Selecting Your First Stock

A journey of a thousand miles begins with a single step, but this first step can be a challenge for the average investor given the plethora of investment options available in the stock market. In Singapore's stock market alone, there are close to 800 listed companies for investors to choose from. The task becomes even more arduous when investors venture out into the Hong Kong and US stock markets, where they are confronted with tens of thousands of listed companies in total. As such, having a sound investing framework, with a clear set of rules and guidelines, can go a long way towards helping investors pick the right stocks for their portfolios.

Fundamental Analysis Or Technical Analysis?

There are generally two main techniques that investors use to analyse and make stock selection decisions – fundamental analysis and technical analysis. Fundamental analysis seeks to determine the true value of a stock (intrinsic value) by examining the underlying financial health of a company, focusing on its financial statements, including the balance sheet, income statement and cash flow statement. Fundamental analysis serves to answer questions such as:

1. Is the company profitable?

2. Has the company been growing its revenues over the past few years?

3. Is the company highly leveraged? Does it have the ability to pay off its debts?

4. If it has been paying dividends, can its cash flow sustain future dividend payments?

Besides looking at quantitative data, fundamental analysis also involves the analysis of qualitative factors, such as the track record of a company's management, its branding power and any other proprietary patent or technology that the company owns. On a broader scope, investors can perform fundamental analysis on the industry (e.g. competitive landscape and consumer trends) and economy (e.g. economic growth, political stability and regulations) that a company operates in, as both of these are underlying factors that affect a company's current business performance and its future prospects. In contrast to fundamental analysis, technical analysis attempts to predict future stock price movement by analysing past trading data, such as price movement and trading volume. Unlike fundamental analysis, investors who employ technical analysis in their investment decisions do not analyse a company's fundamentals to determine its intrinsic value. Instead, they analyse past trading data through charts and other various technical tools to identify trends and patterns that can help to predict future price movements.

While there is no definitive answer as to which investment analysis technique is more superior, one thing for sure is that both approaches have their respective merits and drawbacks. In fundamental analysis, long-term investors have access to a logical and sound investing framework that measures the intrinsic value of stocks, by examining related economic, financial and other qualitative and quantitative factors. Not only will investors have a better understanding of a company and its business, the intrinsic value determined through fundamental analysis can also help them decide if a particular stock is overvalued or undervalued. The downside, however, is that this method is time consuming and there is no guarantee that the assumptions used in estimating a stock's intrinsic value will materialise. On the other hand, technical analysis is favoured for traders to time their stock purchases and make short-term profits. As chart patterns are easily identifiable, technical analysis is also less time consuming as compared to fundamental analysis. However, it does not take into consideration the fundamentals of a company, which can be a risk especially if the company is under financial distress or trading at excessive valuations, and it does not always work as no one can accurately predict the future.

Stock Picking Guidelines

We list down some guidelines that investors can follow when picking their very first stock.

1. Invest In The Best

As many long-term investors consider blue-chip stocks to be secure investments, they can be great starting points for investors who are looking out for investment opportunities. Blue-chip stocks are typically well-known and established companies that have sound business models, strong balance sheets and cash flows, and have historically shown to generate consistent growth. They also typically have a reputation for quality management, products and services. As such, in times of market downturns and adverse economic conditions, blue-chip stocks are known to be resilient and are seen as less volatile instruments as compared to other stocks. Their stable and reliable growth, coupled with their dividend payments, make them suitable candidates for addition to an investor's portfolio. Of course, investors need to carefully consider the risks, future business prospects and valuations of these blue-chip stock before they actually make the investment.

2. Stay Within Your Circle Of Competence

The concept of 'circle of competence' is fairly simple. When investors stay within their circles of competence, they invest only in stocks whose business models are easy and straightforward for them to understand. If investors possess specific industry knowledge about a company that others may find complicated, they can also use this knowledge to their advantage as they will know which companies in a particular industry are potential candidates for investment, and which ones are those that should be avoided at all costs. By staying within their circle of competence, investors stick with what they know and invest only in the companies that they understand, thus reducing the probability of making investment mistakes. Furthermore, it helps investors narrow down their investment universe to those companies that they are comfortable having in their portfolios, instead of having to sieve through the thousands of companies that are available in the stock market. As investors acquire more knowledge in a given field, they expand their circle of competence, and will be able to evaluate more companies for their portfolios. Staying within our circle of competence is important, because investing in businesses that fall outside of what we know (especially when we are buying into hype) represents pure speculation and is a sure-fire way to lose money on our investments.

3. Price Is What You Pay, Value Is What You Get

A stock that is $10 per share can be more expensive than another stock that is $100 per share. This may sound counter-intuitive to many, but it captures the essence of Warren Buffett's adage, that "price is what you pay, and value is what you get". Price and value and not always one and the same – price is simply the amount that a buyer and a seller is willing to transact at for a particular stock, but value represents how much a stock is actually worth given its fundamentals and future prospects (also known as intrinsic value). As stock prices are influenced by fundamentals in the long-term, investors should always assess stocks by looking at their value and expectations for future earnings, investing only in those that are reasonably expected to worth more in the future (i.e. stocks that trade at prices below their intrinsic values).

4. Evaluate Financial Health

It pays to look at the financial statements of a company before investing in its stock. Ideally, investors should invest in companies that have a consistent history of revenue growth, stringent cost control and healthy bottom line, not just for the recent few quarters, but over a longer period of time, such as ten years. The focus should be on the ongoing operations of a company, as extraordinary items on an income statement can paint an inaccurate picture of a firm's earnings power. Also, investors should examine a firm's balance sheet carefully to ensure that it does not have excessive debt, as a high debt-to-equity ratio can result in large interest expenses and volatile earnings, which in turn can lead to a volatile share price. Such companies are also at greater risk of going bankrupt, in which case their shares will become worthless. While there is no universal definition of what constitutes a high or low debt-to-equity ratio, investors can compare the debt-to-equity ratio of a company to its other peers that are operating in the same industry, as different industries rely on different amounts of financial resources to operate.

5. Use A Stock Screener

We understand that selecting a good stock from amongst the tens of thousands of companies out there is no simply task. If you're still unsure of where to start looking for your first stock investment opportunity, we have a useful tool on our website to help get you started – the stock screener. The stock screener helps investors narrow down the sheer number of investable companies to those that meet their standards and strategy. Using the stock screener is fairly simple. Investors need only specify the fundamental or technical criteria, and the screener generates a list of stocks that meet the stated requirements. It is certainly a good place for investors to start their research process, and it saves investors time by narrowing down their options to a more manageable group. Investors can then pick a few stocks from the list to continue their fundamental research before coming to an investment conclusion. While it is far from useless, the stock screener should not be seen as the be-all and end-all of investment research. Investors are setting themselves up for failure if they build their stock portfolios based entirely on what the list that the stock screener generates.