In other words, buy-and-hold investing requires focus, patience and most importantly, discipline. In order to succeed, investors must avoid getting caught up in violent market swings or other short-term influences and invest in stocks that they feel comfortable holding for the long term.
Let’s take a look at how to find these stocks using both fundamental and contrarian indicators.
Fundamental indicators are among the key tools used in long-term trading. Fundamental analysis is one way to determine whether a stock is undervalued or overvalued. It involves looking at a company’s earnings, cash flow and other financial benchmarks in relation to its industry and to the overall stock market, its historic growth and future growth potential, among other factors.
Good fundamental indicators
Many good indicators can help you determine whether a stock is a good long-term buy. These include:
A price earnings (P/E) ratio is calculated by dividing the price of the stock by the earnings per share (EPS). A company that has a higher P/E ratio compared to its competitors or the industry could mean that investors are paying more for every rupee of earnings, which suggests that the stock is overvalued. A lower number compared to the company’s competitors or industry might signal that the stock is undervalued.
For example, if XYZ company has a P/E ratio of eight, while the industry has a P/E ratio of 12, this suggests that XYZ’s stock is relatively less expensive in terms of earnings compared to the industry, one needs to examine why the market is not giving it a higher multiple. This is most probably because the weaknesses in the areas of liquidity, asset management, profitability or leverage.
The market might perceive XYZ to be a risky stock due to its financial weakness and more risky stocks tend to carry a lower P/E ratio than less risky stocks. Conversely, if PQR company is trading at a P/E ratio of 15, while the industry has a P/E ratio of 11, this would indicate that PQR is overvalued - investors are paying more for every rupee of earnings.
However, these numbers should be considered along with other factors. Some companies or industries that are growing rapidly, for example, will tend to have higher P/E ratios due to their higher growth rates.
Similarly, during times when the economy is expanding, a high P/E ratio may be acceptable for some types of stocks, particularly those in high-growth industries such as technology. When earnings are contracting, however, a high P/E ratio could signal an overvalued stock.
Price/book value ratio
The book value is another way to determine whether a stock is over- or underpriced. Basically, book value represents what a company would be worth if it stopped doing business tomorrow and was liquidated.
The price-to-book value ratio (P/BV) is calculated by dividing the current price of the stock by the latest quarter’s book value per share. If a stock is selling far below its book value per share, it might be undervalued. Conversely, a stock priced above its book value could be overpriced.
For example, if HIG has a book value of Rs.25 and is trading at Rs.20, the stock could be undervalued. However, if QRS has a book value of Rs.15 and the stock is trading at Rs.30, this may signal that the stock is overvalued. However, the stock of a rapidly growing company could trade well above book value and still represent a good buy in some industries.
As with any fundamental indicator, book value also must be considered in conjunction with other indicators. It is more meaningful when used to analyze stocks in certain industries compared to others.
For instance, in the above example of HIG, the P/BV ratio is 0.8. This is lower than the industry average of 3.5 and might reflect various aspects of financial weaknesses of the company.
The dividend yield (DY) indicates the ability to generate dividend income as a percentage of the investment. It is calculated as the common dividend per share divided by the market price per share. This is a particularly an important valuation measure for investors seeking regular income. Typically, higher dividend yields are associated with more stable and mature companies. Conversely, growth oriented companies tend to pay lower dividends.
Cash flow vs. debt
Cash flow is the amount of money that is moving in and out of a business. Operating cash flow is revenue less operating expenses, including adjustments to net income. Cash flow is a good indicator of a company’s financial health because it is more difficult for companies to manipulate than earnings. As such, some investors prefer it as an analytical tool.
Debt is the total amount that is owed by a company, including bonds and outstanding loans. While debt can finance growth during times of prosperity, it can also become a burden if a company is having financial difficulties. A company’s debt obligations should be manageable in relation to its cash flow.
Price/cash flow ratio
The price/cash flow (P/CF) indicates the price of a share in terms of the cash flow per share. It shows the rupee amount an investor has to pay for each rupee of cash flow generated. Although not widely reported, this is in fact very useful ratio because the price of a share must be related to the actual cash flows generated by the firm to its shareholders.
For instance, if the P/CF for XYZ is 8.1 and is lower than the industry average of 12, the market is pricing the XYZ stock at a lower P/CF multiple, most likely on account of financial weaknesses in multiple areas.
Contrarians believe that the crowd is always wrong and that when everyone is overwhelmingly optimistic, it is time to sell stocks and take profits or to focus purchases in neglected corners of the market. When everyone is buying like mad, prices are too high, so it is in fact best to sell then and vice versa.
There is a huge amount of literature on the dangers of going with the herd and why the right time to buy is when there is ‘blood in the streets’ and so on. The ‘masses’ get carried away in booms and then panic at the first sign of trouble. As a result, they buy and sell at the worst possible times.
The appealing logic is therefore that by simply doing the opposite of the masses, one can buy and sell at the right time. On the other hand, contrarians believe investor pessimism presents opportunities to purchase overlooked stocks at low valuations. The key is to wait until everyone feels certain about something and then do the opposite. Successful outcomes can sometimes take a year or more to develop, so the strategy requires patience.
For example, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out.
One possible distinction to find out a value stock, in finance theory, can be identified by financial metrics such as the book value, P/E ratio cash flow analysis, etc. A contrarian investor may look at those metrics, but is also interested in measures of ‘sentiment’ regarding the stock among other investors, such as earnings forecasts, trading volume and media commentary about the company and its business prospects.
Successful long-term trading requires that you have a time horizon of one year or more and be willing to focus on the big picture. Investors can use fundamental indicators, such as the price-earnings ratio, book value, cash flow and debt, to determine whether a company is financially sound and if its stock is trading at an attractive price. Contrarian indicators, how optimistic or pessimistic investors are and can be used in conjunction with fundamental indicators to find a good long-term buy.