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Importance of Market Research in Trading

Importance of Market Research in Trading

In the fast-paced world of trading, market research serves as the bedrock for informed decision-making and strategic planning. Understanding market dynamics, trends, and patterns is essential for traders to navigate the complexities of financial markets successfully. This blog delves into the significance of market research in trading, how it empowers traders to make informed, profitable decisions and what you can you do as a part of your due diligence to make informed decisions.

Conducting market research before investing in the stock market is like preparing for a competitive exam. Your preparation may not guarantee your selection, but it will certainly save you from embarrassing yourself in an exam!

Investing in the stock market without prior research is comparable to attempting the IIT-JEE or UPSC exams without preparation or revision; you'd be relying solely on luck, or God's Grace. While it's possible to find your very own Godfather in a well-researched stock broker today, it's still crucial to conduct your very own thorough research. When researching a company, the first and most crucial step is to thoroughly understand the business. Many people skip this step and jump straight into analysing the stock price. While focusing solely on the stock price can be effective for short-term strategies, gaining a deep understanding of the business is vital for long-term investments.

Is Market Research Important?

The answer is straightforward: the better you understand the company, the stronger your conviction to hold onto the investment, especially during challenging periods such as bear markets. It's essential to remember that during bear markets, stock prices may fluctuate, but the fundamentals of the business remain unchanged. A solid understanding of the company and its operations provides you with the confidence needed to justify staying invested in the stock, even when market sentiment is negative. It's often said that bear markets create value, so if you have a strong conviction in a company, consider buying its stock during these times rather than selling. Admittedly, this approach is counter-intuitive and requires years of investment experience to fully grasp and implement.

This includes proper due diligence, analysing stock fundamentals, estimating intrinsic value (valuation), examining revenue and profit growth, earnings per share (EPS), gross profit margins, debt levels (balance sheet check), and comparing sales versus receivables. All forms of intrinsic value calculations can help you make an informed decision.

A strong market research will empower you with the following advantages

It is essential to comprehend the numbers and evaluate if both the nature of the business and the business’s financial performance complement each other. If they do not complement each other, then clearly the company will not qualify as an investible grade.

Informed Decision-Making

Market research equips traders with the information needed to make well-informed decisions. By understanding market trends and economic indicators, traders can anticipate potential market movements and adjust their strategies accordingly. This reduces the reliance on guesswork and enhances the probability of making profitable trades.

Risk Management

One of the primary goals of market research is to identify potential risks and develop strategies to mitigate them. By analysing historical data and market conditions, traders can assess the risk associated with different trading opportunities. This enables them to implement risk management techniques, such as stop-loss orders and diversification, to protect their investments.

Identifying Opportunities

Market research helps traders identify lucrative trading opportunities. By keeping abreast of market trends, emerging sectors, and economic developments, traders can pinpoint undervalued assets or anticipate price movements. This allows them to enter and exit trades at optimal times, maximising their returns.

Understanding Market Sentiment

Market sentiment refers to the overall attitude of investors towards a particular market or asset. Understanding market sentiment is crucial for traders, as it can influence price movements. Through market research, traders can gauge investor sentiment by analysing news, social media trends, and trading volumes. This insight helps traders make strategic decisions that align with the prevailing market mood.

Staying Updated with Regulatory Changes

Financial markets are subject to regulatory changes that can impact trading conditions. Market research helps traders stay informed about new regulations, policy changes, and geopolitical events that may affect the market. This awareness enables traders to adapt their strategies and remain compliant with regulatory requirements.

Enhancing Technical Analysis

Technical analysis involves studying historical price movements and trading volumes to predict future market behaviour. Market research enhances technical analysis by providing additional context and data points. By integrating market research with technical analysis, traders can develop more accurate and robust trading strategies.

Tools and Techniques for Effective Market Research

Financial ratios are vital metrics used to evaluate a company's performance and financial health. While a single ratio may not provide comprehensive insights, analysing trends over time or comparing them with peers can yield significant information. Financial ratios can be categorised into four types: profitability, leverage, valuation, and operating ratios, each offering a unique perspective on a company's business.

EBITDA and EBITDA Margin

EBITDA represents the earnings before interest, taxes, depreciation, and amortisation. It measures the company's operational profitability by subtracting operational expenses from operating revenue. The EBITDA margin indicates the percentage of profitability at the operating level.

Profitability Ratios

Profitability ratios like PAT margin provide insights into a company's overall profitability. The Return on Equity (ROE) ratio is particularly valuable, showing the return shareholders earn on their initial investment. However, a high ROE accompanied by high debt can be a red flag. The DuPont Model decomposes ROE into different components, offering a detailed view of the business's efficiency.

Leverage and Efficiency Ratios

Return on Assets (ROA) indicates how efficiently a company utilises its assets. Return on Capital Employed (ROCE) measures the overall return generated from both equity and debt. These ratios are useful when compared with industry peers and analysed over time.

