Replicating Wall Street’s success
When it comes to investing, Wall Street represents the gold standard. Wall Streeters’ goal is to make money and they do it well. For generations, traders and investors have created tremendous wealth by investing in the stock market. Through my career on Wall Street as a trader and a program leader, I come to appreciate that investing is a science. It requires rational thinking and grounded research. This fact-driven approach is one of the most important things that make Wall Street successful.
Professional traders and investors make investment decisions based on deep market knowledge and thorough analysis. Better research produces better results. If you are serious about stock investing and are eager to improve your skills, this article will show you how to approach investing like a Wall Street professional. Over time, you will improve your analytical skills and make more rational decisions. After all, knowledge really is money in investing.
Sector knowledge – invest in what you know
The first step to make a great investment is to choose the sector you want to invest in. When it comes to investing in the stock market, industry knowledge can make a huge difference in your success. Buying a company’s stock is to own a share of its business. Just as you wouldn’t start a company in the field you know nothing about, you should invest in a sector that you know or are passionate about. Else you might just gamble away your hard-earned savings.
For example, if you are a computer programmer, you might want to first look at stocks of technology companies. If design is your passion, you can look at fashion companies and jewelry stores. This allows you to bring your expertise into your decision-making process. It gives you an advantage to investors without industry knowledge. Additionally, investing in a sector you know further motivates and engages you as it becomes more than just a set of figures but something concrete and relevant to you.
On the other hand, it is not a good idea to blindly follow trends and invest your money in something you don’t understand. A prime example of such behavior is Bitcoin investment. While many people have invested in Bitcoins, very few understand the technology that enables it and the challenges it faces. This makes a risky investment and could lead to devastating losses.
Industry analysis
Once you have selected an industry that you want to focus on, the next step is to summarize and research on the crucial themes in the field. Themes are overarching conditions in the industry. It can include trends, growth opportunities, and challenges facing the industry. These themes affect all companies. Additionally, how each company reacts to the industry themes can have a huge impact on their performances. For example, when oil prices tanked due to oversupply, all oil companies are affected and the ones with coping strategies and more diversified revenues would outperform their competitors.
Research resources
There are many resources online you can use to distill industry themes. We recommend the white papers and articles published by the big four: KPMG, EY, Deloitte, and PWC. These companies are the biggest and most trusted professional services networks in the world. They publish independent reports and policy analyses that offer in-depth views on many sectors. Not only are these resources available to you for free, but they are also trustworthy and insightful.
Distilling industry themes
Through your research, you can distill a set of industry trends and opportunities. In this article, we will use the gaming industry as an example to illustrate the thought process. We picked out four major themes in the video gaming industry from reports published by Deloitte and PWC.
These themes will guide our research and help identify the companies best positioned to thrive.
- Gaming Industry Growth Trend: video games and eSports revenue in the US increased to $24.4bn in 2018 from $22.7bn in 2017. The annual revenue growth is expected to stay at 5% a year with gaming revenue reaching $31.1bn in 2023.
- Mobile Gaming Growth: mobile gaming is expected to continue grabbing market shares from PC and counsels as mobile devices become better and more available.
- The Rise of eSports: eSports is currently less than 5% of the overall U.S. gaming market. Yet it is gaining traction among young audiences and advertisers. In 2017 alone, 600 brands sponsored eSports events and the annual revenue is expected to reach $1.5 billion in 2020.
- Shifts in Distribution Channel: Game distribution becomes more digital resulting in the decline of physical game stores.
Deep dive – company research
Understanding industry themes helps provide a factual context in which we can evaluate potential investments. With the overarching themes in mind, we now can move to evaluate individual stocks.
Identifying potential investments
Selecting a good investment requires peer group analysis. A company might look good by itself but it can appear less attractive among its competitors. In order to optimize your investment, you should collect and compare a group of companies in your chosen sector. By comparing and contrasting these potentials, you will have a better idea of their relative strengths and weaknesses. The more companies you research, the better your selection will be.
You might already have some companies that you want to look into deeper. This is a good starting point. One way to generate more potential candidates is by using a company’s SEC filing. Each public company is required to evaluate their own peer group to stay competitive and measure growth. You can find this information in a company’s DEF 14A filing, accessible on the SEC website. This shows you which companies a business considers as its competitors and peers.
For our example, we selected Electronic Arts as one company to look into deeper. By reviewing its DEF 14A, we are able to further select three more gaming companies to include in our analysis: Activision Blizzard, Take-two Interactive Software, and Zynga.
Peer analysis
Once you have collected a group of companies, the next step is to analyze and compare these companies in depths.
Quantitative analysis
Quantitative analysis is the most direct way to understand a company’s performance. We like to use ratios to understand the profitability, relative valuation, and capital structure of each company. Each investor has their own approach and preferred indicators to look at. There is no golden formula and you can include more variables if they help you make better decisions.
Profitability
The first number we look at is the net profit margin. It shows you how profitable a company is. From the table below, you can see that ATVI has the highest net profit margin compared to its competitors. Further, we calculated the ROE (Return on Equity) which shows how effective the company is at generating profit with its equity. Among the four, EA has the highest ROE at 19%. However, sometimes a higher ROE can result from higher financial leverage. To account for this, we calculated the ROA (Return on Assets) for each company. With a 10.15% ROA, ATVI comes to a very close second. Based on both net profit margin and asset efficiency criteria, ATVI and EA are leading among their peers.
