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The way to see companies to invest in stocks

When I was starting my passion of Investments & portfolio management, I came to know a fact about investment in equity stocks through Stock Exchange’s folk. An old guy of around 75 (years of age) told me with an intellectual smile, don’t invest in shares but invest in companies. It was my fist lesson on the first day visit to Karachi Stock Exchange. It opened a door of Financial Statement / Economic / Sector / Cluster / Operational analysis for companies. It was the practice to understand which company worth more for investment in Equity Stocks.

I can talk about Financial Modeling, Corporate Valuation Models or any other complicated aspect of analysis of the company’s financial health but I would keep myself restricted to the core facts. This is necessary for masses to understand and implement.

Before going to any thing, we need to know that Company never works in isolation of its sector and economy. Companies with great financial health can book failures if an uncontrollable environment hits them and their management exposure in facing this particular kind of situation is rare or nil. Financial statement is the keys to understand the company’s performance. Financial Statement is the historical record and our investment works in future that is unseen but can be forecasted. You can make sound premium by investing in financially weakest company but with sound management and stability in external environment (KEY FACTOR; RISK ASSESMENT & RETURN). We have to see what sort of new projects; the concern shall be staring in next five to ten years. It depends upon your threshold also. May be a company is jumping in a great project (in term of profitability and value) that can shrink cash flows for next five years for benefits in 10 years after that. In this regard you need to valuate the firm value in short term and long term. You need to finalize you objective that whether you are seeking for rise in market value of the share or seeking dividends.

If you are analyzing Financial Statement of the company, you need to care things beyond numbers. The understanding of Financial Activities and Operations is the key. It is not merely calculating ratios and decides. This is the main reason that makes Charted Accounts lesser effective in Business Decision making. In this regard required people are financial analyst, operational cum financial experts, sector and economy analysts. You can sum up the traits by saying “FINANCIAL RESEARCH & MANAGEMENT PROFESSIONAL (F.R.M.P.). F.R.M.P is a person who has sound knowledge of economy, the prevailing corporate environment, accounting & auditing procedures, regulations and regulators, human assets ability to convert policies in performance etc. A charted accountant and good mathematics / statistic mind can be a good F.R.M.P. but it is not necessary that all the CAs and Great Mathematicians /statistics expert can be good decision makers. The bottom line is numbers (outcome) are not important but the variables that make this number (outcome) appears are the area of concern for future.

Just take a simple example. We have two companies. One is company A and other is company B. Profit of company A is $1 million and company B’s profit is $2 million (for 2008). If we jump to the number for our decision, company B is an attractive investment opportunity. Now there are many things (assumptions or facts) in this regard that are mentioned below;

May be company A is having more non fund expenses; like depreciation, amortization etc. it says the company A is more liquid than company B.

May be company A’s profitability is effected by Taxation laws (deferred taxation or advance tax etc.). Company B will face the same in next 5 years and will look inferior before company A.

May be there are some non-recurring expenses in the PNL (Profit and Loss Statement) of Company A that cut the profitability. May be there are some non recurring income elements there in the PNL of Company B that enhance the profitability of B than normal.

May be Company B is getting more revenues from non operational activities like Investment in Shares and Bonds etc. May be B’s operations are in weaker position while comparing them to A. It simply adds the risk in investing in B, even with higher profitability.

May be the capital expenditure (CAPEX) is the cause of shrinkage in finance in company A. If they are going to wrap this in next year they will become more profitable than B.

Above mentioned assumptions (facts if they come out from historical record) are few points to show you that a number can not be self explanatory in the world of business and financial decision making. We need to see things in relevant context. This gives us a way to see thing beyond their presentation.

The market value of the stock is the function of supply and demand of the shares floating in the market. A good company (good book value) can work on cheap prices or vice versa in stock exchange. People says it speculation also but even speculation can not be derived with out movements in supply and demand functions. The stock market investor never acts on rumors except when he sees its reaction on supply and demand of the shares. This supply and demand can be temporarily structured but it has to be there for massive reactions. This type of transactions, its benefits and short comings are positively and negatively massive. It is recommended that you need to see your size while dealing in shares, if you want to play safe so play in companies with some basic knowledge and moderate level of RISK.

Here those people who invests blindly known as risk takers but it is really a non sense. Risk taker is the one who knows the RISK very well. Calculation of RISK has to be there. This calculation must be quantitative in term of professional valuator and common investor can make qualitative measurement. You need to invest in different companies with different kinds of risks so your total risk can be reduced.

If you are not capable to understand the basics of company’s operation and financial statement, so it is far better to invest with Mutual Funds and Fund Managers. They will have firm professional track of all the companies listed in stock exchange. There portfolio is highly diversified to get reduce risk.

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Asma Says:

very helpful material. Do write more regarding investment guidance.

30 - November - 2009 09:41:58 AM

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Mr. Omer

Mr. Omer [1982 born] started  his professional career as a commercial / investment banker after achieving Gold Medal in Finance at master level from University of Karachi in 2006.

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