Trading on the ASX, The age old story of “how do I choose a stock” to invest in has always been a hot topic. With the Australian Stock Exchange (ASX) pushing into long-term highs, reaching towards 5,000 points for the first time since April 2011, a wave of investors are shifting cash back into the stock market. In this article, we take a look at a Fundamental approach to trading on the ASX.
Finding a trade is not just a process of selecting the best known company. Markets rise and fall, as do Economies. While one country’s economy may be performing well, another may not. And within that Economy, there will be some sectors that perform better than others.
The path in choosing an individual stock to invest or trade in can be as simple or as complex as you want to make it. Some investors will utilize their Brokers’ knowledge; take tips from subscriptions, newspapers or friends, while others believe they can make their own decisions.
No matter whether you decide to take a recommendation, or whether you are choosing a stock to trade or invest in on your own, you will need a methodology to confirm whether that stock is suitable for what you want to achieve – which clearly is to make a profit.
Over the last 100 years, one of the most proven and respected methods of analysing has been the Top-Down Approach. It is the style of investing that many successful managers have adopted for decades, including Warren Buffet and George Soros. Traditionally it has been used as a means for investors to build long-term portfolios with stock; however, we can adapt this strategy to suit both investing with stock, options, or commodities, or for shorter-term trading.
Our belief is that by understanding what state the Economy is in, you will choose the ideal strategy that suits the current economic conditions, resulting in better trade selection and ultimately better profitability for trading on the ASX.
So what is the Top-Down Approach?
Starting with the bigger picture of the Economy, the process establishes what state of an economic cycle we are currently in. It then evaluates the strength of the Sectors that make up an economy, sometimes whittling down to the Industry’s within those sectors. Before finally evaluating stocks within the Sectors of choice.
If you were looking for a potential long-term Growth stock, where would you start investigating? Would you choose the Top 20 listed companies on the Australian Stock Exchange? Or would you buy a subscription that provides recommendations to Buy, Sell or Hold, and then wait for the next recommendation?
No matter whether you are conducting the analysis yourself or if you are evaluating a recommendation that you have received, the Top-Down approach will help you. Here is a quick look at how to do this for yourself. Be aware that this is not an extensive review of the analysis approach as that would be too much to discuss in such a short article.
1) The Economy
Markets move in cycles from Expansion, to a Boom, to Contraction, to a Recession. One economy may be in one phase of the cycle, where another economy might be in another phase. Due to the global access to stocks, you can choose to buy and sell stocks on virtually any market in the world. Therefore, why not choose an economy that is in an Expanding phase, as this has a greater opportunity of stock prices continuing to rise?
We evaluate an economy using economic indicators, including:
– Inflation (Consumer Price Index)
– Interest Rates
– Gross Domestic Product
– Housing Data
– Retail Sales
The stock market can be broken down into specific Sectors. Various research firms define the sectors differently, but we like to use the Standard and Poor’s Global Industry Classification Standard (GICS) which lists 10 sectors (following).
Where one sector might be performing well, another may not. Hence, it stands to reason to look for a Sector that has future growth potential rather than one that is peaking or is in a weaker cycle. Again, we can use Fundamental and Technical indicators to evaluate the strength of each sector.
iv. Consumer Discretionary
v. Consumer Staples
vi. Health Care
viii. Information Technology
ix. Telecommunication Services, and
Each sector is made up of sub-Industries. Just because the broader Sector is performing well does not mean that each industry is. If we were to consider Information Technology for example, Software companies might be performing well but Hardware companies might not.
Finally, once we have established which Economy to invest in, which sectors have growth potential and evaluated which Industry/s we would like to focus on, we then begin to evaluate the stocks within those industries.
A lot of the time, investors will focus on the leading companies within an industry. You might like to evaluate the top 3 and compare their competitive advantage, revenue, costs of business etc. However, you might also consider evaluating smaller companies and comparing them to industry leaders as this might offer some insight into a potential Growth company.
Techniques used to analyse a company include various financial ratios to depict whether there is future earnings potential, and whether the current stock price is at Fair value, Over-valued, or Undervalued.
The Australian Stock Exchange is one of the more popular markets for long-term investors in the world. Our economy over numerous decades has proven consistent and is professionally regulated in a manner that does not produce inconsistencies in trading activity.
Choosing a stock to invest in on the Australian Stock Exchange can be a daunting task that scares many new investors. The anticipation and fear of what might occur in the future can overwhelm many investors. This should not be the case if the individual has taken the time to learn how to make decisions in the market. By using a concise and proven approach to analysing stocks, trading on the ASX should be routine with manageable Risk – the ultimate goal of any investor.
The nuances of the Australian Stock Exchange is that most investors will focus on the Top 20 stocks. And so the Top Down approach is overlooked as a process of decision making. However, this process can also be reversed as a means to evaluate Blue Chip stocks in a “Bottom Up” approach. If you are interested in a particular company, evaluate its Fundamental ratios, compare it to other Industry/Sector leaders, and define whether the economy is in a cycle that will best suit that stock.
Australian Investment Education (AIE) provides course on how to analyse stocks using the Top Down Approach. Please contact us if you would like to know more.