If you are new to the stock market, chances are, you are lost in a sea of information found on the internet. With so many different schools of thought and “sure-win” methods floating on the net claiming to “beat the market”, to whom should you be listening and in what exactly should you be investing?
As renowned financial blogger AK always says, “No one cares more about our money than we do”. It is certainly worthwhile to spend some time improving on our financial literacy instead of handing over your money to someone to invest (hedge funds with exorbitant fees) without understanding what kind of investment you are making and the risks involved.
So, how do we get started? I gained some insight from one of AK’s blogpost about how he approaches the stock market.
“How do I usually decide on whether a company is a worthwhile investment these days?
First, I look at the sector versus the economy. Second, I look at the company’s numbers to ensure that it is not overvalued, that it is profitable, that it is not too highly geared and that it has good cash flow. Third, I compare the company’s numbers to its peers… Then I use technical analysis (charting) to decide on fair entry points…”
Apparently, AK will carry out further evaluation of the company he invests in, but these few points are the fundamentals new investors should all consider learning. Although he first made these comments back in 2010, his methods are still relevant today.
First, consider to which sector the company belongs. Is there room for the industry to grow or is it facing increasing turmoil like the shipping and marine industry? Anticipating the future development of the industry is important to estimate the future growth of the company.
Next, ascertain if the company is overvalued at its current price. The importance of having a margin of safety cannot be understated, that is buying when shares are trading at a significant discount to its intrinsic value.
Investors can protect themselves that way as the intrinsic price may be lower than expected but as long as the share price was low enough, investors can still profit from this investment.
As there are many different ways to evaluate the “real” value of a stock. For example, some might use the discounted cash flow model; others might consider PER (price-earning ratio). You can refer to AK’s post for further elaboration.
AK also recommended the book “The little book that beats the market” which provides insightful advice with regards to evaluating a firm’s value. Personally, I find the book fascinating and very easy to digest. It will be a good point of entry for beginners who do not have much financial knowledge.
Following which, AK determined if a company is profitable. Investors will need to read its income statement to find out how much profit they are making – how much is left after accounting for cost of goods sold and expenses incurred etc.
Next, ask ourselves, how much debt does the company use to finance its operations? A company with a massive debt will have a higher default risk i.e. they may go bankrupt if they experience problems with servicing their debts.
However, debt is usually a cheaper alternative to raise capital as compared to using equity. Hence, if the amount is put to good use to generate high returns and the amount is not overly large, we should not worry ourselves needlessly.
Good cash flow is extremely important as companies need liquidity for daily operations, such as to pay their suppliers, rental fees and utilities. If the company is incapable of generating positive cash flow from its operations, it’s a telltale sign that the primary business of the company is not sustainable.
If revenue is high but cash flow is low, we may need to look out for possibilities of worsening credit ratings of customers, or loosening of credit policies of company. The worry is that if these receivables cannot be collected, they will have to be written down as bad debt expense instead of profits.
Objectives: passive income or capital gains?
At the end of the day, we need to have a clear goal when we buy a stock. Are we investing for income – to receive regular dividends – or are we more concerned with capital gains? As AK said “if it is for income, then, price movements should not matter as long as the fundamentals are intact and it is bringing home the bacon”.
One will be looking out for stocks with high dividend yields, such as REITs that distribute most of their earnings to their investors.
If you are investing for passive income, you will not need to panic-sell your stocks when prices go down, especially when the stock is still giving out regular and substantive dividends.
You may want to try out your luck at trading – buying low while selling high in a short span of time. In Benjamin Graham’s book “The Intelligent Investor”, he emphasised the importance of not mistaking speculation with investment.
If you are only buying the stocks because prices are rising and selling when prices fall, you are not investing but speculating. Speculation can bring in money at times, though one is unlikely to consistently beat the market without a more in-depth analysis of the stocks and the company’s operations.
Thus, over at Shares Investment, we are advocates of investing rather than speculation.
If you believe that you have an idea of the intrinsic value of the stock, you may choose to invest it when it is priced at an attractive price, especially when the Mr Market is moody and prices plunge.
Lastly, for those who feel that all these steps are too complicated and troublesome, and want to do as little as possible, an index fund can be a good option. Exchange traded funds (ETFs) that track an index can bring about an average market return. ETFs may be good enough for those who do not have the time or expertise to analyse individual stocks.