Profit as the 'Essential Nutrient' in Investing

Everybody knows that selecting nutrient-rich foods to include in our diet is the key to staying healthy. However, do you know that the same discerning attitude applies to stock investing as well? Billy Mak, Associate Professor, Department of Finance and Decision Sciences at Hong Kong Baptist University and member of the Consultative Committee at the Investor Education Centre, reminds investors to look at the "nutrient label" - the potential profitability of stocks - in stock selection.

"When we select what food to eat, we choose according to what our bodies need. By the same token, when we pick stocks, we should consider our financial needs in order to select suitable companies to invest in." Mak sees the similarities between eating healthily and stock investing.

A Top-Down Approach to Stock Selection

The "nutrient level" of an enterprise is a synonym for its profitability, or the ability to generate a profit, Mak explains. In general, the higher the profitability, the stronger the stock performance and dividend distribution capabilities. However, returns are always accompanied by risks, and companies adopting different earning models often have different kinds of "nutrients" - the contrasting nature of potential returns and risks. Before making any investment decisions, it is worth considering your investment objective - is your primary goal risk management or return optimisation? With the answer in mind, you can choose stocks based on their 'nutrition level' according to your needs. For example, defensive stocks such as utilities generally have modest earnings growth but their performances are relatively stable and they have lower risks. Thus, defensive stocks maybe more suitable for investors with a lower risk tolerance. In contrast, growth stocks such as "new economy" stocks and internet stocks have larger earnings growth potential. However, these stocks are more volatile and may suffer occasional drops in earnings. Therefore, they maybe more suitable for investors seeking capital appreciation.

"Among various types of stock selection techniques, I recommend the top-down approach to investing. This approach can be applied widely across different sectors, and it is a time-tested method that proves effective over a long period," Mak notes. A top-down approach begins with evaluating opportunities in geographical regions. In this step, countries amid cyclical upswings are favoured. Afterwards, we can go on to identify industries that are experiencing upturns in the earnings cycle. This can be done by assessing the economic cycles of different industries. The last step involves stock analysis to detect companies suitable for investing. Mak advises investors not to focus solely on Hong Kong stocks; there are hidden opportunities in China A shares, too. You can even invest globally through the ETFs in US market.

For instance, with the interest rate cycle stuck in low gear, the level of rental income contributed by real estate investment trusts (REITs) is more attractive than interest rates paid by banks and bonds. REITs as an asset class entails a higher profitability than the others amid a low interest rate environment. If you have decided to invest in REITs, the next step is to select the suitable option by taking into account the dividend records, rental growth and property portfolios of different REITs.

Peer Group Analysis with Financial Ratios

The many stock analysis techniques out there can be overwhelming to investors. Mak suggests that investors begin their evaluations with P/E ratio, P/B ratio and dividend yield. He stresses that the ratios of a target company should be compared only to peers with a similar profile. For example, IT stocks usually have high P/E ratios but they are not necessarily overpriced. Investors have to determine if the elevated P/E is due to inflated price (P) under positive earnings (E) outlook, or due to sliding share price as a consequence of shrinking earnings. The former case may suggest buying opportunities, but investors should stay on the side-lines if the latter holds true.

 For companies with high asset values and volatile earnings, such as real estate stocks and financial stocks, P/B is a better gauge of their performance. If a P/B ratio is less than one, it means the share price (P) is selling for less than the book value (B) of the company's assets. Generally speaking, the greater the discount, the higher the investment value of the stock.

 Furthermore, some kinds of stocks, such as utilities, mainly use their earnings for distributing dividends. Therefore, their share prices may never witness significant ascent. Since dividend income and share price increases are both sources of asset value appreciation, dividend yield is a more appropriate indicator for this kind of dividend-paying stocks.

 To conclude, Mak sums up his experience in stock selection: "When you screen industries to invest in, avoid making the wrong bet. Choose sectors with large earnings growth potential rather than sunset industries. In stock selection, go for recognised companies that have a competitive edge within their industry. The advantages of industry leaders, in terms of the availability of capital, technology and distribution channels, are harder to supplant in a short timeframe. They are also more resilient in the face of unexpected risks."

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