Stock investing is tough, but it is rewarding.

If you understand how to read a company’s balance sheet and select the right firms early, you can generate much more profits compared to investing in lower risk assets such as FDs, ASB, and ASM.

On Sunday (30 June), I invited analyst Azharuddin to discuss the fundamentals of stock picking.

For patrons who are Learners and above, you may watch the full recording on Patreon and YouTube.

Scroll down for a written summary of the session.

Q1: What does your portfolio look like? Does it mainly comprise of MY stocks?

My investments are mainly in the Malaysian stock market (60-70%), but I do own a bit of Hong Kong stocks.

I invested in a few US companies previously, including Amazon and Google, but I sold them off years ago because I needed money at that time.

I decided to keep my portfolio centered around Malaysia because I’m more familiar with local stocks.

If you’re a new investor, that doesn’t mean that you should always start with the Malaysian market. The key is to choose whichever market that you understand the most and stick with that.

Q2: What’s the first and most important thing you will always look at before investing in a stock?

The ROE (Return on Equity).

It is a measure of a company’s financial performance by dividing net income with shareholders’ equity.

Long-term US growth companies such as Apple, Google, and Microsoft have an average ROE of above 20%.

Meanwhile, the S&P 500’s average ROE as of Q4 2022 is 13.29%. Investors tend to use this as a benchmark to determine if a stock’s performance is good or poor.

But since we’re not the US, I tend to prefer Malaysian stocks that have an ROE of above 10% per year.

You can easily obtain this information from the web (KLSE Screener, Yahoo Finance, etc.).

Of course, this is not the only indicator that you should look at, but you can use it as a starting point, just like I do.

Q3: How do I read and understand a company’s balance sheet? What should I look out for?

Here’s a 5-point checklist that will make things simpler:

1. Check the firm’s ROE.

Is it above 10% per year?

If not, how does it compare to its peers within the industry?

2. Is the Profit Margin growing or at least steady?

Profit margin measures how much a firm makes per ringgit of revenue.

A good company should have a growing or steady profit margin.

Have a look at the numbers below.

The firm has grown its operating margin from 14.16% in 2014 to 22.38% in 2023. This means that it is becoming more efficient in converting its revenue to profit.

3. Historic Share Price

What is the stock’s trend over the years? Does it cycle, or is it in a downtrend/uptrend?

Typically, good growth companies will have a steady uptrend, as more investors acquire the stock over the years.

4. Operating Cash Flow (OCF) and Free Cash Flow (FCF)

A company’s cash flow determines how much money it has received from its businesses.

Sure, a firm may have great revenue growth, but if it doesn’t convert the numbers to cash, it may mean that it is struggling to receive payments from business operations.

Good companies tend to have growing OCF and FCF numbers.

From the table below, not only did this company pose steady growth in revenue, net income, and profit margin, its OCF and FCF have also increased significantly since 2014.

These are the green flags that you should look for if you’re investing in a stock for the long term.

5. Are the firm’s assets more than liabilities?

This question may seem a bit technical, but think of it this way:

• Would you like a company that has a lot of debts and outstanding liabilities?

• Or would you prefer a firm that has significantly more assets than its debts?

The answer becomes quite clear.

Healthy and cash rich firms tend to have more assets than liabilities, regardless of whether it is current or not.

Q4: How do I take profits without feeling guilty?

This is the dilemma that all investors face, including me.

While there is no hard a fast rule to taking profits, you can use these four steps as guidelines to make you feel less guilty:

1. Take profits when you need the money.

I should begin this with a disclaimer.

Before investing, ensure that you have a financial cushion. ⚠️

Save up 6-12 months for your emergency fund, and at least have medical insurance.

This is to prevent you from liquidating your investments prematurely at a loss.

Once you’ve taken these steps, you can take profits on your investments whenever you feel that you need extra money, be it for a wedding, down payment for a new car or house, etc.

2. Take profits when a stock hits your target price.

Let’s say you invested in stock A in January this year at RM7.00 per share.

You set a target of RM9.00, and you expect it to be hit in the next 2-3 years.

However, just 6 months in, stock A has rallied to RM9.50.

In this case, you should look to take profits because it has already hit your target price.

3. Take profits when you believe that the industry or share is about to turn around.

Top Glove (TOPGLOV) is a classic example of retail FOMO and greed.

Everyone believed that the glove company will continue making record profits.

Everyone said it will reach RM20 when it has rallied 500% in less than 2 years to RM10.00.

During the pandemic, demand for sanitary gloves surged while supply remained relatively constant.

This caused a supply shock, driving prices—and the company's profits—sky high.

However, the pandemic soon came to an end, and competition from China eventually emerged.

The supply shock quickly turned into an oversupply.

As a result, Top Glove's profits plummeted, leading to a sharp decline in its share price after its peak.

The lesson: a company’s dominance will not last forever. Always be on your heels and be ready to take profits if you believe that the turn around is imminent.

4. Take profits to rebalance your portfolio.

This method is perhaps the most unbiased, emotionless, and straightforward tactic in taking profits.

You rebalance your assets whenever a stock goes out of your preferred percentage.

Here’s an example:

You invested 20% in tech stock A, 20% in commodity stock B, 20% in utility stock C, and the remaining in other assets.

Your goal is to maintain this percentage as accurately as possible.

Over the next few months, Tech Stock A rallied to an all time high, but stock B and C have declined slightly.

Instead of 20%, stock A now occupies 30% of your portfolio, while B and C have dropped to 15%, respectively.

In this case, it is an indicator for you to rebalance Stock A by taking profits and allocating it into Stock B and C.

Q5: If a stock drops by 20% even with good fundamentals, would you sell?

No. Perhaps I will buy more, if my portfolio allows.

As long as you stick to your principles (for me it is the 5 point checklist), you should not be too worried about temporary price swings and volatility.

Don’t invest in the stock. Invest in the company.

Know the business. Understand what it does to make a profit. Check its shareholdings.

There is no shortcut in picking the right stocks. You’ll have to do a fair bit of homework and make a couple of mistakes.

But I can assure you this, you’ll not only be a better investor, but someone who has the capability to read businesses.

And that, will go a long way for your financial future.

Thanks for reading till the end! Watch the Full Replay for more.

Azharuddin (X: @Azha_Nordin) is formerly an investment analyst and has spent a large part of his career as head of research, leading both the equity and economic teams in several investment banks. He has also held management positions in listed corporates.

This summary is based on what I (the writer) have learned during the live session. It does not fully represent Azhar’s thoughts.

Disclaimer: The information contained in this newsletter is for informational and educational purposes only. Nothing herein shall be construed to be financial, legal, or tax advice.