How to choose the right method for evaluating securities, shares to trade

It’s not enough to conduct a general overview of the various factors to consider when investing in shares as this may not paint a complete picture for you when making the decision.

In this article we aim to divulge techniques that investors use to determine the specific factors to consider. It is important for investors to evaluate their investment objectives prior to determining the approach to use in making any investment decision. We look at a number of approaches.

Fundamental analysis

This entails examination of underlying factors that affect the health of industries and companies, with the goal of deriving a forecast of future price movements.

To forecast future stock prices, fundamental analysis combines economic, industry and company examination to derive a stock’s fair value. When the fair value is equal to the current stock price, it is believed the stock is fairly valued; when the fair value is higher than the stock price the stock is believed to be undervalued and you should buy it.

Lastly, when the fair value is lower than the stock price then the stock is believed to be overvalued and an investor should consider selling their shares. Fundamentalists believe investors operate in a “weak-form market” i.e. prices do not accurately reflect all available information, hence analysts capitalise on ensuring the information is available to investors to help in decision making. Kenya’s stock market was in weak form since inception in the 1950s, but has drastically improved to partially semi-strong form as more information is readily available.

There are two main approaches that can be used in fundamental analysis; bottom-up and top-down. The top-down approach starts with the overall economy then the larger industry narrowing down to specific companies.

In the bottom-up approach an investor overlooks the broader sector and economic conditions and instead focusses on analysing a specific company, with a view of seeking strong companies with good prospects regardless of industry or macroeconomic factors.

This form of analysis is mainly suitable for long-term investors as it is based on long-term trends and is considered as a technique for identifying value underlying a given stock. This method is appropriate for investors who opt to wait for one to two years for their investments to grow. It assists in understanding if the long-term prospects of the company are good and whether the company is valued right. Some of the factors you consider include; price to earnings ratio; earnings growth; corporate governance, and future cash flows. The analysis also allows investors to develop an understanding of the key value drivers and companies within an industry. Fundamental analysis is therefore very valuable in decision making for a long term investor.

Technical analysis

This technique is mainly used by short-term investors seeking to make a return in a year or less. They mainly observe the stock trend and make conclusions based on prices and volumes of the stocks. Charts are used to identify which stocks are having momentum and where investors could make “smart money.”

The practice values stocks based on their past volume and pricing information. An investor will usually observe the trends of a given stock to make any decision and the underlying factor under consideration is the supply and demand of the stock which also determines prices. Technicians usually concentrate on trends and patterns in the data that indicate future price movements.

Most important is for the investor to find a suitable entry and exit point as well as looking for chart patterns. Some of the technical analysis tools include: On-balance volume (OBV)— measures the positive and negative flow of volume in a security, relative to its price over time. Moving Average Convergence Divergence (MACD) — used to signal both the trend and momentum behind a security.

Relative Strength Index (RSI) – used to signal overbought and oversold conditions in a security. Plotted between a range of 0 and 100, with 100 being the highest overbought condition and 0 being the highest oversold condition.

Technical analysis is more suitable for investors with a higher risk appetite, ready to take on speculative counters which are actively traded, those boasting of higher liquidity. Stocks like Kenya Airways Ltd and Mumias Sugar Co Ltd are good speculative stocks, thus technical analysis would be very appropriate in considering entry and exit positions for short term investors.

Social analysis

This is where many of us lie, whereby we make our investment decisions based on “herding” behaviour. Here you look at the stocks that are most talked about in social channels and identify the ones that have the strongest “sentiment”. You can also use social channels to identify if people “love” or “hate” the brand, the product and the company.

Ms Gatebi is a senior research analyst at Nairobi-based Kingdom Securities. [email protected]