Profitability
| Company Name | Activision Blizzard | EA | Take-two | Zynga |
|---|---|---|---|---|
| Net Margin | 24.17% | 20.69% | 12.47% | 1.65% |
| Return on Equity | 15.93% | 19.13% | 16.32% | 0.94% |
| Return on Asset | 10.15% | 11.38% | 7.85% | 0.70% |
Relative valuation
Next, we reviewed the relative valuation of each stock. This shows you if a stock is overvalued or undervalued. The most popular indicator is the PE ratio, also called the price multiple. A large PE ratio means that the stock price is relatively high in comparison to the earnings it generates. Due to ATVI’s price drop in 2018, its PE ratio looks most attractive among the four companies. (Zynga has negative earnings, thus a negative PE ratio. Negative PE ratios are not meaningful and often omitted in reporting).
Relative Valuation
| Company Name | Activision Blizzard | EA | Take-two | Zynga |
|---|---|---|---|---|
| PE | 20.13 | 27.76 | 38.05 | -46.46 |
| EV to EBITDA | 11.20 | 20.05 | 22.25 | 101.65 |
| Price to Book | 3.13 | 5.68 | 5.19 | 2.12 |
The EV to EBITDA ratio is considered more comprehensive than PE because it accounts for a company’s debts and liabilities. A low EV to EBITDA ratio reflects a cheaper valuation. Due to Zynga’s limited revenue, its EV to EBITDA ratio is incredibly high, making it a bad candidate. Among the four, ATVI’s ratio is more preferable.
Lastly, we calculated the PB ratio (Price to Book Ratio), which is the ratio between a company’s market valuation and its book value. Within the same industry, overvalued stocks tend to have higher PB ratios and vice versa. ATVI’s price to book ratio looks attractive compared to its peers.
Capital structure
Lastly, some basic understanding of a company’s capital structure is helpful. We reviewed the asset to equity ratio for our four companies. This indicator measures financial leverage and a company’s ability to repay its financial obligations. Creditors are more willing to lend money to companies with a smaller asset to equity ratio. We can see that ATVI and Zynga have healthier ratios.
Capital Structure
| Company Name | Activision Blizzard | EA | Take-two | Zynga |
|---|---|---|---|---|
| Asset to Equity | 1.57 | 1.68 | 2.08 | 1.34 |
Overall, based on our analysis, ATVI seems to be a good candidate with high profitability, modest valuation, and low financial leverage.
Qualitative analysis
A scientific approach to investing goes beyond data collection and number crunching. Businesses are alive with stories and nuances. An understanding of company strategies and the market helps us make a more well-rounded decision. Qualitative analysis focuses on company policies and products. It builds on top of quantitative analysis to provide insights and predictions on a company’s future performance.
This is where the industry themes become helpful. A good way to start your research is by reviewing how each company reacts to sector themes that we have distilled earlier. For example, through our research on the gaming industry, we discovered that mobile gaming and eSports are becoming increasingly popular. With these themes in mind, you should look into each company’s strategies around eSports and mobile gaming. The table below uses ATVI as an example for qualitative research.
| Industry Theme | ATVI |
|---|---|
| Mobile Gaming Growth | ATVI has a heavy emphasis on mobile gaming. Its mobile engagement reached a new record in 2018 with a daily gaming time of 38 minutes per user. |
| The Rise of eSports | The Overwatch League under ATVI is the first major geographical eSports league. The first season of Overwatch League captured 10 million viewers for its finale and generated $200 million in sponsorship. ATVI’s infrastructure for organizing eSports events and winning sponsorship will help the company build a dominant presence in this growing industry. |
| Shift in Distribution Channel | Compared to its competitors, ATVI has the highest digital distribution percentage except for Zynga, who specializes in mobile gaming. With the decline of physical game stores, ATVI is in a better position to adapt to the market shift than the other gaming giants. |
Other factors to look into include the company’s management strength, brand value, research and development, and other industry-specific items.
Qualitative analysis can be highly subjective. The same news and information can be interpreted differently. However, the goal is not to discover the absolute truth. Rather, it is to build a sound thought process that you can improve on with feedback from the market. If your investment does not perform well, you can then go back and reconsider your method. Through trials and errors, your analysis will become more accurate.
Risk factors
While selecting an investment is about seeing a company’s strengths and potentials, it is equally important to be aware of the risk factors that can negatively affect your profit. A good grasp of the risk factors can help you monitor your investment effectively. As an example, we have listed two risk factors for ATVI:
The decline in monthly active users
One of the major risk factors for ATVI is a further decline in Monthly Active Users (MAU). The selloff of ATVI in 2018 was mainly driven by the decline in Monthly Active Users and increased competition from free-to-play games. While ATVI has implemented major restructuring within its company in response, one could argue that the users are simply losing interest in its headline games. In that case, the restructuring and increased developing power would not be able to stop the decline. MAU will be an important factor to monitor for this investment.
Concentration risk
58% of ATVI’s revenues are generated by several of its main games. This concentration leaves the company vulnerable to further erosion from other game developers.
Stock investing as a science
The stock market can appear to be a black box of impenetrable numbers, unpredictable movements, and unwanted surprises. On top of that, there are many different voices in the media that could disrupt your own intuition and analysis. While one expert tells you to buy a stock, another suggests the opposite. Sometimes, putting your money in the market can even feel like gambling.
Yet, the lesson to learn from the professional investors on Wall Street is that despite the uncertainties of investing, grounded research and rationality often result in better returns. Unlike gambling, investing has a set of rules and principles that resemble a science. The first step to becoming a better stock investor is to realize that investing is a skill that can be learned and mastered by you. Your investment return will improve as you become a better investor.
