HOW-TO explain my decision-making system?

Oct 12, 2023

In the 21st century, financial and information technologies have reached such a level that we have an absolutely barrier-free environment for making investment decisions in the stock market. Brazilian investor does not need to live in the USA to buy shares of American companies. No need to be on a phone call with a broker or sit at a computer to make a stock market transaction - simply having a smartphone and internet access is sufficient. Market data, news, and financial reporting - all are becoming more accessible, striving for absolute transparency for the private investor.

Technologies have significantly simplified access to the market; however, they have not revolutionized its comprehension. I believe that future generations will also wrestle with what to invest in, even with the assistance of Artificial Intelligence. Therefore, I am confident that stock investors will always grapple with three questions:

- which stocks to choose?
- at what price to buy them?
- and in what volume?

I have designed my decision-making process, which can be represented as a crystal, to answer these three questions.



Imagine that the light penetrating the crystal represents the initial information about the company, contained in its financial reports, news, and market quotes. Algorithms and stock analysis principles work inside the crystal, processing the collected data and emitting it in a new format(*). Thus, the light reflected by the crystal, forms already new, derived information, convenient for processing by the investor.

(*) If you have not read my previous posts, I strongly recommend reviewing them to understand the algorithms and principles discussed.

Each facet of this imaginary crystal helps to examine the studied company from various perspectives and ultimately answer the three questions posed.

There are only 5 of these sides (facets):

1. Fundamental strength
2. Cash flow dynamics
3. News
4. P/E ratio
5. Rainbow Indicator

Thus, in my work, I utilize the principle of transforming complex information into a convenient visual format. This approach can be described as visual analysis of stocks based on fundamental data. If 90% of the information about the surrounding world originates from our vision, why not leverage our wonderful and clear eyes to answer the top three investor questions?

Now, let's take our crystal in hand and get started!

Question №1: which stocks to choose?

This question plagues any investor. After all, the US stock market itself trades thousands of companies' shares. To answer this, I will need to examine three facets (Fundamental Strength, Cash Flow Dynamics, News) of each company. Believe me, studying each one is not an easy feat, even while employing visual analysis tools.

To simplify the task for myself, I apply the concept I developed in my description of the Fundamental Strength Indicator:

My business valuation model is more suitable for companies engaged in the production of goods or services, where tangible assets play a substantial role in the business.

This is due to the set of financial ratios I utilize in my model (*).

(*) Learn more about this in the article: What can financial ratios tell us?

For example, I am unlikely to assess the operations of banks, financial institutions, and insurance firms using the Fundamental Strength Indicator. The activities of these corporations depend only slightly on their physical assets. Due to this, some of the ratios I utilize in the Fundamental Strength Indicator, such as "Inventory to Revenue," are inapplicable. Additionally, there are cases when the actions of one ordinary employee of a financial organization threaten the existence of the company itself. It suffices to recall the story of trader Nick Leeson, who successfully bankrupted his employer - the English 'Barings Bank'.

An organization that makes use of tangible assets is the perfect potential company in my opinion. For instance, a microchip or nut manufacturer, a wholesale store, or a raw material supplier. In general, those who trade in tangible objects.

Let's take a look at the companies that align well or poorly with the above thesis. For this purpose, I shall employ TradingView's Stock Screener service. The screener allows me to see a list of companies that satisfy particular criteria (filter). For instance, I can choose businesses whose stock is listed on the US exchanges.



Or companies from the sector I have selected. A sector refers to a broad category of economic activity in which a company operates. For instance, businesses like The Coca-Cola Company, Nike Inc., and Colgate-Palmolive Company are included in the "Consumer Non-Durables" sector. They manufacture fast-moving consumer goods.



Thus, to avoid checking each company for compliance with the thesis, I filter at the sector level. I classify sectors into different tiers of groupings in my decision-making process.

The first-tier sector group consists of sectors that I prioritize and review first.

The second-tier sector group includes sectors that I review in the second order if I do not find sufficiently fundamentally strong companies in the first-tier sector group.

The third-tier sector group includes sectors that I review in the third order if I do not find sufficiently fundamentally strong companies in the second-tier sector group. The Fundamental Strength Indicator for this category of companies frequently indicates a dearth of the data needed for calculation. This is due to the specific nature of the company's operations.

So let's take a look at the groups of sectors of different tiers using the example of the US stock market (Filters: Market - US, Country of incorporation - US, Sector - selectable).



Given the size of the American stock market, I use another filter - "Capitalization", to eliminate very small companies. I look at companies with a capitalization of $ 1 billion or more. However, everyone can set this threshold for themselves independently.

Now, I can create a 'Watch List' for each sector, specifying which group it belongs to. For example: 'Retail Trade - tier 1'. In this way, I can add the entire sector at once rather than adding each company's ticker to the Watch List individually. To do this, I download a sample of companies obtained in the Stock Screener and upload it to the Watch List.





Next, I add the Fundamental Strength Indicator twice to have two indicator panels. In the first panel, I will see the histogram and the blue line (Fundamental Strength). In the second - the Cash Flow dynamics.



Switching between tickers and analyzing the latest value of the blue line, I select companies with a Fundamental Strength equal to 8 and above. Such companies are moved to a specially created section within the Watch List - 'Fundamentally Strong Companies.' The arrangement of companies within this section will depend on their Cash Flows (*). The better the cash flow picture for me, the higher I will position the company in this section.

(*) Learn more about the Fundamental Strength Indicator and Cash Flows here: HOW-TO evaluate the state of a company's cash flows?

To keep track of companies close to fundamental strength, I use another section in my Watch List - “Candidates”. Companies that have recently lost their fundamental strength can also be included there.

Moreover, I mark fundamentally strong companies with a green marker and candidates with an orange one. This allows me to avoid switching between Watch Lists and, for example, see all companies marked in green.

So, using the Screener and the Watch List, I create a database of companies segmented by sector. Next, I apply the Fundamental Strength Indicator to categorize the companies within the Watch List. The strongest companies are listed first on the Watch List, followed by the candidates, and then everyone else.

This sequence of actions allows me to evaluate two facets of my magic crystal - Fundamental Strength and Company Cash Flow. However, this is not all that will help me answer the question - Which stocks to choose? Because there is a facet that can make me doubt even if you have the most fundamentally strong company in front of you, with perfect cash flows. But that will be covered in the upcoming post. See you!