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Selecting Stocks with Fundamental Analysis

Fundamental analysis is the determination of the security’s value/intrinsic value/fair value. Fundamental investors select/pick stocks through two major types of fundamental analysis;

Top-down Approach

An investment approach that starts by looking at the “big picture” first (i.e the economy and sector) before narrowing down the analysis to the companies or stocks within the identified sector

Selecting-Stocks-With-Fundamental-Analysis-Top-Down-Approach

  • For instance, U.S. economy is starting to normalise interest rate as the country is on path of recovery → Investors in Malaysia will be impacted as the local currency will lose momentum against the Greenback → The weakness in local currency will indirectly benefit the local export sector → The local export sector comprises of furniture, semiconductor, rubber, plantation and etc industry → Business that has the highest exposure to currency fluctuation (% of sales denominated in USD vs. costs denominated in Ringgit) will be the biggest beneficiary.

Bottom-up Approach

An investment approach that focuses on the analysis of individual stocks. In bottom-up investing, the investor focuses his or her attention on a specific company rather than on the industry in which that company operates or on the economy as a whole.

Selecting-Stocks-With-Fundamental-Analysis-Bottom-Up-Approach

  • For instance, piling specialist, Econpile Holdings Bhd’s initial public offering was on 30th June 2014 → There is a change in dynamics in the industry as developers are focusing on high-rise buildings due to limited supply of land and protect margins → The boom in construction sector complements the increasing usage on piling expertise → Budget 2014 to 2017 highlights the importance of the construction sector, serving as the backbone of the country towards the high income nation till 2020 → Surplus of foreign direct investment to fund the economy’s growth.

 

Having selected a specific stock to invest, we determine the fundamental qualities of the company through various measures such as identifying the historical growth rate, valuations metrics and compare them with their peers in the same/similar industry.

A strong fundamental company traditionally has the below fundamental metrics;

  • Double digit revenue and core earnings growth
  • Net Cash position (depending on nature of business)
  • Stable dividend pay-out
  • Positive Operating Cash Flow

Based on the table below that measures the historical Price-to-Earnings of Technology giants listed on Bursa Malaysia.

Price-to-Earnings-of-Technology-giants-listed-on-Bursa-Malaysia

According to the table above, Inari Ametron Bhd appears to be to most under-valued stocks amongst its peers in 2012, KESM Industries Bhd in 2013-2015 while Malaysia Pacific Industries Bhd in 2016. Albeit that, a more complete measure will take into of the earnings growth through Price-to-Earnings Growth Ratio (PEG).

Generally, the lower the PEG (preferably less than 1.0x), the less you pay for each unit of future earnings growth. Therefore, even a company with a high P/E, but promises high projected earnings growth, the stock may be a good value. However, the drawback of PEG is that it is about year-to-year earnings growth and it relies on projections, which may not always be accurate.

For example, Company A has a P/E of 15.0x and projected earnings growth at 10.0%.

PEG   =   Untitled-1-02   =   Untitled-1-01   =  1.5x

Meanwhile, Company B has a P/E of 20.0x and projected earnings growth at 30%.

PEG   =   Untitled-1-02   =   Untitled-1-03   =  0.7x

Investors would find Company A more attractive since it has the lower P/E at 15.0x vs. Company B trading at 20.0. However, Company A doesn’t have a high enough growth rate to justify its P/E. Company B is trading at a discount to its growth rate and investors purchasing it are paying less per unit of earnings growth.

 

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