3 steps to analysing stocks during the reporting season for your SMSF

The next reporting season is not far off and that means DIY investors should be prepared to do a review of their ASX share portfolio. Here's what good analysts do…

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The next reporting season is not far off and that means DIY investors should be prepared to do a review of their ASX share portfolio.

Whether you are running a Self-Managed Super Fund (SMSF) or a casual investor, you should be reviewing your share portfolio at least once every quarter, particularly around the twice-yearly reporting season in February and August.

Many everyday investors might feel that reviewing and analysing stocks is beyond them and best left to professionals. This isn't necessarily a bad idea although analysing shares isn't as difficult as what you might think.

This article will outline three steps to analysing stocks that anyone can do and should do – regardless of whether you use experts to help you with your investments or depend totally on yourself to pick and sell stocks.

Don't get bogged down by numbers

Sure, analysts make lots of calculations to work out a price target and forecast sales and earnings. This will surprise you, but the calculations are the easy part of the job.

The head of research at one of the investment firms told me when I first started in the industry that she could train a monkey to do the maths!

I can only hope she wasn't saying something about me, but the key point is that the hard part of the job is the qualitative analysis as that drives the assumptions an analyst will input into the financial models.

Being good at the qualitative is more important than being good at the quantitative. This is because the first tells me about the quality of the company while the latter tells me about price I am paying.

If you had to make a mistake in your analysis, experience has shown me that it is far better to overpay for a quality stock than to underpay for junk.

3 steps to good analysis

This is why whenever I first screen a stock (which to me is the most important part of the exercise), I don't pull out my calculator but I follow the three steps outlined below.

  • Scrutinising management

This to me is the more important part of analysing a stock because management is often the single biggest factor behind a company's success of failure.

This is particularly true when it comes to small cap stocks, although it's just as relevant to blue-chips.

You will want to know the track record and history of the key executives as this will not only give you an indication of the probability of success but it will also give you insights into the governance of the company.

My golden rule is never to invest in a company with management I don't trust, no matter what the valuation tells me.

  • Assessing the financial health

I may have exaggerated when I said you don't need any maths as you will need to look at the company's latest accounts or annual report to make a judgement on its financial health. But I can sincerely say that you only need the same level of maths skill as a primary school student to assess the strength of a company's balance sheet.

You will want to make sure that a company has sufficient cash to fund and grow the business and doesn't rely too much on debt.

What the right cash and debt levels are depends greatly on the type of business. One trick to work this out is to look at its competitors (particularly stronger rivals).

You should also take a close look at a company's quarterly cash statement if it is required to file one as that can give you further clues on whether it will need to undertake a capital raise and roughly when.

While this analysis is important for large caps, it is particularly critical for shares at the smaller end of the market as they are the ones that often have no or little revenue but relatively large cash requirements to build the business.

The rule of thumb when it comes to cash levels is to be alert when a company's account balance drops to $2 million or lower, and alarmed when it drops below $1 million.

Few things drive a stock sell-off more than a whiff that management will need to undertake a capital raising in the short-term.

  • Rating the outlook

Staying up to date on financial news will help you decide on a company's outlook over the short to medium term.

More importantly, it can also help you determine if any earnings downturn or upturn is based on cyclical or structural forces – with the former being temporary and the latter permanent.

To make an educated guess, you will need to understand what the main revenue drivers of the business are, its cost base, its competitive advantages and disadvantage and the broader operating conditions for the sector.

If you have a positive view on all three of these steps, there is a good chance that the stock will outperform.

Happy investing my fellow Fools!

Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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