What To Look For Before Risking Your Money

Foreword from ShareInvestor

This article “What To Look For Before Risking Your Money” by Rachel Lin was first published in The Business Times on 08 AugĀ 2005 and is reproduced in this blog in its entirety.

WHEN it comes to investing, gurus and investment tracts abound. For the uninitiated, there’s no running away from seemingly arcane terms, strange acronyms and the columns upon columns of figures. It therefore pays to brush up on the essential information to ready yourself for making investment decisions. So here are some tips on what to glean from the harvest of books, statements, reports and articles.

First Steps

The first thing to do is familiarise yourself with the concepts and terms used in investing. ‘It’s important to get a general understanding of the stock exchange,’ says senior vice-president of ipac Singapore, Roy Varghese. ‘You should also understand that equity is ownership, it’s not lending. You only get the residual profits after the creditors have been paid. Understanding the concept of ownership is vital.’

He recommends getting a good working knowledge of how stock markets interact in the global environment and strongly emphasises a solid grounding in economics – the impact of interest rates on cash, bonds and equity, for example.

For absolute first-timers, it’s better to gain experience on paper first, without playing with real money. That way you can gain investment experience without the pain of losing a chunk of your income.

The Annual Report

The first thing to know about a company can be easily gleaned from its annual report. ‘Read the annual report from back to front,’ says Joseph Chong, chief executive officer and founder of boutique financial advisory firm New Independent. ‘Though usually you can ignore the chairman’s statement.’

Check the notes to accounting to see if changes to accounting policy have taken place. Look for the company’s return on capital and return on expenditure. Also look for the amount of leverage – that is, how the company invests borrowed money to amplify potential gains at the risk of greater losses. A company with high returns on capital is likely to have good growth prospects, since it means the company is able to reinvest its capital and its market is able to absorb its high returns.

Watch out for companies that seem to have too much leverage and insufficient cash and vice versa, because while high liquidity tends to mitigate risk it also tends to reduce profits.

Observe how good its dividends are, given as the earnings per share in the annual report.

Of course, one of the most important figures to look at are the company’s profits and losses, though equally vital is its cash flow statement. ‘Ask yourself, how much cash is this company generating? Is it growing or not?’ says Mr Chong.

Mr Varghese emphasises the need to zoom in on three or four companies you can relate to first, rather than searching indiscriminately. ‘Look at the balance sheet for the financial standing of the company, how much cash it has and how much it’s borrowing. Also look at the profit and loss, compare it to prior periods and the industry.’

A rough grasp of basic accounting is therefore vital.

But browsing through just one annual statement won’t be enough; reading up on the company’s track record is crucial. Mr Chong recommends reading back ‘as far as you can find’ as long as the company remains under the same management, although he admits that a span of three to four years should be sufficient.

Reading Around The Company

Also important is to consider the industry of the company you want to invest in. If you’re looking to sink your money into a company, read up on trends in the industry and the potential risks or upturns it may face. ‘Let’s say you’re looking at air travel,’ says Mr Varghese. ‘What’s the impact of higher crude oil prices on air travel, or the impact of terrorism? Look at how airlines around the world have done.’

Also, is the outlook for growth good, or are there too many fish in a small pond? Choose companies with high prospects and a high return on capital.

‘Check how much revenue can, or cannot, grow,’ explains Mr Chong. ‘Is the environment growing or not growing?’

He likens companies to predators. Even the fittest lion won’t be able to survive in an environment with a small number of prey. The best combination, then, is one where fit predators encounter lots of prey. ‘Read what analysts and competitor companies say about your firm.’

Mr Varghese agrees. ‘Past performance is no indicator when it comes to considering future prospects. Rather, things like market share and prospective performance are the things to look out for.

‘This often depends on inside information which is generally not available to the retail investor, but reading articles in magazines like Fortune and Forbes can help.’

Don’t Let The Iron Cool

With all this in mind, it’s tempting to just keep on reading and accumulating knowledge. But ultimately one has to take that risk.

Says Mr Varghese, ‘You can do lots of historical analyses but you can form a decision pretty quickly. Sometimes, even by waiting three months, you could be too late.

If you see a rising market, you cannot wait too long. If you’re bullish about India and China, and think that prices will rise, then take the plunge. Timing is very important when it comes to shares.’