Valuation Ratio

Valuation ratios estimate a company's worth. They involve inputs from both the profit and loss statement and the balance sheet. The Price to Sales (P/S) ratio compares the stock price with sales per share, indicating how much investors are willing to pay for a company’s sales. The Price-to-book (P/B) ratio compares the stock price with the company’s book value, reflecting its intrinsic value. Earnings per Share (EPS) measures profitability per share, while the Price to Earnings (P/E) ratio indicates how much investors are willing to pay for earnings.

Sometimes, a mediocre business at a ridiculously cheap valuation may be a great investment option instead of an exciting business with an extremely high valuation.

The valuation ratios help us develop a sense of how the market participants value the stock price. These ratios help us understand the attractiveness of the stock price from an investment perspective. The point of valuation ratios is to compare the price of a stock viz a viz the benefits of owning it. Like all the other ratios we had looked at, a company’s valuation ratios should be evaluated alongside the company’s competitors.

Evaluating valuation ratios alongside competitors' metrics is essential for a comprehensive analysis.

  1. Price to Sales (P/S) Ratio: This ratio compares the company’s stock price to its sales per share, indicating how much investors are willing to pay for a company's revenue.
  2. Price to Book Value (P/BV) Ratio: This ratio compares the stock price to the company's book value per share, reflecting the market's valuation relative to the company’s net assets.
  3. Price to Earnings (P/E) Ratio: This ratio compares the stock price to the company's earnings per share, indicating how much investors are willing to pay for a company's earnings.

You can find the Index P/E valuation daily on the National Stock Exchange (NSE) website. Note that NSE uses consolidated earnings to calculate the NIFTY P/E ratio. For accuracy, it is advisable to use prices from BSE/NSE and calculate EPS from the annual report.

NSE published standalone PE for the NIFTY up until March 2021. Starting in April 2021, they switched to using consolidated earnings to calculate the NIFTY PE ratio. Please be informed that if you pick up P/E from any other source, it could be wrong. Hence, we would advise you to take the price from BSE/NSE, calculate your own EPS by referring to the annual report and then get P/E. 

Return on Equity (ROE)

Return on Equity (ROE) measures the return generated on shareholders' equity, indicating the efficiency of the company in using equity investments. An ROE above 20% is generally favourable. However, these returns mustn't be solely due to high financial leverage, as low debt levels are preferable.

Sales vs Receivables

Analysing sales in conjunction with receivables is critical. High receivables might indicate that sales are credit-based, raising questions about the sustainability of these sales. This could mean that the company is pushing products on credit, which is not an encouraging sign.

Debt Levels – Balance Sheet Check

Examining the debt level on the balance sheet is vital. High debt indicates significant financial leverage, which can be risky. Large debt results in high financial costs, reducing the firm’s retained earnings. Sustainable growth should not be driven by excessive debt.

Gross Profit Margins

Gross profit margins, calculated as Gross Profits divided by Net Sales, indicate the profitability of the company's core activities. Gross Profits are derived by subtracting the Cost of Goods Sold (COGS) from Net Sales. This metric provides insight into the efficiency of production and the company’s pricing strategy.

Earnings per Share (EPS)

EPS measures profitability on a per-share basis. A consistent growth rate in EPS and PAT indicates that the company is not diluting earnings by issuing new shares, which is beneficial for existing shareholders. This metric reflects the management’s efficiency in generating profits.

Cash Flow from Operations

Cash flow from operations is a critical indicator of a company's financial health. Positive cash flow from operations demonstrates the company’s ability to generate cash from its core activities. Negative cash flow may signal potential issues and raise red flags.

Revenue & PAT Growth

Evaluating revenue and Profit After Tax (PAT) growth is fundamental in assessing a company's growth potential. This can be analysed from two perspectives:

  1. Year-on-Year Growth: This provides a sense of the company's annual progress. It is important to consider industry cycles, as flat growth may be acceptable if it is consistent across the industry.
  2. Compounded Annual Growth Rate (CAGR): CAGR offers insights into the company's growth over business cycles. Companies that can navigate through different cycles typically exhibit a healthy CAGR, making them attractive investment options.

To summarise

In the ever-evolving landscape of financial markets, continuous market research is essential for staying ahead and achieving long-term profitability.

It doesn’t matter how motivated, inspired, sentimental or trending a stock is, the time in the market will always prevail over timing the market. Nobody in the would advise you to face bowlers like Boult, Bumrah or Rabada without protective gear, the stock market can be much more lethal than that! 

Market research and financial ratio analysis are critical for making informed trading decisions. By understanding and applying these concepts, traders can navigate market complexities, identify profitable opportunities, and manage risks effectively. Continuous learning and adaptation are essential for long-term success in the dynamic world of trading. Comprehensive analysis, including valuation ratios, ROE, debt levels, profit margins, and growth metrics, is essential for identifying sustainable and profitable investment opportunities. 

 

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