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This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
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The Finance Ghost: Welcome to episode 188 of Magic Markets. It’s really good to have you here. Thank you for giving us your time this week. It’s been a good couple of weeks of shows, I think Moe. We covered why the US election matters for people. We looked at the automotive sector as an investment. Last week we looked at how to prepare for a crash, or at least a major sell off. Pretty interesting. Of course, a lot of that has now reversed, so I’m pretty happy with how my Meta position and one or two of those dips that I bought are looking week-on-week. It’s quite lovely. That’s the beauty of a sell-off. Who knows? In a week’s time it could look different.
But today we are going to dig into maybe the most important topic of all, which is how to do stock research. Or at least how we do stock research. Goodness knows there are many different schools of thought on this, but today we’re going to share how our process works.
Mohammed Nalla: Yeah, indeed, Ghost. I think it’s an important topic to unpack because what a lot of people don’t realise is whilst we collaborate on Magic Markets, we do have a very different approach to the markets. I think we come at it from different angles. You say stock research, I think of it more as investment process, because I start off from the macro. I’m a macro guy. I have some macro models and ideas around that and I use that to frame my allocations when I actually allocate to a stock. So we’re going to try and actually close off both of those. And I think just because I start off from the macro, I’m going to actually start this week, if you don’t mind, I’m going to jump right in and just maybe touch on that particular aspect first and then delve into how that translates into stock research for me specifically, because then we can obviously compare that against your own approach, which we know is more bottoms-up orientated. You start from the stock level and then work your way up.
So starting off with that macro picture, I think it’s so important because if you look at the macro, we always see the headlines, and we’ve covered some of these here on the podcast. We’ve covered the interest rate cycle. You know, what’s the US going to do with rates? What does that mean for South Africa? And often you see that in the newspapers, you see that in the headlines. But it’s very difficult to draw the line from those headlines to how you actually implement managing your own money and your portfolio. So what do I do is I just look at the macro cycle. Are we in a rising interest rate cycle or a cutting interest rate cycle or an inflection point as we find ourselves today? And the reason I do that is because under those various economic regimes, if you want to call it that, you’re going to pick up differential performance in various sectors. If you look at inflation, for example, we know that when inflation is running hotter, you actually want to allocate to the likes of retailers, for example, or you might want REITs that specifically give you exposure to the consumer because they generally tend to benefit from rising inflation. You want to look at retailers, maybe even possibly some of the grocers, you know, that would go into consumer staples, because they tend to benefit from some of those macro trends.
And now if we’re going into a reversal of that, if we’re seeing inflation cool off, if we’re actually seeing the prospect of lower rates globally, well, then you want to actually allocate to stocks that might benefit from that. And one that pops out into mind for me right now would be looking at the broad REIT sector, because we know that REITs sometimes trade as bond proxies. So if you actually get lower rates, it stands to reason that the listed property sector might actually start doing a lot better. So that’s just at a very high level.
What I do on a macro level is I look at it and I say, which sectors do I want to be allocating new money to? Now, why I say new money is because there’s another part of this entire process, which I think happens at a macro level as well. And that is what I’m going to refer to as pruning. And why I say pruning is, again, you know, any good growth in a portfolio, like with your plants, for example, is a product of pruning. I’m not one that certainly leaves the winners to run until they make up 50% of your portfolio. Berkshire Hathaway did that. But guess what? They recently pruned their Apple stake from around 50% down to 25%. So again, testament to the importance of this particular thing. So when you look at your portfolio, you say, am I happy with the existing exposures? What can I prune? What’s looking too big in the portfolio? And which sectors do I think are not going to benefit from the new economic regime that we’re going into? I then prune those positions and effectively then end up with a pot of capital that’s either new money or money that I’ve taken off from other stocks. And I then look to allocate that a sectoral level. So that’s my primary screen.
I’m going to stop there. I’m going to come across to you now, because that’s where we start to blend the macro with the bottoms up approach, because once you’re looking at specific sectors, it makes sense to start looking at these specific stocks. Ghost, what’s your approach when starting out that process now?
