Exchange Traded Funds: The Easiest Way to Invest

The stock market is a confusing place. People can get very rich in the stock market, but it is much more common for very rich people to lose a lot while investing. Granted, many of these these people are using some exotic instruments, and borrowing up to 25x the money they actually invest, but for the everyday person the risk in the stock market is something to be aware of.

However, staying away from the stock market is almost as stupid as ignoring the risk is you want to grow your wealth. So, is there a way to invest that won’t end in you losing your life savings in one day? The answer, is yes, but with a caveat.

Risk is something to always be aware of. Always invest with this in mind. However, the overall stock market is relatively stable over time, and over the last hundred years, it has returned on average about 7%. That means, even through the crashes that have happened, the stock market has grown at about 7% a year for the last one hundred years.

Now, a guy called Jack Bogle invented a way for people to invest in the market, with very little cost. This is what is called an Exchange Traded Fund or ETF. What the exchange traded fund does is buy, on your behalf, a large collection of stocks that is designed to track the stock market.

Because the stock market is so big, it is difficult to accurately track it. So what we do is make what we call indices. These are collections of stocks that are a good approximation of the market as a whole. The S&P500 is one of these indices. It includes the 500 biggest companies in America and is widely regarded as the best approximation of the American stocks markets’ performance.

Several companies (such as Vanguard) offer ETFs that buy into the S&P500. This allows your stock market returns to be the same as the S&P500, without having to go to the trouble (and expense) of buying 500 stocks. By owning an ETF that tracks the S&P500, you are well diversified and will get, over the long term, a return of about 7% a year. This is much better than your regular savings account.

Now, I will address the issue of how to handle the risk of the market going up and down in a subsequent post, because that is a topic all in itself. However, if you are interested in learning more about investing, or exchange traded funds, then the following books will be a great starting point. They will help you get your finances in order, and to know where to start in the stock market.

The Barefoot Investor: The Only Money Guide You’ll Ever Need

Getting Started in Shares for Dummies

How to read Financial Statements

Once you start learning how to analyse public companies, you will quickly come across financial statements at some point. Financial Statements are one of the most important things you will need to understand. However, they can feel like an impenetrable mass of jargon and numbers. So how do you get started?

The first thing to understand is that there are three major parts of financial statements: The Income Statement, The Balance Sheet, and the Cash Flow Statement. These are three separate statements that show different things, but who work together to give you a good picture of how the business is performing. Here’s the function of each statement.

The Income Statement shows the profit or loss of the company, and how that is made up from its income and expenses.

The Balance Sheet shows what the business owns, and what the business owes.

The Cash Flow statement shows how the business has used, and how the business has spent cash.

If you approach the statements from this perspective, they become relatively easy to understand. I won’t spend the this post going through line by line how to understand each statement. That is better served in separate posts for each. Instead, it will go through how the statements give us an understanding of the business.

Income Statement

The important thing to understand when it comes to the income statement is the concept of accrual accounting. In accrual accounting, we recognise revenue and expenses when they are incurred/earned, not when the cash flows in or out of the business. So if you sell something on credit, meaning the person is going to pay you back at some point in the future, you get to recognise that revenue now, rather than having to wait. This allows for two things:

  1. Non-cash income and expenses can be included in the business profit and loss
  2. Revenues and expenses can be incurred in the correct periods.

The reason we need to understand this, is because it allows us to understand that the profit a business makes does not necessarily equal the cash it makes. Here is what you need to understand:

Income = increase in assets or decrease in liabilities

Expense = decrease in assets or increase in liabilities

Here we can see a link between the income statements and the balance sheet. The balance sheet ends with a profit or loss. This is the difference between our income and expenditures.

Balance Sheet

The balance sheet lists all of the assets of the business and how they are financed. Financing is a tricky topic, but essentially means how are all of the assets paid for.

Assets can be paid for in one of two ways: equity or debt. Equity is simply any money that is put into a business by its owners. When a company sells its shares to the public through an IPO, those proceeds become equity.

Debt comes from loans that the business takes out. This can be directly from banks, or it can be from the public through instruments like bonds.

