Are there rules of thumb in investing?

Question: I would like to invest in the stock market using a system that I have developed. My system looks at specific financial ratios like net profit margin, earnings growth, return on equity and recent price movements. If companies and their stock prices meet the hurdle numbers in my system, I either buy or sell the pertinent stocks depending on the signal provided. Would this system be enough?—posted on PFA’s “ask a friend, ask Efren” service at www.personalfinance.ph

Answer:  Firstly, congratulations for coming up with a methodical approach to investing.  All too often, newbies would just jump into the bandwagon and end up holding the proverbial bag.

Now if I understand your question correctly, you are trying to come up with rules of thumb to take much of the agonizing analysis out of stock investing.

The phrase “rule of thumb” is said to have originated from the many ways the thumb could be used to estimate things such as the alignment or distance of an object, depth for planting seeds, temperature of beer and even as a substitute measurement for an inch.

But whatever the use, a rule of thumb is a convenient standard for approximate calculations or making some determination.

A rule of thumb is not to be considered strictly accurate for every situation.

Financial ratios help in analyzing the financial performance of a company at a given time and condition. It is in the assignment of absolute values to financial ratios that such ratios are transformed into rules of thumb.

Still, such ratios would mean very little if they are not taken in context with the actual business of a company.

For example, while debt-to-equity ratios should ideally not be high, they could be high for banks simply because banks’ debts, which are largely savings deposits, bear very little cost. You only have to see how much interest banks pay on their savings deposit accounts.

Secondly, such financial ratios should be compared to their historical trend.  A net profit margin of 20 percent will not be high if, historically, the company had been posting net profit margins of 30 percent.

A company’s financial ratios should also be compared to those of other companies in the same industry.

A return on equity that is higher than those of companies in the same industry may be a sign of a competitive edge for the company whose stock you are contemplating on buying.

Financial ratios, or at least the numbers they are based on, can be secured from the stock broker you deal with, annual reports of companies, financial data compilation services and even the Securities and Exchange Commission (either manually or through the online SEC iView service).

More importantly, since stock investing is mostly forward looking, you should do the preceding comparisons using forecasted financial ratios.

If you have the time and expertise, you can do the forecasts yourself. If not, you can secure the help of the stock broker you opened an account with.

Reuters and Bloomberg also provide such estimates. A certain level of data would be for free. Deeper insights will be provided for a fee.

One more thing, you will need to ensure that your financial ratios are derived from financial reports that were generated based on the same accounting principles.

At the risk of making your nose bleed, a capital-intensive business that uses the double declining balance formula for depreciation will not exactly be comparable to one that uses straight line depreciation. Comparing the two companies without making possible adjustments will be like comparing mangoes and durians.

On price movements, there are both technical and fundamental reasons for prices to move in a particular way.

That a stock’s price drops by 10 percent from its previous close does not necessarily mean that it is cheap. It could be that a major reduction in the company’s market share necessitated a drop in its price to bring it in line with its expected reduced earnings.

Just with financial ratios, movements in stock prices are better used as signals to do some more investigation.

So to answer your question, yes there are rules of thumb in investing.  However, these rules of thumb are just starting points. Remember that you are investing your hard-earned money. Therefore, you owe it to yourself to do some critical thinking for a more accurate assessment of which companies to buy or sell.

If you want to learn more about how to perform effective wealth as well as cash, debt and risk management, please visit www.personalfinance.ph. There are lots of free resources there for you to sink your teeth into.

You may also attend EnRich™ personal finance training on Nov. 9, 2013, in Davao City and March 1, 2014, in Baguio City. Details for EnRich™ may be found on the website.

(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or emailed to [email protected]. To learn more about the RFP program, attend a FREE orientation on Nov. 14, 7 p.m. at the PSE Center. Email [email protected] or text <name><e-mail><RFP> at 0917-3464126 to register.)