The Finance Ghost: So that top down versus bottoms up? I mean, if you’re buying a house, top down is choosing the suburb and then bottom up is finding the house, right, as anyone who has ever owned some property or looked at property prices will know. It’s the old location, location, location joke. And at the end of the day, swimming upstream is really difficult. And it’s not different with stocks.
You can pick the best company in the wrong industry. You’re probably still going to have a bad time, unless you got it for a dirt cheap valuation, then you are in value investor land and that is a whole different story. It’s a different skill set. You’ve got to be able to deeply unpick financial statements and you’ve got to have a very strong stomach to be able to ride out a lot of volatility. That is an art unto itself, which actually has had a really tough time in the markets in recent years, mainly because of very accommodative economic policy and the Fed and lots of stimulus and lots of money flowing around. None of that is great for your value stocks but is very good for growth stocks.
So these are the sort of top-down bits of analysis that are really important. I’m glad you started there, Moe.
The other thing that’s quite interesting, and it’s mainly a South African market issue or smaller markets issue, you could go top down and end up with only a couple of names. And for example, one of the trades I put on this week, well, it’s an investment, it’s not a trade, was to go long Cashbuild. I literally did it this morning because the thesis there is that there’s probably going to be some improvement in consumer discretionary spending on their homes over the next couple of years versus the last couple of years. And you don’t have to really dig into the balance sheet to just think about this logically, right? You had terrible consumer sentiment. Now there’s better energy in a GNU environment. You had lots of load shedding. People were doing solar projects. That misses Cashbuild and Italtile completely. Now we kind of have a load reduction environment, but it’s way better than it used to be. People might be more likely to either just skip solar altogether, or those that want it have done it now. So when they have some more spare money, they might do a different project on their homes. So that really helps. And when interest rates start to come down, I’m hoping that’s like the trifecta of happiness for these businesses and they finally get a bit of an upswing. Because Cashbuild is a cyclical business and you can’t buy it when everything is great because you will have a bad time. That’s how cyclical businesses work. If you buy them when they are in the headlines for all the right reasons, it’s going to suck. If you buy them when no one else wants them, provided you can ride out a bit of volatility, you can do okay. So that’s the sort of top-down, bottom-up piece. And in South Africa, you can end up with a top-down thesis that leads you to maybe two names, because those are the only two names you can buy. And then you go and do the research.
Where we focus in Magic Markets Premium, which is globally, it’s a little bit easier than that, right? There are a lot of different stocks you can look at. I mean, if you define your top-down very broadly and say, hey, I like tech platforms, there are 50 names you can go and look at, ten of which are really huge, and the rest of which are kind of B-Teamers that are actually gigantic companies in their own right. And I think that’s part of why we do what we do in Magic Markets Premium – focus internationally.
Mohammed Nalla: Yeah, indeed, Ghost. The international markets are just deep, they’re broad. You get a lot of options, you get a lot of choice. And again, when you’re looking at that, I always caution against just using these stock screeners that you find online. Because, for example, if you look at a sector like specialist retail, you know, that’s going to include everything from Dick’s Sporting Goods all the way to someone who actually goes and sells specialist equipment in construction, for example. But they’re specialist retail, so those screeners are not necessarily the most effective. And that is why a lot of deep research makes a lot of sense.
I think I like your house analogy because they always say, you know, don’t buy the most expensive house in a bad suburb. Go and actually find a house that’s reasonable, but in the best suburb. And that’s why the top-down component works for me.
But now let’s get into some of the tools that I use in terms of my bottoms-up approach, because I first of all run separate portfolios. And when doing that, there’s a growth portfolio. And the reason for this is because the metrics that you tend to look at in growth stocks versus the metrics you look at when you’re looking at dividend yielders or an income portfolio, those are very different. And at the moment, I’m actually looking at allocating a lot of my newer capital to a dividend portfolio. So I’ve been focusing a lot in that space and there it might be something as simple as looking at dividend yields.
