How can you tell if you are you an investor or a speculator? Many casual investors buy stocks and assume they are investing, but in reality, they are actually speculating. True investing entails conducting a thorough analysis of a company, determining whether the current price is justified, deciding whether the stock would be a good addition to your portfolio, and repeating the process periodically; speculation is simply buying a stock because you think it’s a good company or you heard a good tip, but you really don’t know how the company makes money, who its competitors are, or in some cases, even what it does. Most people would say they are an investor, but unless you are employing the fundamental analysis discussed below, you may actually be a speculator.
Suppose you believe that the new Affordable Care Act will benefit pharmaceutical companies and you want to capitalize on that potential gain. In a top-down approach, you would first generate a list of all the publicly traded pharmaceutical companies. Then you would compare them among each other using that industry’s metric. If any of the companies are non-US companies, then you need to translate the company’s currency to the US dollar for an equal comparison. Some common comparison metrics include: profit margins, sales, market capitalization, market penetration, debt/equity, etc. In addition, each industry has its own unique metric. For example, airlines use (revenues per passenger miles) and hotels use (average daily rate). Once you have identified the best stock within your filtered list, then you can determine whether the stock price is cheap or expensive versus its competitors.
Suppose you are an avid Facebook user and want to invest in the stock. In a bottom-up approach, you would first obtain financial information for Facebook to understand how it makes money. What are its income sources: advertising, selling products, partnerships? How much of their income comes from each source? Who are its competitors and what do their numbers look like? Keep in mind, just because a company makes a ton of money, it still doesn’t make it a good investment. Facebook made $5 billion in 2012 while Microsoft made $74 billion in 2012, yet Facebook stock trades at almost 143 times the value of Microsoft.
Some investors prefer to rely on research reports prepared by prominent analysts at investment banks. One of the many lessons the recent financial crisis taught us is that investment banks have countless conflicts of interest. There is no shortage of headlines where an investment bank issued research reports where they also did investment banking for the company in question. Unless the research is truly independent and neither the analyst nor their firms have a vested interest in the companies they cover, their assessment of a company is tainted by their firm’s relationship with the company being reviewed.
As you can see, researching individual stocks is very labor intensive whether you use the top-down or bottom-up approach. The analysis doesn’t stop when you buy the stock, you must continue to monitor the company (not just the stock price) to ensure it still meets your criteria. It’s ok to invest in stocks, but investors must recognize that unless they conduct ongoing and thorough analysis, they are merely gambling.