When stocks go up, investors celebrate.
And when stocks are down, investors commiserate.
But what is more important is to find out what is happening to the business behind the ticker symbol.
Periodic checks are therefore necessary to ensure your investments are chugging along nicely and are not running into trouble.
Much like a regular health check, it pays to examine whether our original investment thesis still stands.
Here are some methods and metrics you can use to monitor the financial health of the stocks in your portfolio.
Gross Profit Margin
The gross profit margin, or GPM, is an important financial ratio that signals if a company has pricing power.
The level of GPM may differ by industry.
At the company level, you can compare the year on year change in GPM and determine if the business may be losing or gaining ground when it comes to pricing.
Note that industries such as nitrile gloves are seeing a huge spike in GPM due to pandemic-induced demand.
Such instances of higher GPM may be exceptional and investors should note that it may be temporary.
In general, GPM that persistently trends lower is a sign that a company is experiencing an erosion of its pricing power.
The question you should ask yourself is whether such a decline invalidates your investment thesis or if there are compensating factors that justify hanging on.
Competition is an ever-present risk for all businesses.
Competitors’ moves may either strengthen or weaken a company’s prospects and also depend on whether the industry is concentrated (i.e. a few key players) or fragmented (multiple players vying for a piece of the same pie).
For example, a telecommunication company such as M1 may start a price war to gain market share.
Such a strategy would impact the revenue and earnings for competitors such as Singtel (SGX: Z74) and StarHub (SGX: CC3).
There could also be good news at times when a competitor is reported to have gone bust and left the industry, thereby easing competitive pressure for the incumbent.
By checking on competitor’s business strategies and plans, you can get a better sense of how your investment may be impacted.
Free Cash Flow
A core aspect to look at for any company is its ability to generate free cash flow.
Cash is, after all, the lifeblood of any business.
Free cash flow is computed as the operating cash flow of a business minus necessary capital spending.
Do a review of the level of free cash flow generated by the business to see if it falls significantly, remains constant or even increases.
By assessing a company’s cash flow generation ability, you get a sense of how well it’s performing.
Retirees and income-seeking investors rely on a steady stream of dividends for passive income.
Investing in dividend stocks and REITs allows you to enjoy a consistent flow of dividends that helps to supplement your other income sources.
Dividends also act as a signal as to whether a company is performing well, or not.
REITs that drastically slash their pay outs could be facing issues with their tenants or could be seeing fewer customers visiting their investment properties.
On the flip side, companies that have raised their year on year dividends, such as iFAST Corporation Ltd (SGX: AIY) and NetLink NBN Trust (SGX: CJLU), could be signalling better times ahead.
Management discussion and analysis
A reliable method of gaining insights into a company’s success or troubles is to read through its management discussion and analysis (MD&A) section.
The MD&A accompanies every company’s earnings release.
It provides a review of how the business fared during the period in question.
The commentary will also provide a business outlook and detail any business development initiatives put in place by management to grow the business.
As an example, Jumbo Group Ltd (SGX: 42R), a food and beverage chain that is famous for its signature chilli crabs, announced a muted outlook during its fiscal 2020 earnings ended 30 September 2020.
The MD&A described how its outlets were impacted by the pandemic where some were forced to temporarily shut.
The group also provided information on measures it has taken to mitigate the impact, such as controlling costs and negotiating lease terms with its landlords.
Get Smart: A necessary health check
Just as we need to periodically conduct a health check to ensure that we are in the pink of health, our investments also need a regular check-up.
The five aspects above will provide a good indication of whether the business is coping well with challenges and whether it can continue to grow.
We are in the golden age of growth where there is no shortage of growth trends. Over the past decade, we have seen the likes of Apple (NASDAQ: AAPL), Amazon (NASDAQ: AMZN) and Alphabet (NASDAQ: GOOGL) surpass the trillion-dollar market cap mark. Growth trends alone will not guarantee success. You need to find excellent companies that are capitalising on these trends too. And we believe cloud computing is one trend that fills this sweet spot. Join us for a FREE webinar: The Golden Age of Growth to maximise your chances of success in this booming trend.
Disclaimer: Royston Yang owns shares of iFAST Corporation Limited and NetLink NBN Trust.