The important thing to understand about the balance sheet, and probably the most important equation in accounting is this:

Assets = Liabilities + Equity

Every asset needs to be funded by something. You can’t even have cash in the business unless the owner put that cash into the business.

Cash Flow Statement

The Cash Flow statement is the most straight forward financial statement. All it tells us is how the company got cash, and where it spent cash. Most companies will split up the cash flow statement into three sections

  1. Cash from operations
  2. Cash from investing
  3. Cash from financing

Cash from operations includes any cash used during the normal course of business. If a business buys and sells cars, then all of the cash directly related to that is included in operations. This includes wages paid to staff, rent, bills and admin costs.

Cash from investing includes anything that relates to long term assets. Things like buying buildings or land, or machinery. Proceeds from selling these things also gets included here.

Cash from financing includes everything related to debt or equity. Taking out loans will be a cash inflow, while paying out debt will be a cash outflow.

The ending cash balance for a period is what is reflected on the balance sheet.

How Warren Buffett Invests

Warren Buffett, nicknamed the Oracle of Omaha, is one of the most successful investors of the last century. But how does he do what does?

Buffett’s style of investing is known as value investing, and is, in fact a really simple concept. The idea is to buy stock in an excellent business for a fair price. It doesn’t get anymore complex than that! Buffett is not using fancy derivative instruments, or hedging his positions, or shorting stock. He is just buying quality businesses.

How do you find a quality businesses?

The simple answer to this is to read, a lot. Warren Buffett reportedly spends most of his day reading. In fact, many of the great CEOs of our time (Bill Gates, Jeff Bezos) advocate reading as the best way to gain knowledge.

There are no simple formulas for finding great businesses. It all comes down to understanding as much about the business as you possibly can. This comes from reading deeply and reading widely. However, there are a few general concepts that can set you in the right direction.

  1. Controlled debt levels – businesses who are weighed down by debt will not be able to return value to the shareholders.
  2. Honest management – managers of businesses should not act like politicians. That is the politicians job. You want to be able to trust that managers will act in your best interests.
  3. A solid history of strong earnings. Buffett generally wants to see at least a decade worth of solid earnings growth. This should be at least 10%, but 15% is most desirable.
  4. Simple business – this will make it easier for you to understand, and easier for the managers to manage. Overly complex businesses are difficult to grow, and difficult to adapt when times get tough.

What is a reasonable price?

A reasonable price is anything below what we call the ‘intrinsic value’ of the business. Put simply, the intrinsic value is the present value of all of the cash flows the business will provide to investors going into the future. This should include dividends and capital gains. If you can find a company trading significantly below its intrinsic value, and that company is a solid business, then it is likely that it is a good investment.

Calculating intrinsic value is a more difficult topic. It involves predicting the future performance of the business. This is made easier if you follow the advice above in selecting a quality business.

We are lucky, because every year Warren Buffett writes a letter to shareholders of his company, Berkshire Hathaway. Over the last several decades, Buffett has provided immense value in these letters, and if you read them you will be able to gain a lot of knowledge about how he analyses businesses for investment. Luckily, the letters have been compiled into a book for us, separating them into the different areas of business to make them easy to navigate. The book is linked below. I encourage you to read it, to understand if Buffett’s investing style is for you.

The Essays of Warren Buffett: Lessons for Corporate America, Fourth Edition

Bitcoin in 2019 – Time to get back on the [block]train?

It has now been over a year since the great bitcoin bull run and crash. So where do we stand now in terms of crypto currencies?

There has certainly been movement over the last year, despite the large downturn in crypto prices. However it is not all doom and gloom. The bull run of 2017 was certainly good for some things, including building attention around the blockchain technology, and what it can provide us.

Neo Banking

I think that neo banking may be where we see the development of a more ‘currency’ like application for the blockchain. We are starting to see neo banks pop up all around the world. Neo banks are essentially banks that are building everything from the ground up, to better fit into the new digital world. That means everything from payment clearing to internal data management. It is likely that block chain technology will be adopted for this purpose, which could see some innovation in the space.

