How does one go about investigating the potential future of a stock?

Question

I tend to buy stock based on random information I've heard or read, or based on "emotional" decisions like interest in an industry or particular company. This sometimes works out, sometime sdoesn't. For the most part I've done well with my choices with a few less successful choices. I'd like to be more informed in my decisions, though.

Right now seems to be a good time to buy into the market. Obiously the coronavirus is having an indirect impact on numerous industries due to the global stay-at-home mandates. Other industries are being impacted by different factors.

For the sake of this question, let's look at the oil industry. Due to the conflict between Russia and OPEC (and others? I haven't been paying much attention to the situation), the cost of oil has dropped to below $0 for the first time ever. This is obviously a concern for oil stocks across the board.

My question, in this particular case, is: how does one look at the information to get an idea of which companies will survive let alone increase in value when oil returns to normal (assuming it does)?

Answer 1

Substantial loss of revenue combined with a high debt-to-equity ratio is a risk of bankruptcy.

But many companies only see a percentage reduction in revenue while having a moderate debt-to-equity. Consumer staples can do okay, pharmaceuticals can do okay, and telecommunications can do okay. Utilities and power production can do okay.

Utilities and telecommunications are not actually examples of moderate debt but they tend to hold on to their revenue.

Some young companies have future prospects, large amounts of cash, and no debt. These companies of particular prospects don't trade on the current economic reports.

But de-leveraging in the financial markets reduces support of everything.

Answer 2

The last three words of your question - "assuming it does". Holds the key to carrying out a proper analytics exercise. You should take everything you know about the current situation and make a range of assumptions on when things might return to normal. That gives you what i'll call the duration of pain for the universe of companies you want to look at (oil companies as an example from your question)

Then, you want to evaluate the liquidity of your companies and try to assess the odds of them remaining solvent in each of your return to normal scenarios. How much cash do they have, how much debt do they have to service? Will they need to raise more cash? Can they even raise cash if they need to? Tip: Look up solvency and liquidity ratios as a starting point to create a benchmark.

Since we're sticking with the oil example, i'd also urge you to do some homework on the pre-COVID state of the oil markets so you can answer the question - how much of the fundamental problem does returning to normal solve for oil companies? You can read my thoughts here for a beginning framework of how to think of that.

Answer 3

how does one look at the information to get an idea of which companies will survive let alone increase in value when oil returns to normal (assuming it does)?

One word: debt.

When buying stocks of a company for $100 having a P/B ratio of 0.1 and debt-to-equity ratio of 200%, think of it as follows.

You're buying equity of $1000 for $100. With it, you are taking a debt of $2000 (for which you are not personally liable, so if the company goes bankrupt, you are limited to $100 loss).

So, think that the total price you're paying is $2100, not $100.

So, the stock that seemed very cheap on the P/B ratio basis, isn't actually cheap at all.

If you're buying stocks of an indebted company, you should think that you're not buying a stock; you should think that you're buying an option to purchase a part of the company by paying back its debts. Ok, if you own less than 50% of the company then you can't pay your share of the debts, but why would you use different assessment criteria for buying less than 50% than what you use for buying more than 50%?

I do my long-term investments in stocks. I wouldn't invest in options for the long term. Why would you invest in options, if investing for the long term?

Therefore, stay away from option-like stocks and buy stocks that have reasonable debt.