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Stocks - The Long Term Investor Point of View

An investor in the long run can play in a number of ways, be it by application of fundamentals and technical analysis, fundamentals, or technical analysis.  I'm in favour of fundamental investments, with emphasis on buying low and selling high.  What is fundamental investments?  My definition of good fundamental stocks are based on:-

1.    Annual Revenue growth for past 5 years > 25%

2.    Annual Profit growth for past 5 years > 25%

3.    Quarterly Revenue growth for past 5 quarters (compared to same quarter the previous year) > 25%

4.    Quarterly Revenue growth for past 5 quarters (compared to same quarter the previous year) > 25%

5.    ROE > 18%

6.    ROA > 5%

7.    Current ratio >= 1

What is the meaning of these terms, and why do I place my decision on them?  Lets go into them one by one:-

1.    Annual Revenue growth for past 5 year > 25% - Revenue refers to the gross income generated through sales of goods/ services, as well as any investments.  Revenue growth refers to the rate of increase in revenue as compared to the previous year.  A company with revenue growing consistently at a rate of 25% or more shows a consistent growing company, which means a high potential for price increase.  Usually, this company is either eating up market share in a mature market, or capturing market share in a developing market, both of which signifies increasing market value.

2.    Annual profit growth for past 5 year > 25% - Profit refers to nett income after accounting for operating expenses.  Profit growth refers to the rate of increase in profits as compared to the previous year.  A company with profits growing consistently at a rate of 25% or more shows a company whose sales is growing, while expenses related to the sales including margin is constant or decreasing. 

3.    Quarterly revenue growth for past 5 quarters > 25% - Similar to (1), a company with revenue consistently growing with respect to the same quarter the previous year signifies strong consistent short term growth.

4.    Quarterly profit growth for past 5 quarters > 25% - Similar to (2), a company with profits consistently growing with respect to the same quarter the previous year signifies strong sustainable short term growth.

5.    ROE > 18% - Return on equity refers to the profits generated from the equities of the company.  A high ROE signifies the ability of the management to generate profits from its equities, and is a sign of strength,

6.    ROA > 5% - Return on assets refers to the profits generated from the assets of the company, and is generally used for companies whose income is produced from its assets.  It also signifies the ability of the company to generate returns from its assets.

7.    Current ratio >= 1 - Current ratio is the ratio between its current assets and its current liabilities.  A good current ratio >=1 shows the ability of the company to pay up its short term liabilities, and is a sign of strong balance sheet.

I'd pick stocks with the above requirements as candidates for my watchlists.  The next critical factor to the final selection of the stock comes from its competitive advantage.  By this, I mean if the company had to increase its price, would its sales be affected?  A company with sustainable competitive advantage usually has some form of monopoly, and hence would be able to increase its price to meet with inflation without impact on bottomline.  This also means significant barrier to entry for competitors.  The final shortlist comes from stocks who also have sustainable competitive advantage.

Once the stocks are shortlisted, the few remaining steps to be taken is to set a target buy and sell price for each of the stock, which has to be done at least every year.  The means to set the buy and sell price is highlighted below:-

1.    Obtain 10 years of historical financial data, focusing only on earnings per share, which is determined from profit divided by the total number of shares outstanding.

2.    Obtain the corresponding price range of the shares during the period.

3.    Tabulate the ratio of earnings per shares vs price(high) and price(low).  This ratio determines the initial rate of returns you could obtain from the stock.  Why is this so?  This ratio shows the earnings you could reasonably expect from your investment in percentage terms.  This is because the stock is first chosen based n fundamentals, from which we do not expect earnings to decrease normally.  Hence, an E/P ratio of 12% implies that you will at least obtain a 12% returns on your investment in the first year.  As the stocks chosen shows a historical record of achieving 25% rate of growth in profit, you can reasonably expect the returns to approach 25% over the very long run, so long as the fundamentals of the stock does not change.  But why do we target the 2 E/P ratio?

4.    When the current E/P approaches historical high, that means price has reached close to its bottom for this year.  A purchase at this price would give you the highest possible initial rate of return at the lowest possible risk.  Does a high initial rate of return affect your stock in the long run?  You bet!!!  Just by taking initial rate of return of 5% and 15% respectively.  At a 25% rate of growth, it would take them 10 years and 5 years respectively for them to reach an average return of 23% per annum.  And this is assuming the E/P remains constant.

5.    In reality, when E/P approaches historical low, the reverse is true.  The price is overpriced and is waiting for a correction.  However, does this mean you should sell?  That depends on a few factors, whether you have other things to invest in, whether the opportunity cost is high, whether future growth is there.  In general, I do not advocate selling UNLESS the fundamentals have changed OR the E/P has gone way below(25% or more) the historical E/P(which will not come often, if at all).  However, I DO advocate buying in whenever the E/P hits the historical high.

A 25% returns is entirely possible for the average investor in this way.  This is in contrast with an investor with lets say $100m to invest, due to the diseconomies of scale they encounter due to their bulk.  The average investor can enter and exit the market easily with no impact over the price.  This means you can have a reasonable expectations of the price you pay and get when you buy and sell the stock, and to me is a powerful tool that gives me an edge over the big boys.

This is the basis of my theory of buying for long term, and I will go into other tools in future topics.