Many stock market investors have seen their investment drop in value after investing in stocks. Shares can go up and down, but it can be frustrating to see your investment drop in value. There will be many different reasons why people lose money on the share market, but this could be your wake-up call to learn more about investing in financial markets. Let's focus on strategies and tools that have a higher chance of making money no matter what's your style.
In most cases, investors or traders who keep losing money might not have persisted with the market for long. Investing in financial markets over the long term can be a great way to grow your wealth, but it is important to educate yourself to make the best decisions possible. But Rome was not built in one day and you need persistence while learning from mistakes.
There is an old Chinese saying that roughly translate into: do not seek profit from things you don't understand. In my view, this statement is a fundamental principle. It applies to anyone who wants to make money from any activity, including share market trading or investing. Ok, let's get down to business. What does getting a deep understanding of trading or investing in the stock market involves? It actually sounds very simple but you need to learn the theories, and you need a lot of practice.
Understanding the market
To make money from the share market, you need to understand the share market. It involves understanding the market and understanding the stocks we buy into. We need to pick winners. We need a strategy. We also need to be mentally prepared for short term setbacks, and we need to make changes or refine our strategies along the way.
There are roughly two different schools in trying to pick winning stocks:
- fundamental analysis, and
- technical or charting analysis.
The first involves analyzing the companies’ businesses and financials. The second studies the price history, trading volumes, share price patterns etc.
To truly win with the shares, one needs to utilize both tools to find winning stocks.
Finding a good company to invest in
Let’s start by using some methods to find a target share to invest in. Note the example we use here is to illustrate the points and does not constitute advice of any type.
It basically involves two steps:
- Use charting tools to identify stocks that have displayed an initial upward trend after spending a long time going sideways,
- investigate the fundamental side of the stocks that have passed the charting test. Check out the industry sectors the companies operate in: is it a growth sector? how is the company positioned within the industry if it's a competitive industry? How fast is the company growing its revenue? operating leverage?
First step: go through 3-year weekly charts of all the stocks in your chosen market. Look for stocks that show:
- Share prices have been stagnant for a significant period of time (you can say it's been bouncing at the bottom), and
- are recently picking up or have already picked up but the price appreciation is still early yet.
This can be easily done nowadays. There are many websites which can provide stock information and let you bring up price charts. Good online trading platforms would be a better tool to perform chart-based stock selections. For New Zealand investors looking to trade international stocks, (Rockfort Markets holds a Derivatives Issuer Licence issued by the FMA) TWS platform provides a comprehensive charting package.
We then look at the fundamentals of the companies we have found. We check out the industry sectors the companies operate in and ask ourselves a few basic questions:
- is it a growth sector?
- how is the company positioned within the industry if it's a competitive industry?
- How fast is the company growing its revenue?
- operating leverage?
Step 1: looking at the charts
What they are looking for are stocks that have built up a big enough base and have just broken out of the base pattern. If you understand what I am saying here, great, you have good knowledge about charting. If you are not familiar with looking at stock charts do some reading to equip yourself with knowledge in charting or technical analysis in stocks.
The length of the base (or basing period) should to be between 12 months and 3 years to avoid the noise, don’t use anything less than 8 months. Example:
Chart1: TPW.asx Feb 2016 - Aug 2017 weekly chart
Now zoom in to daily chart to have a better view:
The stock traded at over 60c after coming onto the market at the beginning of 2016. Then it gapped down on the 26th of February 2016 after releasing a bad financial report.
After some initial volatile price action, the stock settled into a narrow range of between 12c and 20c from late April 2016 to late July 2017. This is a period of 14 months. This is the pattern we are looking for where the company share price goes sideways.
As the chart shows, on the 26th July 2017, TPW share price broke above the 20c resistance with above-average trading volume. Before this breakout, the stock went through higher than normal volatility trying to move up, on relatively high trading volume. TPW share price did not drop back below or even trend toward the 20c resistance. This is a confirmed breakout (stay above resistance 3 days after initial breakout). So what we are seeing here is a stock with a base pattern of 14 months long, and a confirmed breakout into the upside. This is a very strong buy signal for purely chart based stock players.
This is a perfect candidate: a broad base lasting 14 months, a clean breakout with a visible increase in trading volume. What we do next is to check out the company’s business operations and financials.
Step 2: doing a fundamental analysis
Now let's look at the company's business operations.
The company's website says:
Temple & Webster Group is Australia's leading online retailer of furniture and homewares. The Company's vision is to be the first place Australians turn to when shopping for their home. The Group currently operates the Temple & Webster online platform and the Milan Direct private label furniture brand.
The Australian furniture retail market was a $13billion industry and the online share is less than 4%. TPW was the largest online furniture and homeware retailer. It does have space to grow, and the social demographic trend supports the growth story.
How was it doing then?
