Brass tacks on the bottom-up method

With what we’ve seen as to how the market has been reacting to mixed economic data and business results abroad, it looks like our local market will continue to move along a pattern of a small rally followed by an equivalent pullback, producing a general sideways movement that may persist for quite a time.

I’d like to believe that such trading pattern is a manifestation of what is called a technical consolidation by the market over reports that—when you examine it more closely—add up to be more positive than negative.

This observation is in consonance with the forecasts of the World Bank on global economic performance that, first: the global economy is slowly picking up steam, and second, it is led by advanced economies. This report augurs well for the local equity market as one whose performance continues to be strongly influenced by developments in the world market.

The forecast, however, is not without forewarnings. Forecast growth continues to be seriously threatened by the fiscal uncertainties in the US, complications that would further delay economic recovery in Europe and setbacks in the restructuring policies of China to prevent an avoidable economic downturn.

As seen in 2013, these factors made a great impact on the performance of equity markets around the world, including ours. As in our case, they led to volatilities that drove down market prices practically back to where they started for the year.

To digress, market volatilities are not exactly bad. They somehow help put a brake to excessive market reaction. They help reduce many of the risks posed by wild price run-ups that, in turn, often lead to over valuations—and their eventual decimation—leading to financial imbalances. Price volatilities are as well pleasant surprises that benefit active market punters. Enhanced by good timing, the turnovers they produce add up to increased return on investment.

They also serve as a good mechanism to separate good from weak or artificially price-supported stocks floated in the market. One caught in the quagmire of this market play, however, could either make or break one’s investment kitty. From experience, to the one who made a bet on the wrong stock, this will prove to be a very regretful and costly experience.

Bottom-up method

These concerns bring us back to the bottom-up method. It effectively saves one from the “inglorious and painful experience” of investing in the wrong stock. If done thoroughly, the stock you pick up through this method will more likely become a winner.

The bottom-up approach, as discussed, “de-emphasizes the significance of economic and market cycles. It concentrates on the study of individual stocks. A detailed review on the industry where the target company belongs to is not an essential issue on the subject to buy or not to buy its stock. This applies as well to the economy as a whole. This is because, as previously observed, a company “can do well in an industry that is not performing very well.”

The method, therefore, deals closely with a thorough knowledge of the company’s products and services, its financial stability and what is called economic moat or comparative advantage over completion.

Peter Lynch, as also mentioned last time, practices “The Two-Minute Drill.” This is his simplified version of applying the principles in the identification and selection of value and growth stocks that we’ve previously featured in this column. What makes this approach great is the simple logic it applies to get an “assurance” that the price of the stock will go up. It equally serves as a short but efficient guide to determining “how much should you pay for it.” In other words, it’s a concise tool to help you ascertain “what makes a company valuable, and why it will be more valuable tomorrow than it is today.”

The drill makes you first determine what type of stock you are dealing with. Classify them into what he calls a “slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical.”

Lynch defines a slow grower to be “usually the large and aging companies expected to grow slightly faster than the gross national product.” Since these stocks are bought on the basis of their dividends, it is important to know if they “have always paid dividends, and whether they are routinely raised.” If the dividends paid are at a low percentage and more earnings are retained, the company has a cushion in hard times. It can also mean that it can earn less and still be able to pay dividends.

Stalwarts are also large companies that “are not exactly agile climbers, but they’re faster than slow growers.” They are those that come in with “10 to 12 percent annual growth in earnings.” The key issue on a stalwart is its price. According to Lynch, the P/E ratio is one effective way to help you determine whether you are paying too much for the stock. The company’s growth record must be consistent, especially on recent years. And if you plan to “hold it forever,” you have to “see how it has fared during previous recessions and market drops.”

Fast growers are “small aggressive new enterprises that grow at 20 to 25 percent a year.” These are the potential 10 to 100 or even more than 200-baggers, according to his experience. What’s makes a fast grower a worthy pick, is if “what enriched the company comes from its major product or service.” Its growth rate must be consistent and has good chances to grow and expand successfully.  Erratic growth, even though high, does not make a good fast grower.

Turnarounds are companies that have not experienced growth or near bankruptcy for quite a time and are now rebounding but not necessarily on cyclical terms. Business is coming back and they are turning cost efficient. They start to earn money withstanding the burden of their loans and debt costs at the same time.

The asset plays usually involve companies whose assets have been hidden, overlooked or undervalued by the investing public. This may be as simple as cash level, wherein its cash per share is higher than its current market price. Another is real estate holdings of the company.

Cyclical companies are those whose sales and profits rise and fall in predictable fashion. They expand and contract according to the different economic times. Quite critical to a cyclical company’s prospects is the presence of new competitors during recovery times.  New entrants can threaten good earnings.

Bottom line spin

The World Bank report speaks of an estimated global growth of 2.4 percent in 2013 that will grow to 3.2 percent in 2014, and 3.4 percent in 2015. As described by the bank’s chief economist, these numbers are not exciting, but “It’s a strange world we live in that news that an uneventful economy ahead of us is meant to be good news.”

This remark is a telling sign of what the market could be in the next two years. It’s also a good argument for the use of the bottom-up method as an ideal strategy for the said market scenario.

The writer is a licensed stockbroker of Eagle Equities Inc..  You may reach the Market Rider at [email protected], [email protected] or at www.kapitaltek.com