JPMorgan a few weeks ago announced that they will be launching their own cryptocurrency based payment management service called JPM coin. Notably, this is not a bank issued cryptocurrency, but rather a way for JPMorgan to handle large payments between large institutional clients. It will be redeemable 1:1 with the US Dollar.

Institutional Money

Some people are predicting that we will see more listing of traditional derivative assets on exchanges that are tied to crypto assets. This may begin driving institutional money into cryptocurrencies which could begin to see them becoming more accepted.

Actually using cryptocurrencies?

Japan is an interesting case for the adoption of cryptocurrencies as a main payment method. In Japan, most of the payments take place using physical cash. However, next year the world will descend on Japan for the Olympic Games. The problem they are facing is that neither the physical or digital payment systems in Japan are up to the task of the millions that will be spent. There is a compelling case for the rapid transition onto a blockchain based payments system that will be capable of handling the load.

What happened to Bitcoin?

Bitcoin was synonymous with blockchain and cryptocurrencies at the end of 2017. But there has been a definite separation between the two. Part of this is the adoption of blockchain technology in other applications, which has made more clear the differences. However, there has also been movement in the cryptocurrency space since then. Ripple is really the new star of the show for crypto speculators, as common wisdom is that the trading of bitcoin futures will cap the gains that can be made in bitcoin due to the heavy trading pressure.

Want to learn more?

There is no doubt that the block chain is going to become a very large part of the economy in the future, so learning about it may be the best investment you can make. Luckily, the books on cryptocurrencies and blockchain are very inexpensive, so you can’t go wrong dropping a couple bucks on the below books and getting some knowledge on the subject.

Cryptocurrency Investing Bible

Blockchain Revolution: How the Technology Behind Bitcoin and Other Cryptocurrencies is Changing the World

How to get started in the stock market

So, you want to get started in stocks? You want to earn millions while you sleep, work from an island in the Bahamas and and have crazy parties like you saw in the Wolf of Wall Street. Well, that may not be a realistic goal, but investing is certainly something everybody can do. I will lay out some of the basics of stock market investing for you.

What is a stock?

A stock is simply an slice of ownership in a company. It can also be called a share. If you buy Apple stock, you become an owner of Apple – yes, literally.

Stocks come with a few rights. First, you get the right to any dividends, or profits that the company pays out. Second, you get a voting right at any meetings of the shareholders. Now, Apple has millions of shares, so don’t be expecting to go deciding if the next iPhone should have 10 cameras or not. In fact, most everyday investors will never vote their stock.

How do I buy a stock?

You will buy your stocks through a broker. This is someone who will act on the stock exchange on your behalf. They will charge you a fee called brokerage to cover their costs of doing this.

A brokerage account will act much like a bank account, and will allow you to buy and sell stock with the money you deposit into it.

How much money should I invest in stock?

As much as you can afford to lose. Remember, some people make their entire careers out of investing in stock. It is not as simple as just clicking buttons and making profit. Treat your investments as spending you won’t get back when you are a beginner, and you won’t get yourself in trouble.

How do I learn about strategy?

The best way to learn about stock market strategy is through books. The books below are some of the most popular investing books ever, and can be relatively easy to understand for beginners. Click on the links to check the latest prices on the books and to purchase them!

The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Books. Big Profits)

The Intelligent Investor

Rule 1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week

Invested: How Warren Buffett and Charlie Munger Taught Me to Master My Mind, My Emotions, and My Money (With a Little Help from My Dad)

The Role of the Investment Banker

Investment Bankers are often in the media and making headlines. But many people do not know what they actually do. Investment bankers are known to earn high salaries, and the banks themselves are known to hold significant amounts of power and wealth. However their operations are shrouded in mystery, or so it seems. In this blog post, I am going to do my best to explain what the investment banker does, and why they are important in the economy. 

What is a bank?

I have another post that deals with this theme in a bit of depth. You can read this below. Put simply, though, a bank takes deposits from savers, and makes loans to spenders. This provides the movement of money through the economy that is vital for its healthy operation.

The investment bank, in its pure form does neither of these things. So what do they do, and why are they called a bank? The idea of the investment bank is a very old one. In fact, some of the functions of the modern investment bank can be traced back to the 14th century, in the Medici Bank of Italy. More modern developments in the industry include the issue of bonds and stock by the Dutch East India Company.

