What triggers growth?
If you are a positional or swing trader trading trends in stocks, you would do well knowing which fundamentals move the stock price.
When you trade stocks with a great technical and fundamental lead, you will be trading as if you are holding aces, which will improve your chances of success.
That said, you don’t always need to go all out and study each of your prospective trades in detail. Doing that will defeat the purpose, because as a trader, you need to be reasonably nimble and if you go into too much depth about the opportunity you could be too invested and complacent about the opportunity.
Such over analysis in fundamentals can also lead to analysis paralysis, meaning you could end up taking no action at all.
I personally use the platform Stockopedia, which takes a huge amount of fundamental analyses 'time' out of my personal approach. For those interested in doing the same I have managed to arrange a 25% discount to all their packages:
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I personally like to focus on the 'quality' aspects of a stock and see other positive metrics as a bonus.
Mark Minervini, one of the best swing traders around, says in his book (Trade Like a Stock Market Wizard) :-
“In real state the mantra goes, location, location, location and in stock markets, the mantra goes earnings, earnings, earnings".
I would argue that the mantra should be Quality, Quality, Quality. Either way, having good fundamentals combined with technicals is the main goal.
Sticking with Mark's approach, It’s crystal clear that earnings matter, but how do you approach earnings?
Most businesses start small and get bigger when they expand their capacities, launch new products, get into new geographies and enter new service lines. In such cases, the company's sales grow, margins expand and profits grow even more.
Let’s look at each of these aspects one by one.
Sales Growth
As stated earlier, a company can grow its sales by selling more of its existing product/service, launching new products/services, and expanding its geographical reach. In each of these cases, the sales often see explosive growth if the company is starting from a small base.
The business-specific factors coupled with an industry tailwind leads to accelerated growth in sales.
Let’s take one of the most popular companies in the world, Apple Inc. as an example. Apple was doing pretty well on the sales front from the year 2000 to 2007 on the back of multiple successes including the iPod, iMac, and iTunes.
These were new products that were already giving a solid increase in revenue, which grew from USD 8.2 bn in 2004 to USD 24.6 bn in 2007. Then came its most successful product, the iPhone. Launched in 2007, the iPhone gave an accelerated advance to Apple’s growth leading to sales growing many folds over the following decade.
Apple revolutionized the world of mobile phones benefitting itself, the industry, and humanity as a whole. Such impacts are considerable in the world of business and when these impacts happen, they give the stock market participants several opportunities to trade and invest.
Operating Margin Expansion
The second driver of any company’s earnings is operating margin expansion. Which is when the company starts making more money on each dollar of sales.
'Operating Margin is a key Quality component I look for in a stock'.
Margin expansion can happen when the company raises the prices of its products and services or sells higher value products, while the cost of production remains the same or the company makes its operations more efficient by introducing automation etc.
Cutting costs and getting rid of loss-making operations are a few of many other ways to improve margins for a business.
While improving margins in isolation is a great way to expand earnings, phenomenal growth can happen if the business sees healthy growth in sales 'with' expanding margins. This leads to an increase in profits which is higher than the increase in sales.
Let’s see how this happens.
Assume a company sees a sales growth of 50% by launching a new product. As the new product sells at a better margin, the business’s overall operating margin jumps by 5 percentage points, from 10 to 15%.
The combination of sales growth and higher operating margin leads to a 125% growth in operating profit, which is 2.5x the growth in sales.
Ultimately Margin is a key overall multiplier.
EPS growth
Post the operating profit, there are other non-operating items like interest cost, depreciation, amortization, and tax expenses. If these expenses don’t increase at the commensurate level with operating profit, naturally higher growth in net profits and EPS will result.
For example, while Apple’s revenue grew 10x in its hyper-growth phase, its quarterly EPS grew by more than 40x in the same time. That was the result of the combination of higher sales, higher operating margins, and lower non-operating expenses.
The cocktail of growth.
Stock prices are 'often' a function of a multiple of earnings, sales.
For example, if a company's EPS is $10 and the kind of business the company is in deserves a 10x multiple on EPS, its stock price should be in the vicinity of $100.
The multiple that the market ascribes to any stock is generally dependent on the nature of the business and the growth it is clocking.
A business that’s growing by 50% per annum will get a much higher multiple than a business that’s growing at 10% per annum.
The magic happens when the initial multiple is subdued and the growth picks up. It leads to gains from both earnings growth and multiple expansion, sometimes resulting in a multifold increase in stock price. That’s the most rewarding cocktail of growth one can look to trade or invest in.
Of course there is never a perfect linear correlation with EPS metrics an stock price, but this is where the technical aspects of a chart help you to time your trade accordingly.
Narratives
Sometimes stocks in certain industries like tech or biotech tend to move rapidly led solely by the promise of growth. Such stocks can also be good trades. For example, the dot-com boom was entirely based on the promise of growth that the internet can bring and many traders made a fortune trading on narratives.
Narratives are not for me but I know people have done well off them. I'm personally more risk averse and want to see what the stock is doing now rather than the promise of narrative....
Conclusion
There is no doubt that fundamentals have a huge say in moving stock prices., however, you must not get complacent with your positions when they get sour even when you think that the fundamentals are good. You must have a risk management plan and follow it regardless of your fundamental view. Very often price precedes fundamentals and having a technical exit is a wise move.
'Don't get married to stocks, Jeremy'.
A good grip on fundamentals can bring a huge change in your trading results. When you mix fundamentals with technical, you get a perfect combination that will help you identify high-probability trades. All you have to do then is to act timely and manage your risk well.
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