Are they buying or selling stock? How many options do they have outstanding? Study both relative and absolute valuation. A stock may appear cheap when compared to a stock in another sector, but very expensive against its peers. Thus, different investment situations call for different valuation metrics to be used. You should also study the rate of growth of the earnings metric you chose.
A company may look expensive at 30x earnings, but if it is doubling revenue every year and tripling earnings, it may not be so expensive after all. In fact, if you believe that this trend can continue, it may be an excellent long investment idea.
How does the company control for this? How do you as the investor assess the downside risk from this? If a catalyst is expected to take place in the near future, you probably want to have your position fully sized immediately. If not, it may make sense to taper into a position. That means when a stock continuously goes up, day after day, the investor feels like he or she is missing an opportunity, and will be inclined to buy the stock. This pile-on mentality causes more investors to become a part of the action.
This is a classic, human reaction to a strongly outperforming stock, and it can often lead to poor returns due to an undisciplined approach and the fickle nature of the market.
The same thing can happen when a stock continues to drop in price. Investors tend to panic and sell at exactly the worst time. During the heat of the battle, people tend to get emotional and sell their best stocks out of fear. The liquidity of a single stock is not a reason for a fundamental investor to buy a stock, but it can definitely be a reason for an investor not to buy a stock.
The less liquid a stock is, the riskier the position becomes, as it is difficult to exit an illiquid position—especially during turbulent market conditions, when liquidity is often demanded. In order to determine how liquid a stock is, you need to see how many shares trade on a regular basis. If your desired position is much larger, then it could take many days to accumulate the desired position — and similarly, it could take a long time to unwind the position when you want to exit.
This makes the investment much more risky. Therefore, a stock may have fantastic management, excellent earnings growth, and an attractive price, but if there is no liquidity you probably simply cannot buy it. You may think that you have found a gem: Fortunately, that notion is relatively easy to confirm or disprove.
For example, suppose that W. Grace GRA offers an exciting investment opportunity, according to your analysis. However, looking at the holders list, you determine that other hedge funds are well aware of this opportunity, as the top shareholders include large hedge funds such as Lone Pine, York Capital, TPG Axon, and Hound Partners.
It may not be a bad thing that other hedge funds are involved. You will probably be invested in a good company in this case, as large hedge funds rarely get involved in unsound investment ideas.
That being said, crowded trades can, again, be very risky. First, if the market is already anticipating good news, it may be that the good news is already baked into the stock price. Second, if bad news comes out, then everyone will likely be forced to run for the exits at the same time. This will lead to adverse price movement that could destroy your holding.
Hedge funds in general tend to be short-term focused, so it could turn into a situation where one investor exits swiftly and triggers a domino-effect panic, crushing other investors in the wake. Looking at charts can be very deceiving and can create misleading signals.
For example, the stock chart below shows a quickly rising stock price, but that does not mean it is expensive. It may be cheap relative to its own history, the rest of the sector, or the market as a whole. The entire stock market might have been going up rapidly, or the sector as a whole might have had a big rally, and relative to the sector the stock underperformed, so it may actually be cheap on a relative basis. You may also want to compare several valuation metrics simultaneously.
Relative to the market that is high, but relative to its own history, that is a normal trading ratio. It is just as important to understand the industry in which a company operates as it is to understand the company itself. For example, if you are studying a homebuilder, it is important to understand the companies the homebuilders buy supplies from. If the building products companies are raising their prices and the homebuilder cannot raise prices, the builders are going to see their margins compress.
A change by the mortgage originator will likely have an impact on the entire industry. If Bank of America BAC tightens its origination standards, then people will buy fewer homes; homebuilders will buy less carpet to go inside the homes; fewer beds will be sold; etc. Therefore, before considering an investment in a homebuilder or related entity, it would behoove you to perform checks to see what else is occurring in related industries and sectors across the value chain.
Companies with barriers to entry have a huge advantage relative to companies that do not. These barriers can occur for a variety of reasons, but some of the most common include economies of scale, substantial investment requirements, technological innovation, favorable government regulation, and networking effects. Both buyers and sellers are unlikely to go to other sites, because both realize that eBay offers more individuals on the other side of the aisle to transact with.
This makes it hard for new auction companies to compete with eBay effectively. Companies in most industries will claim that they have high barriers to entry, but time will often show that a company earning significantly higher than its cost of capital will attract competitors.
Put simply, if the company is earning outsized returns on the capital it invests, then it will attract competitor investment seeking to earn comparable returns. This competitive investment will result in increased production and sales competition, and diminished profit-earning potential will surely follow in the future. The low-cost producer can have a huge advantage over its competition.
In industries with large legacy assets, such as cement or coal production, the players with the newest assets are typically the lowest cost providers, and that allows for lower pricing often results in greater market share. Repeat purchase items, such as paper or office supplies, can create a strong advantage for the producer. The more entrenched companies become within their customer bases, the higher the switching costs for those customers. Companies with large fixed costs need scale in order to make a profit.
The larger the fixed costs, the larger the scale needs to be. Incremental margins can be very high once a company crosses a certain threshold and is able to sufficiently leverage its cost base.
This can make a company highly attractive and cause a company to trade at a high multiple, once the threshold production level has been achieved. Functioning oligopolies can act similar to monopolies, in terms of locking in outsized profit margins from its business.
These situations should not take place for long according to basic economic theory, but they can and quite often do. When one of the four manufacturers raises its prices, the other three can easily follow. For the past five years, none of the players has broken from the pack and tried to steal market share from the other three by offering a lower price.
Whether this increase in margin is sustainable over the long term remains to be seen. How do you know? What is a good return for an individual investment?
This is the equation from the Capital Asset Pricing Model CAPM , which you will learn in school—but try pitching this to a portfolio manager at a hedge fund. He or she will likely tell you to get lost! A more practical approach is to study what percentage of the time you will make money and lose money on your investments. From there, you need to understand how much you make when you are right and how much you lose when you are wrong. Here is an example of this framework:.
Here is what is so troubling about the example given above: So how can an analyst generate a higher return per idea? A higher Hit Rate is very difficult to achieve. Therefore the only real area to control is the Slugging Rate. It is just not a high enough annualized return. What needs to happen in order for a stock price to increase? Either earnings need to expand, or the multiple needs to expand, or a combination of the two. The first step is to look at where the sell-side estimates are for the current year and two years into the future.
Or, you might predict stronger earnings growth and less multiple expansion, or vice versa. As you can see, it pays to think through different scenarios needed to achieve your target return. A common mistake analysts make is to say that they believe a stock will appreciate by an amount but have earnings expectations that equal or are very similar to those of sell-side earnings estimates.
That means that for the investment thesis to prove correct, the stock must increase entirely due to multiple expansion. High insider ownership Well respected Clean accounting Infrequent restating of earnings Not overly promotional Good allocators of capital. Will the company beat earnings expectiations in the next quarter or in the next year? If so, what are the catalysts that will cause the Company to beat earnings e.
Paint the picture of how, when, and why there will be a catalyst that supports your view. Providing an opinion without fully understanding and explaining the relevant value drivers will be a recipe for failure.
What can go wrong? Does your pitch rely on multiple expansion? Where is the company trading relative to its historical multiple? Should the multiple trade at a premium or discount given how the company has changed over the years, and where we are now in the business cycle? Where is the company trading relative to its peer group? If the entire market has seen multiple expansion, then is it fair that this company should too?
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