Remember the big gap down in share price in February 2016 was caused by the company's half-yearly report. The report downgraded previous revenue guidance of $76.2m by 10%. The company also talked about some other issues that have affected the company's performance:
The half-year report is public information and a key place to start looking. From the half-yearly report we see:
- TPW remains the largest player in the Australian online homewares and furniture market
- 1HFY16 revenue was $32.1m with Gross Margin at 38.4% and EBITDA ($7.5m)
- Strong growth in Revenue per Active Customer
- Marketing investment has not performed as expected which has led the Board to put a prudent downside risk estimate of up to 10% on the prospectus revenue guidance of $76.2m
- Redirected marketing mix to focus on online channels which have brought first-time customer costs back towards historical trends
- Accelerating new growth initiatives and synergies
- Temple & Webster is well capitalised with $27m in cash and zero debt and is well-positioned to achieve run‐rate break‐even in CY18.
The market punishes companies that fail to meet their own guidance. By mid-April 2016, TPW shares were trading at below 20c. It stayed there until July 2017 when it finally climbed above 20c. The company has got about 110m shares on issue. At 20c share price, market capitalization was $22m. This was less than the cash amount the company had in its bank account. The stock was cheap but being cheap is not enough. The market does not chase cheap stocks, it buys growth stocks. The company has work to do to earn back market support.
By the time the share price broke through resistance in July 2017, 14 months have passed since the disappointing half-yearly report that sent the share price tumbling down. There was heightened price action in May 2017 which indicated possible changes in the company's fortunes.
Now look at the company's more recent quarterly reports:
- The Company ended the quarter with a closing cash balance of $8.5m and zero debt
- Net cash flows of ‐$3.8m for the quarter are made up of an EBITDA loss of $1.7m (down 61% from a loss of $4.3m in Q3FY16), with the majority of the balance relating to a decrease in trade payables of as a result of seasonal payments to suppliers relating to the Xmas trading period
- Significant year on year improvement in contribution margin (gross margin after all variable costs including marketing costs) up 10.5 percentage points (from 1.7% to 12.2%)
- templeandwebster.com.au has retained the majority of the Milan Direct revenue after the closure of www.milandirect.com.au, with group revenue’s growing 6% on a pro forma basis (ex UK)
- Costs per first time customer fell to $58 for the quarter (down 31% year on year)
- Total marketing spend as a % of revenue is tracking at 11.0% (down from 17.3% last year)
- A continued focus on better, data‐driven buying decisions has seen all inventory metrics improve with overall inventory levels down by 40% YoY, while private label sales are accounting for ~20% of the Group’s sales ‐ Things are looking better at this point. Sales are increasing again, cost-controlled, and inventory is down indicating efficiency gains.
And further going through the company's announcements since February 2016, we found that the company had made a lot of changes to board and management and to its business plan, etc. While the stock price spent its time bouncing along the bottom at very low levels over the 14-month period, the company has been busy trying to improve the business. And the Q32017 report is showing the initial success of the new TPW.
A recovering stock can be a great investment opportunity
This is a very good example of a recovery stock. Typically, one would take an initial position in the stock. What percentage of your investment funds to be put into the stock will depend on your risk appetite. This to me is a perfect growth stock to buy and get heavy over time if the good story continues. It has a perfect chart. The fundamentals support a positive outlook into the future. A 40,000 share parcel at 25c would cost $10,000.
Statistics show that the failure rate is quite high for small to microcap stocks (market capitalization under $500m). The successful ones that eventually make it, the returns will be significant.
One strategy to make a lot of money is not a diversified portfolio of investments. Rather, a concentrated portfolio of very few success stocks bought in early.
To build a significant position in a growth stock, we look for consolidation periods to top up our holdings along the way. Take TPW as an example. After buying an initial parcel of 40,000 shares at 25c in July 2017, we would monitor the stock very closely. If the company continues to make headways in its business operations and the share price continues to maintain its uptrend with periods of sideways consolidation we could look to increase our investment.
The second buying opportunity is the sideways period between September 2017 to December 2017 when it traded at below 40c. The third top-up opportunity is July 2018 at around 70c:
40000 at 25c in July 2017, 40,000 at 40c in November 2017, 20,000 at 70c in August 2018.
Total holdings 100,000 shares, total cost $40,000, or 40c per share.
The stock has maintained its upward trajectory ever since, with periods of consolidation along the way.
The $40,000 investment has been turned into $220,000 at today's closing price of $2.20 per share.
Here is the process:
- look through all the charts to find target stocks,
- check out each target stock to find ones with very high future growth potential,
- take the initial position, and monitor your investment very closely:
- cut and run if subsequent development proved your initial judgement wrong. Add to your positions to get heavy with successful ones.
Cut your loss, let profit run.
With losing stocks, HOPE is a dirty word, cut the losing stocks.
Don't sell your winning stocks, look for opportunities to buy more.
Diversification is for preserving wealth. That is if you already have got wealth to preserve.
To get wealthy through investing, you need concentrated positions in successful companies.
It's not easy, it's never easy to try to make money from the financial market. You need to persist and learn along the way. Learn from your mistakes. You will never be right all the time, but you need to know what you have done wrong each time you realize that you have made a mistake. Remember, success is built upon a big pile of mistakes and failures. Do not let failures and mistakes kill you. Let them make you stronger each time.
Michael Wang - Senior Account Advisor of Rockfort Markets