The word bank traces its roots meaning ‘bench’. This likely comes from the bench at the financial institution where people would handle their financial affairs. In a more general sense, a bank can be classified as an institution that provides financial services to clients. And that is where we get the investment bank.

Commercial Banks vs Investment Banks

Commercial banks deal with our normal deposits and loans as we normally associate banks with. Let’s consider the commercial bank’s client base.

We have depositors, who want interest earned on their money.

We also have borrowers, who are wanting to use money to invest in something else.

There is no difference between the clients of commercial and investment banks, apart from their size. Due to the size of investment banking clients, their financial needs are more complex, and therefore require access to more types of products. This is what the investment bank does.

Investment Bank

The investment bank provides end-to-end solutions for clients in financing their operations. Clients will generally include corporations, governments and high net worth individuals.

Now, while broking is a large part of what the investment bank does, the nature of what the bank does in accessing exchanges, institutional investors and making markets, requires the bank to risk its own capital in service of its clients. I will now provide a brief description of the operations of investment banks.

Sales and Trading

Sales and Trading relates specifically to dealing in financial instruments. An important part of what investment banks do is provide liquidity in markets so that their clients can execute whatever trades they may need to. This is done both through traditional exchanges, and in off market operations such as dark pools.

This will include equities, fixed income, commodities and futures.

Mergers & Acquisitions

The M&A department of an investment bank is the flashy part that we get to see on TV. The one where deals get made and billion dollar companies join together to take over the world. While some part of this are true, other are of course over glamorised.

The M&A division of an investment bank advises clients in these transactions. This is a very lucrative business for investment banks, as the income made is from fees, and so is relatively low risk and does not require their own capital to be put into the market.

Investment Banking

While it might seem weird for an investment bank to have an investment banking division, this is more of a historical artefact. The traditional investment bank from 300 years ago dealt in primary equity and debt offerings. This is what the investment banking division does. Debt offerings may include offerings of bonds for both companies and governments. Equity offerings can be Initial Public Offerings (IPOs) or capital raising through rights issues and similar products.

The investment bank will often underwrite the offering, and market the offering to investors. They will also handle the issuing of the securities. By underwriting, they take a large amount of risk in this operation.

Wealth Management

While this isn’t considered to be a ‘core function’ of the investment banks, it is becoming a large part of the business. This will mostly deal with high net worth individuals, and will manage their portfolios.

Relationship Management

Relationship Management is arguably the most important role in the bank. The relationship manager is the one who meets with clients and devises solutions for their needs. To the client, they represent the bank, and to the bank, they represent the client. Therefore, the relationship manager is extremely important in delivering the solutions to the client.

Conclusion

This has been a very simple overview of investment banks. Their roles have evolved and changes greatly over the decades and through different legislation changes. Below I will link a few books that if you want to understand further, I suggest you read.

Investment Banking, Second Edition: Valuation, Leveraged Buyouts, and Mergers & Acquisitions

Investment Banking Explained, Second Edition: An Insider’s Guide to the Industry

Investment Banking for Dummies

Value Investing: Why it may no longer work

For nearly the last century, Value Investing has been one of the most popular investing strategies out there. However, in the modern world, is the method being taught by people like Benjamin Graham, Warren Buffett and Phil Town still applicable?

What is Value Investing?

Put simply, value investing is an investing strategy whereby the investor finds companies whose stock price represents a good value, meaning that it is trading at a lower price than the investor believes it is really worth. The idea is that over time, the true value of the company will be realised, and the investor will make a gain.

This hinges on a particular view on the efficiency of capital markets – that the markets are not efficient in the short term, but in the long term they are. This is something I will explore later in this blog post, but I first want to explain how the value investing process works.

Now, the idea is to find an excellent company, and to buy that excellent company at a good price. A recent iteration of this strategy is taught by Phil Town, and provides a framework for valuation. It is commonly summarised by the Four Ms method.

The Four Ms

The four Ms method or, more appropriately, framework, goes as follows: Meaning, Moat, Management, Margin of Safety. I will spend some time here going through what these mean.

