting that the company’s real value was not as high as its share price suggested. And the share price fell, significantly. What the company actually does in view of the wider picture of the industry in which it operates may tell a very different story.

Other less important but equally valid questions to ask would be concerning branding and common sense deductions. It is important not to be too confident about any one brand name as any bad news against the brand, a profit warning, a court case, a scandal, etc. may have big implications. Companies like Unilever or brewers such as Scottish & Newcastle that hold a vast range of brands can be a lot less risky for if one brand name is put under significant scrutiny, the company has plenty of other strong brand names to fall back on. I imagine that the vast majority of people living in the UK do not know that the company who makes Flora Margarine is the same company that makes Persil washing powder is the same company that makes Vaseline healthcare products. If Persil is not cleaning clothes as well as it should, the company can still make money from the fact that Vaseline is still keeping you looking young.

Common sense is also a vital factor in share trading. You do not have to be a whizz kid technical genius to see a good idea or indeed a bad one. Indeed most of the whizz kids in the dotcom bust lost out inspite of all their number crunching abilities. Sometimes somethings are just plain obvious. If you do your work, know your stuff, are sure of your figures, common sense will be an added extra tool that you can use to determine a good trade.

So when all the questions have been asked, what should we do before we invest our money into a company? This question shall be taken up in the next section, Investing.