So you say, for example, I want everything with a dividend yield above 5% and you go and have a look at that. And that’s maybe your first screen that you apply, but thereafter you actually go and have a look at, okay, what’s happening with the dividend, you know, is that dividend growing over the last several years, because that again, will give you some sort of indication in terms of the sustainability of the underlying performance in the company. But again, we’ve learned this and we’ve said it time and time again, those “dividend aristocrat” indices, they’re actually a bit of a misnomer because sometimes companies continue to pay dividends because they know there are investors out there that screen by dividend and they’ve got to make that dividend payment in order to pop onto the screener. And that is the reason why once I identify a subset of stocks I’m looking at, I go and look at other metrics. A metric here, for example, would be what is the payout ratio? Because if a company is paying out greater than 100%, guess what? That dividend is not sustainable. You want to look at companies that have a sustainable dividend payout ratio. And this is specifically in the income portfolio.
Then when I actually look at the underlying performance of the company, again, this is going to differ based on which companies we look at. But you would look at metrics like price-to-sales. What’s actually happening with regards to the stock? Is it being re-rated to the upside? Is there a lot of optimism priced in? Or is this de-rating? Is it looking quite depressed? What are the trends telling us in that space? You’ve got to look at traditional measures like a P/E or an EV/EBITDA. Those are sometimes useful. I say sometimes because again, in other companies, they don’t make as much sense. You’ve got to figure out which segments, which industries make sense when you’re looking at some of these metrics. And then also, and this is one that again, we’ve been at pains at positioning on the show, but I want to unpack that. I like to look at debt levels. Now, the reason I do this is not just because I hate debt. I know we’ve kind of put that out, that Moe hates debt in these companies, that debt’s not necessarily a bad thing. But the reason I use this at the initial stages when considering an investment is that if a company has low debt levels, it means they’ve got the ability to do two things. One is if we go into a bad economic picture, a bad macro regime, it gives the company a buffer. It means that they have the ability to gear up the balance sheet and survive the tough times. And if we’re going into an improving economic regime, it means that the company has the ability to leverage up the balance sheet and thereby actually increase returns to equity holders. So on both of those counts, it makes a lot of sense to look at companies that have reasonable or sustainable debt levels at the initiation point when you’re starting your investment.
Those are just some of the metrics that I like to look at. It’s now trying to blend the macro into the micro somewhere in the middle there. And once you unpack that, you come down to a much smaller subset of companies. I’m keen to hear your views not just on these metrics, but what are some of the other nitty gritties that you like to look at when looking at companies from the bottom up?
The Finance Ghost: All of those metrics are important, and there are many, many others. I mean, we probably have to do a whole podcast series on this, to be completely honest. But what I will say Moe is that the different metrics you use will depend very much, as you’ve mentioned, on the type of portfolio you are looking to put these stocks into. So if you’ve got a relatively high-risk growth bucket in your personal wealth, you’re going to look at different stuff to a portion of your portfolio where you’re actually looking to earn a dividend yield. Or like me, in my tax free savings account, I can only have ETF’s in there. So don’t make the mistake of thinking that an ETF doesn’t also require thought and research. You might not be researching a stock or a single company in the traditional term, but ETF’s are really, really interesting and they have all kinds of different underlying exposures that you need to think through. I’ll tell you what I think is also really important, and that is just the common sense test. It really is so incredibly strong. Just look at what a business is doing. Does it make sense to you? Does it look sensible? If it’s a business where you engage with its products, are they really good or are they maybe not that amazing? Do they look like they have this incredible unassailable moat?
I cannot cancel Microsoft. I literally cannot run my business if I do not have Microsoft 365. I don’t even know what it costs because it doesn’t matter. That is a great business. That is a really good business. Can I run my business without a Zoom subscription? Yes. Do I have a Zoom subscription? No. Can I see that having played out in the Zoom share price over the past couple of years? Absolutely. It really helps to just do some common sense thinking. Retail is actually a great place to do it because you’re engaging with those brands basically on a daily basis.
South Africa is a relatively easy example. You could have very easily missed the whole Pick n Pay collapse and gotten the Shoprite strength by just talking to people. Most people that I know had great things to say about the Shoprite group. They did not have great things to say necessarily about Pick n Pay. A lot of people have been talking about how Woolworths seems to be a bit cheaper thanks to Checkers. And guess what? That has come through in the Woolworths food inflation increases in the past couple of years.
