This is a guest post from aweary of fundamental analysis…he’s talking about regular stocks, but penny stocks are even worse since you can’t trust anything they say!
Writing about growth stocks I realized that a lot of time is spent talking about indicators and metrics. It seems like a good idea to go over some common fundamental indicators, useful around earnings, and technical indicators, useful away from powerful fundamental catalysts, and discuss their flaws. This is not to suggest alternatives, but to just create an understanding of the limitations in what we have at our fingertips.
There is no magic formula to trading, most people do not account enough for the luck involved in great trades and also for the role instinct plays. Luck is wishy-washy and is almost inextricable from skill when you talk about the stock market. Flipping a coin involves luck, but trading uses skill first and then the end result might be considered very lucky. It might also be that you made a brilliant deduction.
If there were a magical formula then someone like Jon Paulson who nailed the real estate collapse could reuse the same exact line of thinking and make billions again, but gold was not such an investment. Happenstance can be important, but success tends to strike the more skillful traders out there. You have to lay the foundation for success. To move to a more pure chance setting, you do have to buy a lottery ticket to get lucky and win. In trading, “buying the ticket” intelligently can increase your chances of luck striking, but luck will never strike if you never make a move.
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Laying the foundation is not just about following a formula. Most traders have deviations from even their strongest rules, even if it is unconsciously. That is because they have instincts and they have seen something that they cannot articulate. In their head they are still following their own rules, because automatic riders appear. Rule number one is absolute, oh but it does not apply in this situation where rule 1b applies.
That is where solid instincts come in. Instincts can be trained, but it takes a lot of time. That learning time can be shortened by interacting with experienced traders, reading a lot, and continuing to improve your skills. Knowledge, skills, and constant practice are the keys to developing good instincts. Even then all people are not created equal, because they have different ways of thinking that have been created since the day they were born. Some people are naturally gifted, some people have to work for it, and others have to work harder. Even the gifted needs to continually practice. You cannot just hang out with a group of great traders for 10 days and then call it quits. Regular interaction will keep your skills and theirs sharp.
That is why metrics and indicators need to be taken down a peg. They are a tool, but not the solution. Pointing out their failings keeps everything nicely in perspective.
Price to Anything Ratios
As fundamental as price ratios seem, they are actually more indicators of sentiment. Who’s to say what the right price ratio is. Take the PE ratio as an example. The most common comparisons are to industry peers, the S&P 500 average, and its own historical range. All those are dependent on how market participants feel about the company. This crowd-sourcing approach to valuation suffers from some serious flaws.
First, using very high numbers of data points can help you arrive at a true average, but only in things that remain relatively objective. The stock market is different. It can be considered extremely insular with massive feedback loops. An example would be one piece of news that is extremely bullish on a stock. Person reads this and suddenly likes that stock. They discuss it in chat rooms and forums, and read about other people discussing the same. Everyone got their information from the same place but they feed the bullishness of each other, but this does not make the evidence any stronger.
Just remember that price ratios are only compared to standards set down by sentiment and belief of the market. These can evolve and change over time, and they are not universal laws. A great many stocks might just work contrary to the expectations attached to its industry. These so called fundamental metrics, since they incorporate earnings, but they are driven by people not some universal law of markets.
Growth Percentages and Margins
You can lump criticism of these together for the same reason. Year-over-year or sequential growth percentages can swing wildly. That sounds like a great development, but it makes it tricky to properly project trends out. Trading and investing is about discovering trends not just having a stock jerk back and forth wildly with no sense to it. Revenue and earnings growth numbers can be very volatile on year-over-year terms, but there might be no early signs of this. It will not be evident till it happens. It can normally be due to macroeconomic issues or some specific problem of the company.
Margins are subjected to these swings less. Gross margins in particular can be robust. Net margins can swing depending on what the company is doing or what issues it is facing. Margins are great to look at, but the wild swings can come as a bit of a surprise. Usually a company will not do something that drastically affects earnings even if margins shift a bit, but they are extremely important. Margins represent the profit in the product and the company itself. Changes can signify the formation of problems, but the potential for swings that are only outliers confounds analysis of trends. As mentioned, margins are less susceptible than growth percentages.
There are plenty of other metrics out there and all have their drawbacks. Hopefully going over some common ones in the price ratios and some more obscure ones like the growth percentages and margins will show how all things in the stock market have their drawbacks. There is no holy grail. Even the best traders lose some. Every trade cannot be a winner, and understanding that is a good idea if you plan on trading for a long time. Understanding the limitations of your tools can help you minimize losses, and just generally be a better trader even in loss.