Meaning: Essentially this is a part of the framework that requires the investor to both care about and understand the company. Essentially this is trying to encourage newer investors to steer away from companies which are overly complex, or to blindly invest on numbers alone.

Moat: This is a nice way to talk about the competitive landscape of a business. The way that it is taught talks about a series of moats that a business may have, such a switching moat, toll moat or price moat. These are all fun ideas designed to neatly wrap up different considerations when determining the competitive landscape of a business. By the value investing methodology, it is important that the business is secure in it’s position in the industry, and won’t have its margins squeezed by expensive competition.

Management: We could devote an entire blog to the topic of what makes good managers. In fact, there are degrees that cost tens of thousands of dollars that attempt to teach you just this. Essentially, the management portion wants you to pick companies with solid management teams.

Margin of Safety: This is really the crux of value investing. The idea of a margin of safety, is to find the ‘intrinsic value’ of the business, and then to buy the stock at some margin below that, to account for any errors you may have made during your valuation. This is where the idea of buying the business at less than it is worth is expressed.

So why doesn’t this work?

This seems like a pretty solid idea, right? In fact, it is possibly the most logical way of investing. Think about it – when you have conversations with people about stocks, they will always point out how good a business is when they think it is good buy. So where does this go wrong?

The answer really lies in the sophistication of the stock market today. This may be a good time to take an aside and talk about the infamous Efficient Market Hypothesis.

The idea of the Efficient Market Hypothesis (EMH) is that the market will always reflect all information in it’s pricing. Essentially, this makes it impossible to outperform the market. Now, clearly this is wrong right? What about those hedge funds, and famous investors who earn huge returns? Well, the fact that they earn outsized returns does not necessarily break the hypothesis, and I’ll show you why.

Markets move because people trade in them. Stock prices aren’t a number that is magically generated. The stock price is just the most recent price that the stock was traded at. If was accept the premise of the EMH, nobody would earn excess returns in the market, and so nobody would bother trading in the market. But, if nobody was trading in the market, there would be no way for the information about companies to be reflected in prices, because prices can’t move without people trading.

In addition, doing research into companies, and acting on that information is costly. So, the outsize returns that people can earn by doing research is essentially the compensation that the market gives them for keeping markets efficient.

Now, getting back to our idea of value investing. The basis of the strategy is to rely on inefficiency in the markets (the stock trading below its intrinsic value) for you to make your returns.

Now, this may have worked well in Benjamin Graham’s day. In fact, we know that this has worked well by seeing the returns that Warren Buffett has achieved. But, if you look at the returns of Berkshire Hathaway’s stock over time, you will see that those returns are getting smaller and smaller.

Now, I will point this out: I am not putting the decline in Berkshire’s returns just down to my opinions on value investing. There are other reasons for it, but I do think that the returns available from value investing are declining, and here is why.

Markets are more efficient in 2019 than they were in 1959. This, I believe, is obvious. Information is more available now than ever before. In addition to that, we have more computing power available to us now than ever before. So, not only do we have more information, we also have more ability to process, analyse and act on that information. Just by this fact, we have to see that markets are more efficient, and that the ability to find stocks that are not trading efficiently much lower.

Additionally, the democratisation of markets means that there are more people out there looking for opportunities and the value investing strategy is one of the easiest out there. The central tenet that the value investor has to rely upon is that they find the opportunity first, and then others find it later, driving the stock price up and providing returns. If you are not first, then your chances of making returns are very low. 

Summary

I would like to conclude this post by pointing out that I am not an expert on these topics. Nor am I arguing with the obvious wisdom and knowledge that people like Buffett have. I am simply making my own observations at to the operations of the stock market as we see it today.

My observation is that with the sophistication of technology, and the availability of information, value opportunities will be hard to come by in the market. The value investing approach relies on the inefficiency of markets, however, as I have shown, the efficient market hypothesis stands up to a good amount of scrutiny.

If you would, however, like to learn about value investing for yourself, and I encourage this, the below books will be a great starting point.

Rule 1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week

The Intelligent Investor – Benjamin Graham

Enterprise vs Equity Value: What is the difference?