Now, it’s harder on international stocks, and that’s where people talk about having an edge, for example. But what we’ve found in Magic Markets Premium is that even though it’s the US and even though there are tons of analysts covering these stocks, it still goes wrong. And it still goes right. It’s not a guarantee that everything is fairly valued.
In fact, it’s almost a guarantee that it’s not – I’m not sure if it’s because there’s been so much monetary policy intervention or what the story is. Just some basic techniques that we apply in Magic Markets Premium, like looking at the historical traded multiples – what is the current multiple relative to that historical average? I’m a big believer in multiple reversion and we’ve seen example after example after example where multiple reversion is a really useful way to, number one, stay out of trouble and number two, find stuff that looks like a good buy. And literally all that means is take your multiple of choice. Is it sales, is it EBITDA, is it P/E? Chart it against its historical levels and look at whether it’s higher or lower. Now this is difficult for the layman to do because you actually need a suitable system that allows you to do it. You can’t go do this on Google Finance. So this is where you need to think about how seriously you are taking your investing. Do you go and actually sign up for the system we use – TIKR? There are many others that you could look at, and this is where I think a lot of the research we do adds a lot of value because we’re doing a lot of that hard work and kind of showing the value of that and also how to use it in practice.
It’s difficult to get single stocks right without doing relatively deep research. You can buy a basket of stuff that you think is high quality, but if you’ve paid multiples that are far above the mean, you can end up in a scenario where you bought a household name and you’re down 20%.
Mohammed Nalla: You’ve raised a couple of very, very important points. I want to leverage on some of those. And the first one is, is there a need for the product that the company is actually putting out there? I think you’ve identified that and sometimes it’s a household name, but that’s why I like to superimpose that in terms of, okay great, so we know you’re a household name. Let’s use Nike as a prime example. But then if you look at what is the total addressable market, what are the growth prospects for that market? Because you could be the dominant household name, which means you’ve got a big target on your back and there are lots of disruptors coming at you that might actually erode long-term returns for shareholders if you’re buying the household name rather than the disruptor or the up-and-coming stock.
And then your next point was really around the systems that one could use. I agree with you. If you just go and look at Google Finance or Yahoo Finance, yes, there’s a lot of information out there, but often you’re going to have to go and pull diverse information sources, pull that all together. We use TIKR. You know, that’s a great system. It’s not free. You’ve got to pay for that. It’s not terribly expensive either. And that’s a great resource. If you’re looking at financial statements, they’ve got a lot of the ratios on there. It’s a nice centralised resource. I then also use another resource called Fast Graphs. Now, I’m not remunerated for this. You can go and have a look at it. You can sign up if you think it’s something that makes sense for you. But if you’re going to have a look at Fast Graphs, what they tend to do very well is they tend to make the adjustments that you’d need to make to your earnings number and then you can actually map the adjusted earnings to the share price performance. And it’s a nice tool to look at whether a stock is trading in line with its own historical multiples. Has it actually ratcheted up? Is it actually looking a little bit depressed based on what is fair value? So I find that quite useful.
And then it actually comes down to making the actual decision, because when you’re using these tools, something I caution our listeners against is just looking at the last quarter, because we’re talking about investment portfolios here. We’re not talking about trading. That’s a separate psyche. It’s a separate model that you got to look at. When you look at long term investments, you’ve got to look at the firm over the last several quarters.
Often when we’re assessing a company on Magic Markets Premium, we go and have a look at not just the latest earnings call, but we look at the investor calls prior to that. We look at earnings that were released over the preceding several quarters. And this helps identify the underlying trends that the company is facing. This is particularly important in companies that exhibit a lot of seasonality.
Once you’ve actually done all of this work, I then look at the technicals, because for me, when looking at an investment portfolio, technicals are still useful. Yes, traders use it for the higher frequency trading stuff, but when looking at an investment portfolio, I look at the technicals because you might find a great company that you want to buy into. When you look at the technical and it means that the timing is not quite right, maybe it’s overbought in the shorter term, and you want to wait for a bit of a pullback there for an opportunistic level, for a support level to materialize. And I use that to frame my timing of deploying the capital.
