So you have learned about stocks in my previous blog. But how do you choose them?! This part of the blog will look into a very basic of how to make your decision on shares.
I have to warn you, it takes years to master stock picking if you expect extraordinary returns. However, a basic understanding will let you create a portfolio with a reasonable return, and this part of the blog will be a starting point.
Everyone whats to find out whether the stock will go up or down. Guess what, there is no easy answer to this question because everyone would be rich then. Although it is prudent to start with fundamentals. The idea is to try to decide what is a good price to pay for a stock-based on underlining company and not just some speculation.
So let’s begin. There are thousands of stocks traded on international exchanges and around 3K in London. Most of them will not be a suitable investment for you due to various reasons. One could be due to significant transaction costs buying from international exchanges, or the company may have a lot of debt, and when times go bad, it will go broke. It could be simple as stocks became too popular and overvalued.
Based on your needs, risk and expectation you will need to choose between growth stocks or dull-but-worthy and often safer income shares. The difference between the two broadly are as follows:
- Growth stocks pay a lower dividend in relation to revenue and make a significant investment as compared with company size. Due to a massive investment, growth is much higher, and investors buy into bright future. You will see that prices are stretched in relation to underlining fundamentals as people purchase the potential of income. Companies tend to be smaller than income companies.
- Income stocks are huge corporation growing modestly over the years and distribute a significant portion of revenues as a dividend, hence income shares. They are safer and more reasonably priced in relation to fundamentals. Of course, there are exceptions. Some may have such stable income that premium is placed.
- When things go well for growth stocks, it will shoot sharply upwards, and you can make a lot of money. I have seen returns 50% and 100%+, but when things start to look bad, it will drop even faster. Do not even think of buying just one of these and hope to make those returns. It has to be part of a larger portfolio strategy.
You must never just jump into buying any stock anyway, an investigation needs to be made for every purchase. I personally find it quite fun it is like playing a detective and if you are good at it, you get rewarded… This is what is called fundamental analysis. Every self-respected investor is using these techniques to choose assets (this do not include traders, we do not call them investors).
So where is the best place to start with this fundamental analysis? Well if you like to do things like did Buffet or other investors in the past, you should start with checking annual reports, notes any extraordinary expenses, irregularities in income, debt. Check prior period revenue and changes over time. Compare company with competitors in the market. If the company has the highest market share, then the slightly higher value can be allocated to the enterprise. Check that dividend and earnings are relatively stable and do not have significant drops. The aim is to find a company that will bring a steady return and integrates well into your total portfolio. As I mentioned before predicting future is very hard, and fundamental analysis is the best we have.
Fundamental analysis is not perfect? Things in the future are not always as they are in the past. This is a highly important point. If any advisor comes to you and says “We have made 20% return last year. Thus, we will make at least 20% next year…!” Then take your money and RUN. Fundamental analysis is based on this particular idea. Effectively, we look back-words to try to guess what will be in the future and this is never 100% sure thing. All annual report tells about company’s financial snapshot in the past over last 12 months. The value of the stock (intrinsic value) is based on the future expectation of the business discounted to today based on historical numbers. Many analysts in the market offer their views on the particular sock. The more some analysts cover one stock less likely it is mispriced in the market. If there are very few analyst that cover the stock, there could be more possibilities to make higher earning. However, note that lower cover usually correlates with smaller companies. Small caps are riskier, and novice investors should not blindly invest without understanding risks.
So you could follow various analyst to evaluate if a specific stock of interest is overvalued or undervalued in the market. Based on consensus/average suggested a price you can buy a stock or sell it. However, note that the same analyst is not free from biases. Thier customers may hold the same stock or the bank, where analysts work, have investment. Thus, unintentionally analyst may be giving better reviews. The analyst is just a human. Have a look at my blog We are but human!!! This applies to investment too.
If you have ever looked into companies annual report, you will know that it is quite a long document with a lot of information. How can you decrease and filter a number of companies you need to investigate? You can use stock screening tools. My personal favourite is Stockopedia. These tool help to limit emotional intervention in decision making and lets you to go through the vast amount of data saving hours of investigative work. Stockopedia base a lot of screens on well know investors who became very successful and recognised for their work and provide a lot of educational material for starting investors. It also has a ranking system that helps you to exclude companies that should not waste your time. There are also some other screening tools worth mentioning that offer similar services Sharescope and Digital Look.
Some more notes on rising and falling markets (Bull and Bear market):
The sound fundamental analysis allows you to be ignorant of the market winds. Quite often you will see sound and profitable companies being sold in the market due to unpopularity rather than a business case. As an investor who is looking to make money, you should not go with the market or at least do not go with the market just because. Do your research.
When you start investing, soon you will realise that a lot it is to do with understanding your personal character. When the markets go down, you want to sell your investments, but quite often it is opposite what you should do. This is natural, but you should resist temptation. Except if there is something fundamentally different with the company than when you bought it. Otherwise, what is happening is that you are getting an excellent company for a lower price and you should potentially increase your holdings.
Word of caution, there could be a situation that one stock is terribly undervalued, you know that it is a great company, but the market is not buying. It is because the market did not change opinion about that stock yet or there is some other hot stocks market is more interested in. It may take some time before the market will start thinking the same way as you. Therefore in the game of buying undervalued stocks patience is key. Not everyone has the stomach for this if you do not, it is ok not to invest this way. Buying broad market index is a valid strategy as well. Their returns will be lower, but foremost You should be feeling comfortable with your investment decision and do not let your advisor push you to any particular investment. If you feel pushed again take your money and find a different advisor.
Directors of a company have to declare if they buy or selling company’s shares. Managers have insider information, and their trading could give some great insights about company’s future. If you carefully review their trading patterns you may be able to use this in your analysis and make a buy or sell decision. What you are looking for is that directors have some equity interest but not overly concentrated. Owning stocks aligns their interest with the rest of shareholders. If they are holding a significant portion of the equity, they may ignore small shareholders interests.
If directors buy company’s shares, could mean that they think the stock is undervalued based on prospects. If they are selling could mean opposite, but further investigation is required. For example, director’s personal portfolio may need additional liquidity.
What is this value investing? It is investment strategy that was/is employed by many well-known investors like Buffet or Graham. Effectively, you are looking for a stock that is selling below the actual value of the company/company assets a.k.a. Intrinsic value. This is as if buying a brand name with a discount in the shop. You just need to know how this discount looks and where to look for it. Maybe the company has a lot of cash, that should be taken into account when comparing with other businesses or maybe they hold some assets/stocks in other companies that are valued more than the market is accounting for. Do not be mistaken, this is not an easy task, but quite rewarding if used with correct strategy.
It is quite hard to value all companies assets, you have to look into how a company accounts for assets and liabilities. Also, valuation requires quite a few mathematical calculation. This process is made easier via tools like Stockopedia Link.
Note, your calculation may be inaccurate, so to protect yourself from making an error, you need to buy the stock when its value drops reasonably well below company’s asset value, which is around 1/3 lower. Also, note that 1/3 would be a very nice example, but very hard to find in the market and sometimes need to be relaxed. This is what is called “margin of safety”. In normal times, this misevaluation of the market occurs in smaller companies, which are by default have a higher risk. When a crisis hits, you may be able to pick some large enterprises at a discount as well. Remember that intelligent investor buys when prices going down and start selling when they are going up.
As usual, I recommend reading, this book will set you on the right path in becoming more intelligent investor: