In this post we shall cover the basics of investing in stocks, also referred to as shares or equity; one of the main asset classes and a key component of most investment portfolios. Bear in mind that stock investing is the subject of entire books and university courses so a single post cannot cover everything you need to know about this type of investment. My objective here is to introduce you to equity investing and highlight some of the things you should pay attention to as you delve into stocks.
Shares are units of ownership issued to investors who contribute equity capital to a company and represent a residual interest in the net assets of the company. The holders of ordinary shares are entitled to receive a share of payments made by the company out of profits, referred to as dividends, and to any distributions made in a winding-up after all creditors have been repaid. Some companies list their ordinary shares on a stock exchange (stock market) where the issued shares can be bought or sold in an orderly and transparent manner.
An investment is defined as the commitment of current funds in anticipation of receiving a larger flow of future funds. For stocks, this return can come from two sources: dividends and capital gains. Dividends are distributions to shareholders paid out of profits, while capital gains result from changes in the share price over time. You can calculate the return on an equity investment from the purchase date by taking the aggregate dividends received per share, adding the change in share price, and dividing by the purchase price.
All investments involve taking risks and very often, the level of risk the investor is willing to take directly correlates to the rate of return on the investment. With stocks, the major risk is market risk that arises from fluctuations in prices due either to factors affecting the stock market, or to company specific factors. In a worst-case scenario, the share price can fall to zero if the company fails. Another important risk from investing in stocks is liquidity risk, which relates to one’s ability to sell shares without material loss of value. I will return to both risks later in this post.
There are different options available to gain exposure to stocks. In Trinidad & Tobago for example, you can invest either by buying shares directly on the Trinidad & Tobago Stock Exchange (TTSE), or by buying units in an equity mutual fund offered by a financial institution. With a mutual fund, the institution pools the funds of many investors to buy publicly traded shares, with each investor owning a portion of the pool of shares via the mutual fund units held. Additionally, in developed markets such as the US, investors can get exposure to stocks through exchange-traded funds (ETFs). ETFs are mutual funds that trade on a stock exchange, just like a share, and can be a simple way to get exposure to the entire market (using a broad market ETF), to specific sectors such as technology (using a sector ETF), as well as to different geographic regions, different categories, such as large cap or small cap, and various strategies including value and growth.
To build a portfolio of stocks you start by selecting the names to put in the portfolio. This requires research that entails finding those companies whose dividend and share price appreciation will generate a reasonable return in the long term. Equity research involves screening the universe of stocks to identify suitable prospects and then conducting detailed research on the short-listed companies to determine which ones to buy. You can generate a list of potential companies to invest in based on criteria such as names you know, industries or sectors you believe are likely to do well, companies that pay high dividends, stocks that appear to be undervalued and stocks that have fallen in price recently. Screening for investments on the Trinidad & Tobago Stock Exchange would be straight forward given there are less than twenty-five companies listed on the exchange. Information on these companies can be obtained from the TTSE website. Screening for names on larger international markets such as the US market is more involved, given that there are thousands of names to choose from. Luckily, there are numerous stock screeners on the web that can simplify the process for you.
The internet has made equity research easier as it is possible to get all the information you need right on your computer. For market information on a stock or on the overall market, you can use the stock exchange website for local stocks and the numerous finance websites covering the US and other foreign markets. These websites will also have company specific information, including quarterly and annual financial statements as well as annual reports. Company websites are another source of information on prospects.
While it is beyond the scope of this post to explain the detailed research required for equity investments, the following are some factors to consider when picking stocks:
- Growth prospects. Generally, companies with high growth potential tend to attract the most investors; which, in turn, moves the stock price upward increasing the company’s valuation in the stock market. In assessing a company’s growth potential, consider the industry’s prospects as well as the company’s position in the industry and its track record in delivering growth.
- Buying stocks that pay dividends can add regular income while contributing to overall portfolio return. When evaluating dividend paying stocks, consider the dividend yield, calculated as annual dividend divided by the current stock price and expressed as a percentage, in conjunction with the potential for share price appreciation. You would accept a lower dividend yield for those companies with better growth prospects. For companies that are not expected to grow, the dividend yield can be viewed as the expected total return for the stock.
- It is important to recognize that a good company may not equate to a good investment if its shares are overvalued. Shares are not always fairly priced in the stock market so there will be shares that trade above their fair value and those that trade below their fair value. Picking stocks involves finding those shares that are priced below their fair value so you can generate capital gains when the market “corrects” itself.
Of course, determining fair value can be an involved and difficult exercise involving the use of discounted cash flows and other valuation models. For a “back of the envelope” approach you can use the Price/Earnings (P/E) ratio as a preliminary screening tool to gauge whether a company is fairly valued. Generally, one can start with the premise that a low P/E stock is undervalued while a high P/E stock is overvalued based on current earnings. However, it is important to consider a company’s growth prospects when looking at P/E ratio. High growth companies have high P/E ratios because their earnings per share is expected to increase in future years. Additionally, a company’s P/E ratio may be low because its future earnings are expected to fall. You can also compare a company’s P/E ratio to the industry average and to comparable companies to assess whether its share price is close to fair value.
- The riskiness of a stock is measured by its volatility, which refers to the level of fluctuation in its share price, where higher volatility means higher risk. Not all stocks have the same level of risk so you should ensure the stocks you choose are consistent with your risk tolerance. You can measure volatility using standard deviation or beta, but these calculations are not easily available, especially for stocks traded on the TTSE. In the absence of these technical measures, you can assess volatility by considering the spread between the 52-week high and low, with a smaller range indicating lower volatility.
- This refers to how quickly an asset can be sold without any significant loss of value. Even with publicly listed shares an investor may have challenges selling a position quicky at the current price. In the context of the stock market, liquidity can be assessed based on trading volume and the difference between the bid and ask prices. Liquid stocks have high trading volumes and small bid-ask spreads. It is especially important to pay attention to liquidity when investing in the local stock market as there are shares with low trading volumes and wide bid-ask spreads.
- This is a strategy for reducing portfolio risk by holding a variety of investments that behave differently, thereby avoiding one investment having a severe impact on the portfolio. Buying many names across different sectors entails lower risk than betting big on one or two companies. To achieve diversification, consider setting a 10% limit for any single exposure for small portfolios, while for large portfolios you could lower this limit to 5%. A simple way of achieving diversification in foreign markets is to buy a broad market ETF.
Having identified the stocks you would like to add to your portfolio, you will then have to decide on the best time to buy. It is very difficult to time the stock market as one can never tell whether it will go up or go down in the short term. To avoid having to guess when prices are at their lowest, you can spread your purchases over time utilizing a dollar-cost averaging strategy.
Although your objective with investing is to generate returns over the long run, it does not mean you can simply buy stocks and then forget about them. You need to monitor your portfolio to ensure the investment thesis remains valid considering new information that becomes available. Monitoring requires that you keep up to date with developments in the economy, the stock market and the companies in your portfolio. As previously noted, the price of a stock may change either because of factors affecting the stock market or the company. Some of the major factors that affect the overall stock market include the current and projected level of economic growth, the rate of inflation, the level of interest rates, political factors, and investor sentiment. Company specific factors to pay attention to include current and projected financial performance measured by revenue and profits, projected growth, and changes in the level of risk. Managing a portfolio involves selling positions that have reached their target price, or are expected to underperform, and adding new names with higher projected returns.
You would have realized from this post that there is a lot to do and consider when investing in stocks, which is why many investors leave it to their financial advisor or asset manager. However, even if you are new to investing you can succeed if you proceed cautiously, follow a process, be patient and know when to seek advice.
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