I currently have a long watch list of quality companies that I like. We discussed this on the show where we said, how do you prepare for a crash or correction in the markets? Have that watch list, have levels on both the technicals and the fundamentals that you would be a happy buyer at for the longer term. And then it’s about discipline. When you get to those levels, don’t look at the chart and panic and say, oh, it’s going lower. Pull the trigger so that you don’t fall into the trap of analysis paralysis. I often have this discussion with my wife where she says, hey, you’re talking about the stock. Did you actually buy it? And I’m like, no, it’s still on the watch list. And she’s like, well, it’s gapped up 20%. And I’m like, yeah, I’m an idiot. So that discipline’s really difficult to execute on, because if you have a lot of stuff on the watch list, sometimes you’re busy, you don’t actually see what’s going on. Be disciplined around that. Some people do leave market orders sitting there at a price that they’re happy to get involved in. I do that on certain stocks, on other stocks where I’m not as comfortable. I actually look to put the trade on manually.
And then a last point that I want to land on is stagger your investment. I might be a happy buyer of a stock at a hypothetical level of, let’s say, 100. And if it falls lower, it stands to reason that if the fundamental picture, the research, the homework I’ve done and I’ve spent lots of time doing, if that research is still intact, if the investment thesis, the core thesis is still intact, then I should arguably be a happier buyer at 85, if the stock’s gone through the correction. And so I tend to stagger my investment, my exposure into these stocks, because I’m buying them with a much longer term lens and a longer term view, and then leave it alone. Once you’ve allocated what you feel is the appropriate amount to this particular portion of your portfolio, let the plant grow.
We discussed how pruning is very important. There’s no point trying to prune the position when the plant is still in its growth phase, when the investment thesis is still playing out. So keep tabs on that. Let it grow. I tend to leave those in my portfolio and then reassess that when we get quarterly results coming out or if there has been a big macro or structural shift in the market that might impact the investment thesis.
The Finance Ghost: Yeah, look, I think a nice place to end this podcast is actually to say that this plant analogy you’ve brought up – I actually quite like that, because it’s like buying plants for your house and your garden. You need to do your research. You cannot go and buy something that needs shade and then go put it in the blinding sun and hope it’s going to work. You can’t do that. You can’t go and buy stocks the way you would just go to a nursery and just buy whatever you find because it’s pretty with no due regard given to where you’re going to plant them. So it’s a little bit like dollar cost averaging into an ETF every month, which is something that a lot of people do. They just go and buy every month into a big diversified portfolio and they let the thing grow over time. Absolutely nothing wrong with that. But if you’re going to start dabbling in single stocks to avoid getting burnt, to avoid the disappointment of that pretty flower dying two weeks after you bought it, you’ve got to do the research.
Hopefully the show has given you an idea of some of the work that goes into that. But of course, we can’t end it without saying that Magic Markets Premium is really where you will find how to research stocks. And for R99 a month, it is vastly cheaper than plowing a whole lot of money into the wrong position. Obviously, we’re not always right. No one is always right. But I think on average we get it, you know, pretty decent. And that R99 a month will really teach you how to research stocks, but also give you some great ideas for your portfolio.
So I think we leave it there. Moe, it’s been another great show. Thank you for this. And to our listeners, go find us on the socials. But more than that, just go and dip your toes into magic markets premium. Give it a try. Chances are very good that you will learn a lot.
Mohammed Nalla: Yeah, I think that makes a lot of sense. One last thought from me is that the reason I don’t like the ETF approach historically has been that you’re buying the good with the bad, and that’s how I’ve migrated from that into a strategy of looking at underlying stocks. Obviously, I concur with you on the immense value that Magic Markets Premium offers at R99 a month. Again, hit us up on social media – @magicmarketspod, @FinanceGhost and @MohammedNalla. Go and find us on LinkedIn. Pop us a note on there. We hope you’ve enjoyed the show that shines a light under the hood in terms of how we view and contextualise our own portfolios and our own investment process. Until next week, same time, same place. Thanks and cheers.
The Finance Ghost: Ciao.
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