When you start to learn business valuation, you start to hear a range of different ‘values’ that a business can have. Book value, market value, equity value, enterprise value. Which one should we use? Which one should I pay attention to?

That’s what I am going to try to explain in this blog post. I’ll start with some textbook definitions, so that you can reference them later.

Enterprise Value: The value of the business’ operations

Equity Value: The value of the business’ assets, net of liabilities

Note: When talking about equity value, book value mean as it is shown in the financial statements or ‘books’ while market value refers to the value of the business’ stock. Obviously, for a private business with no stock, market value is irrelevant. 

So, what is the difference between equity value and enterprise value? We can start to get an idea by looking at the following equation:

Equity Value = Enterprise Value – Net Debt

The biggest difference here, is debt. Remember our definition for enterprise value is the value of the business’ operations. If a business is entirely funded by debt, then it won’t operate without it, and the value of the operations must be zero. However, I prefer a different way of calculating enterprise value, as it shows us better how it actually works. I like using the following formula:

Enterprise Value = Operating Assets – Operating Liabilities

So, to use this formula we need to define what our operating assets and liabilities are. This can be tricky, as it depends on the business and what the business does, but in general the operating assets and liabilites are those that are actively used in creating revenue. As a rule of thumb, anything that would show up related to the ‘cash from operations’ on the Cash Flow Statement, could be considered an operating asset. The big caveat, is that we don’t include cash. Things like inventory, accounts payable and PP&E should be included.

So, our enterprise value shows the value of the assets that make us money, less any liabilities that are involved in making us money. However, this also leaves the leverage of the business in our value. We can see how big the business is using enterprise value. Let’s consider the following example of a business.

Enterprise Value: $900m

Debt: $500m

Cash: $50m

Our Net Debt here, would therefore be $450m. If we use our formula for Equity Value above, we get the following:

Equity Value = $900m – $450m = $450m

So, if we just took the market capitalisation on this business, which has a debt to equity ratio of 1.1, we would see a business that is half the size of what it’s operations can actually achieve.

As a side note, this can show that debt is not the most evil thing in the world, as it allows the business to grow by using a more secured form of funding.

So, which one should we use when valuing a business or it’s stock? Theoretically, the value of a business’ stock should be the value of it’s equity. However, a disconnect appears when you think about buying the stock of the business as buying an ownership stake.

Take this example. Company A has $500k equity and $500k net debt (EV of $1mil). Company B wants to buy Company A. How much should they pay? If they buy all of the stock, and own the company, they will be responsible for the debt. The $500k debt that Company A had on its balance sheet will need to be refinanced. So, a part of the purchase price will have to be this debt.

This shows you the disconnect. To buy the stock, if it is trading at par, you would pay $500k. However, if you did this you would automatically on the hook for double that. Now, to be more realistic, we have to look what the stock is actually trading at. Let’s assume it is trading at $600k. Now, the total purchase price will be $1.1m. However, when buying a company, you must almost always pay a premium. This premium accounts for synergies that might be created by the merger. So, let’s say you actually pay $750k for the stock. Now your purchase price is up to $1.25m.

So this creates a disconnect between the stock price and the price of the company. Even taking out any premium that might be paid, there has to be some consideration of the leverage of the business in the stock price. So and understanding of both what the equity value represents and what the enterprise value represent, and how they fit together, is important for understanding how a stock is priced.

The Stock Pitch

The Stock Pitch is used in a variety of areas in finance, but it really boils down to one simple idea – you are giving an investment idea, and backing up why you are giving that idea.

The stock pitch can come in different forms. Some pitches are typed up in Word and published as PDF. Others will be given in person with a slide deck to support. Whatever the method, the stock pitch will contain certain standard information. This blog post is going to detail those pieces of information.

Stock Summary

The stock summary can usually be whittled down to a few lines, or a simple table. It includes basic information about the stock to give a general picture of where you are approaching your analysis from. Information that is usually included can be

  • Current share price
  • Your price target
  • % Upside
  • Market Cap
  • Enterprise Value
  • EV/EBITDA
  • P/E
  • 52 week high/low
  • All time high/low
  • Relevant trading ranges

It is then useful to briefly summarise your recommendation on the stock. This is simply whether you would long or short the stock, and what your target price for the stock is.

