SYWBS Part 2: So you still wanna buy shares...

This is a continuation to the first part of the series of writings on my views as to how we can break down the logic and rational of investing in shares, especially for the very first time.

In the previous post, I shared my belief that:
1. Share price move based on expectations of making profit
2. People invest with the expectations to make profits
3. The starting point of investment is pitch black and there are thousands of choices and noises in the market.
4. Expectations are elusive and unpredictable, sometimes (most of the times) it defies logic and reason.
5. Most of people starting out have limited capital, so best to first see the surrounding, the battlefield, before making any move. That distinguishes between the brave and the idiot (while not forgetting idiots do have some luck sometimes).
6. One of the ways, by which we can try to 'see' in the dark  or feel the surrounding, systematically is by a top down approach.
7. Top down approach starts with industries within the country. Actually you can even go higher with which country, but i will explain this on if anybody asks. For the time being, we shall keep it local.

So lets continue with the top down approach and look at industry.

A country's economy is divided by industries and each industry has its own 'health'. The health of the industry depends on many things, internal and external. I am not going to explain how to assess the industry here, like the Porter's Five Forces etc, but sufficient for us to understand that we need to find out which industry harbors the most expectation to be prosperous.

Why do we need to find this out? The logic behind this is that the industry that is prosperous would give more chances for the companies within it to be prosperous. Therefore, as the company prosper, the shareholders would prosper alongside it too. That is the general nature or logic of the human brain.

The need to to have the ability to systematically/ logically narrow down choices above is further enhanced by the fact that the human beings are limited by capital and brain power.  Capital is limited in a sense that it is no one person / organization has enough capital to be invested everywhere. Choices has to be made as to where be to invest in. More importantly, in general, the decision making process of investments are done by humans and the ability to have a multiple lateral analysis is very limited.

As I have argued before, the prices of shares are determined by expectations of trading profits. It is not determined by fundamental or analytical calculations. If someone had carried out a fundamental or analytical calculations and comes out with a price, that price is not going to be force fed into the market / system.  They can't do that; they can't determine the price. Otherwise how do we explain all the price targets? If the prices of shares are determined by these calculations there will be no price targets as the next price will be set at that.

In my eyes, the fundamental (FA) and analytical analysis (TA), calculations and outcomes feeds into the expectation of the share concerned. And the magnitude of this expectations depends on the visibility of the shares and how much people believe in it.  Take for example a share which is trading at $1.00 each. We did our own FA or TA and arrived at a price target of $2.00 each. GREAT! Really? Not really.

Our price target above are not visible to others. That means that others does not share our price target hence the magnitude of that expectation that the price will increase to $2.00 has only the strength of whatever capital we have.

But if an analyst comes out with his/her own calculations and sets the price target to $0.50 and that target is then published in the newspaper, it would have an impact on the share price of the company as the visibility of this opinion would affect the expectations of many more investors.

You could probably be right  and the analyst wrong, but since the price is determined by expectations, the price would more probably be swayed by the much larger expectations generated by the analysts.

This also explains how can one share have multiple target prices from multiple credible analysts. Each analyst may have been correct in arriving at their target price calculations but the actual price movement is determined by how much and how many people believed in the upside (of 50%, 20% or even 100%).

So back to the industry selection above, it is important for us to identify the industry that is most visible for the right reason. The more visible the industry is the more investors will be looking at the companies within the industry.

Take for example the oil and gas industry. For the past few years there has been many good news about the industry, mainly that the oil price is at a very high and profitable level. That made it stand out and make people believe that there is more likelihood of success for the companies involved in this industry. And the investing public expects that it is going to generate more and more attention and hence attract more investing money.

In general, the expectations on making a profit in oil and gas companies should be high because  most of the factors that would be fed into the the expectations of rising share prices are all there. The fundamental calculations should be looking good as the industry is doing well. And as sentiment translates into positive share price movements, the TA would also be showing a good sign.

So first, pick your industry or industries.

But before we can make our pick, we need to know how to identify which industry is doing well. The first obvious source would be the newspapers and and other sources of economic outlook, including analyst reports. Look at how the industry is being reported in the news and around us.

You can also look at the indices representing these industries. What has been the trend and whether the indices has been growing in line with all the positive news out there. Comparing the indices against good news about the industry is a good way to gauge the level of visibility of the industry in the eyes of the investing public; whether the investors are paying attention the companies within that industry.

- to be continued-

Next: how do the fund managers usually narrows down which company to buy within a particular the industry.

Next next: How fund managers build equity portfolio and how you can do it with the combination of ETF and shares.