Table of contents:
- 1 The first thing to do is to choose the right sector
- 1.1 Rotation of the lucrative industries
- 1.2 What you should pay attention to in stock analysis
- 1.3 It depends on the product or service
- 1.4 High research and development expenditure
- 1.5 Pay attention to incoming orders as a leading indicator
- 1.6 Consider the competitive situation
- 1.7 Conclusion on stock selection
The core of fundamental analysis is the identification of promising stocks. Interesting are always those shares that are valued far too low or too high by other market participants.
The eternal ups and downs of share prices and the unmanageable number of shares present the analyst with a difficult task. He must always look at the “intrinsic value” of a company in comparison to other companies. The approach of the analysis is no different for special stocks than for large standard stocks (blue chips).
The first thing to do is to choose the right sector
In order to find a good share, the selection of a promising sector is of great importance. Some industries are growing, and others are shrinking. That is why sector growth has a maximum impact on share value.
Experienced stock market experts know that once an interesting sector has been identified, one should take a close look at the three most important companies and the newcomers. The top companies in the sector are the focus of the media. That is why the top three in the industry often show above-average share performance. Newcomers who can revolutionize an industry with a new product or service should not be underestimated.
This is what a rough sector classification could look like:
- Finance, insurance (e.g. Deutsche Bank, Goldman Sachs, Allianz)
- Environment, utilities (e.g. RWE, E.ON, energy companies)
- Mechanical engineering (e.g. Linde, Nordex)
- Cars (e.g. VW, Daimler Benz)
- Electrical (e.g. Siemens, Deutsche Telekom)
- Chemicals (e.g. BASF, 3M)
- Raw materials (e.g. Thyssenkrupp, K+S)
- Construction (e.g. Bilfinger, HeidelbergCement)
- consumption (e.g. Walmart, Nike)
- Healthcare (Pfizer, Bayer)
- Other industries (e.g. printing, paper, textiles
The allocation of a company to a sector should not be too strict. Very often companies are broadly based and the individual business areas overlap with several industries. If you compare companies with each other, the service structure should be similar. If, for example, you were to compare the automotive supplier Continental with VW, it would be more like comparing apples with pears. Both companies belong to the automotive industry, but they do not compete with each other. Their range of services is fundamentally different.
Rotation of the lucrative industries
Within an economic cycle there is a rotation of industry growth. For stock market participants, this means that the use of investment funds must be adapted to the favoured sectors. When selecting a promising sector, the timing (phase within the cycle) is of great importance. For example, a really good stock can show a weak performance because it is part of a weak industry.
Industry charts often help. In this case, an index is formed from the shares of an industry and prepared visually. This enables the analyst to follow the development over a historically relevant period of time. It is then much easier to identify the above-average market phases.
After the sector decision, the share must be selected.
Statistical measurements have shown that in most sectors the first three companies show the best performance. However, the analysis should not be as simple as that. What counts is the “intrinsic value” of a company. It is this value that accounts for the majority of a stock’s movement.
If the intrinsic value is too high, there is more likely to be a tendency to sell. If the intrinsic value is too low, then it is worth buying.
The basic principle of intrinsic value is based on the thesis that market participants do not know all the information about the share. They over- or underestimate the value. The intrinsic value can also be described as fair value.
There are typically two business approaches to valuing a company and its shares.
- Net asset value
- Net asset value
The capitalised earnings value is the forecast of future profits in relation to market capitalisation. The net asset value is calculated as the ratio of net assets plus hidden reserves to market capitalization.
Market capitalization is always a snapshot and is calculated from the number of shares issued and the current share price.
Extensive business management knowledge is required to calculate the capitalised earnings and net asset value. Banks and institutional investors employ specialists for this purpose. This is not a sensible approach for private investors, who often lack the knowledge, information and time.
A small consolation: If you look at the professional analysts’ estimates and compare them with the actual company data, you will quickly realize that the error rate was very high even among the experts.
What you should pay attention to in stock analysis
For the private investor it makes sense to concentrate on details that show the company in its external presentation. The own assessment and the perception of other market participants are decisive. If you have bought a share, you can only win if other market participants believe that the share has a higher value than your entry price.
It depends on the product or service
The company’s profit expectations are directly related to sales expectations. Sales are inextricably linked to the company’s products or services. You should therefore pay attention to the quality and market position of the products. Do you ask yourself whether the product meets the needs of the customer and whether it will be able to hold its own in the future?
Good management increases the value of the share
The qualification of the management is difficult to assess. It is reflected in the ability to attract innovative employees to the company. In this respect, one should definitely pay attention to the image of the company. After all, a good image often attracts good employees. They are the ones who make the difference to the competition.
A tip: Watch out for luxury symbols of management. Experienced fund managers react “allergically” to exaggerated luxury of management. And rightly so. If the company is affording exaggerated luxury vehicles or even maintains private aircraft, this indicates an “ego trip” by the management. Such management does not develop the company further, but manages it. It basks in old successes. These are bad conditions for the share price.
High research and development expenditure
High expenses can also be incurred through research and development. However, these are always expenses that represent an investment in the future. In this case, high company potential is synonymous with a future rise in the share price.
Pay attention to incoming orders as a leading indicator
An important indicator for sales is the number of orders received. Here, one should look at the development of the figures. This also allows a good estimate of the development of the future demand situation. Declining incoming orders have an effect on the short-term liquidity of the company. Quite a few “healthy” companies have already run into liquidity problems because vital income has been lost in the short term.
Consider the competitive situation
A company is rarely a monopolist in its industry. Where money is made, there are always imitators and profiteers. Money is like light that attracts moths in the dark. An increase in competition in the industry acts as a long-term brake on sales and profits. It is said that competition stimulates business. However, this statement usually comes from new entrants to the market who want a piece of the pie. Established companies are less pleased.
Conclusion on stock selection
Fundamental analysis is an extensive and complex subject. It cannot be conclusively clarified how in-depth the analyst’s approach must be. It is difficult for a private broker to gather the right facts. The Internet is very useful in this respect, but in most cases, a personal visit to the company must be avoided. The competitive advantages of banks and institutional investors in research are virtually unassailable. Therefore the private stockbroker should focus on the most important things about the company. Detailed financial analyses of the private investor usually do not bring any benefit that could be converted into profitable trading.
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