Company and Industry Background

This section gives some background on the company and the industry. It informs the recipients of your stock pitch about what the company actually does, where they make their money, and the competition in the industry.

It can also be useful to mention some general industry trends, major legal changes, or important information along those lines. You don’t have to make this very long – the stock pitch is simply a pitch to someone to have a look at your investment idea. You are not trying to get them to fully understand it at this point. Only include information that is vital to an understanding of the rest of your pitch. Don’t bury the important stuff underneath a mountain of details that aren’t really needed.

Investment Thesis

The investment thesis is where you actually present the meat of your investment idea. Usually, an investment idea will focus in one of more of three aspects:

  1. Business Quality
  2. Upcoming catalysts
  3. Valuation

This will hopefully be obvious to you. You have made an investment idea for some reason, and this is where you need to present that reason. Keep in mind, though, that this is the point where you really need to prove that your idea has legs. If you can’t do this, then your pitch will fall flat. Make sure you know exactly what is is that makes this a good stock, and what upside number you can extract out of the idea.

You are trying to convince somebody quickly that they will be able to make money using this.

The problem with presenting a stock pitch, is that you will mostly be disagreeing with what everybody else thinks. The whole basis of a stock pitch is that you think you have found a stock that is trading at a different level than you think it should be trading at. If everyone agreed with you, the stock would already be trading at that level.

Therefore, you need to address this in your pitch. You need to explain why the market is trading the stock at the level it is at, and why the market is wrong. Do you understand the business better than the market does? Are the catalysts upcoming being doubted by the market?

You need to really nail down here to find exactly where your views diverge from that of the market. You can do this by reading industry reports, news, or speaking to people who know that company.

By the end of this section, you should have presented your investment idea, and backed it up.

Catalysts

Catalysts are events that tell the market where they have been wrong. A good example of this would be the release of earnings by a company. If the company is growing at a higher rate than the market has expected, this will cause the stock price to move up. On the other side, if the growth is weaker than expected, the stock price may fall.

The important thing to remember about catalysts, is that without them, there is really no reason for a stock to move. You may have solid evidence that a company is undervalued, but unless the market finds out about it, the stock will never get to your target price. Therefore, it is important to take catalysts into account when developing investment ideas, and to present these catalysts in your pitch.

Some examples of catalysts may include earnings reports, results of clinical drug trials, and regulatory approval.

Valuation

I won’t write too much about valuation, as I have done several blog posts on different ways to value a stock. In a stock pitch, you do want to present a hard stock price as your target, so that you can present the numbers associated with your strategy, however some idea generation can come from thinking about the valuation.

One of the aspects that you can think about is forecasting business drivers. You can gain an idea on if forecasting a company’s financials will provide you with some numbers you can work with by thinking of these things. These are the core things that allow your company to make money. Things like seasonality, macro trends and the opening of new stores can drive a business. Determining if there is something you can work into a model to get the numbers you want can be helpful in deciding which company you want to model.

Relative valuations such as Comps can give you some direction as well. The nice thing about a comps model, if you know what you are doing, is that you can import a list of company financials and export relative valuations focusing on different companies in that group. This can help you find an undervalued company within an industry that has a catalyst coming up, and give you some direction on how your absolute valuation is going to go.

Risks

This is vitally important to include in your pitch. All investment ideas have inherent risks attached to them, and ignoring them may make you look naive or just simply inexperienced. These risks may dive directly into the company’s operations, or they may have something to do with the industry itself. General market movements are not good enough alone when determining what the risks of the investment are.

When you are writing about your risks, you need to be clear on how they would present, and what your plan is if they do present. Will the stock price itself tell you if you were wrong, or will you have to wait for news about a catalyst to determine that?

If you would like a longer guide to pitching investments, you can’t go wrong with Wiley’s series of finance textbooks. Below is the textbook on pitching investments which will be well worth your read.

Pitch the Perfect Investment: The Essential Guide to Winning on Wall Street (Wiley Finance)