Many people will never
experience how it is to invest in stocks. They are, sadly, missing the great
benefits as well as the possibilities that they and their money are capable of
doing. If you are one of those people, take a few minutes to consider how you
can begin the experience and find out what it has really in store for you.
Mutual funds provide
the appropriate ice-breaker for beginners. For just a few hundred bucks, mutual
funds can offer you easy access to thousands of various stocks, giving every investor
enough protection from the variety of broad-based mutual funds. The potential
of losing a significant amount of money may happen when the whole market melts
down; however, losing in one or two companies will not hurt as much as long as
your overall portfolio remains buoyant.
On the other hand, investing in
individual stocks can bring higher returns. This is because choosing the
right individual stocks can offer potentially greater benefits compared to a
diversified mutual fund.
How do the winners choose?
As with everything
else in life, those who succeed are the ones who have perfected the method of
diminishing, if not totally eliminating, careless mistakes or choices. A chef
always has to depend on a recipe to make a perfect dish. A chess player will
have to decide the best opening or defense to defeat one’s opponent and use
either to gain the best positions. A teacher will need to prepare an outline of
every lesson before facing a class. Investors also need a viable strategy.
There are specialized
approaches to investing; but first, you have to get acquainted with the various
methods for analyzing stocks. Chess playing can be more nerve-wracking or
head-splitting than investing; nevertheless, you have to spend enough time
seriously planning how to invest your hard-earned money.
Analyzing Fundamentals -- Buying a Business (Value, Growth,
Income, GARP, Quality)
Buying a share of
stock represents your owning
part of a business or company. Hence, in order to determine the right value
of a stock, you should figure out how much the company’s worth is. In general,
this is done by evaluating
the financials of a business, breaking it down in terms of the value of
each share to arrive at the proportional worth of the share of the business. We
often refer to this as "fundamental" analysis; and for many people,
no other alternative way of evaluating stocks is as good.
In spite of the fact
that evaluating a business may seem like an easy task, the challenge arises
from the availability of various methods of fundamental analysis. Investors
usually raise contrary views and apply subcategories in their desire to fully
comprehend their chosen investing approach. Ultimately, most of them apply a
method that incorporates the best strategies of various approaches. Whatever
unique characteristics that differentiate these approaches are generally
invented academic techniques and not real practical distinctions. And so,
economists who evaluate the stock market categorize value and growth while
practitioners consider these labels to be very useful. It will serve some good
for the beginning investor to understand the following descriptions; hence, we
will clarify what most investors mean in using these terms, although you must
take care to verify the exact meaning of any person using them.
Value
A wise guy once said
that a cynic is anyone “who knows the price of everything and the value of
nothing.” That may apply to many people; but your goal as an investor is to
know the price and the value of a firm’s stock, that is, to buy companies at a
considerable discount to their intrinsic value or the worth of the business if
sold the following day. In short, every investor is essentially a
"value" investor, buying a stock whose value is greater than the
price paid for it. Ordinarily, value investors intentionally look for the
liquidation value of a company, meaning to say, the value of the assets if sold
tomorrow. Nevertheless, the concept of intrinsic value is not explicitly
attached to the liquidation value, making value quite an elusive matter to pin
down. This only goes to show that while so many value investors have their own
specific views, not everyone using the term "value" agree on one
meaning.
Benjamin Graham is
considered as the pioneer who established the foundation for modern value
investing, in his 1934 book, Security Analysis (with co-writer David Dodd),
which is currently used by many investors. There are other personalities known
as dedicated practitioners of the value method, such as Michael Price and Sir
John Templeton. Most of them apply extremely stringent guidelines for buying a
company's stock. Their rules are often usually founded on the connections of
the present market price of the business to specific business fundamentals. The
following are examples:
·
Price-to-earnings ratios (P/E) beneath a
specific absolute limit
·
Dividend returns beyond a specific
absolute limit
·
Total sales at a specific level in
relation to the firm's market value
·
Book value of each share at a specific
level in relation to the share price
Growth
Growth investing
refers to the concept of buying company stock with potentially high growth
rates in earnings and sales. In this case, growth investors often focus the
company's worth as a current business venture. Most of them choose to maintain
their hold on these stocks for long durations. Eventually, growth ceases to be
a real determinant of a company’s value, especially when investors refrain from
buying into companies which are not growing. Two individuals are responsible
for popularizing the idea of growth investing in the 1940s and the 1950s,
namely: T. Rowe Price, founder of the mutual fund firm having the same name,
and Phil Fisher, writer of one of the most influential investment books
published, Common Stocks and Uncommon Profits.
Growth investors
analyze the essential quality of the business and the growth rate before buy
into it. Often, these investors get enthused with the arrival of new
industries, new companies and new markets and buy company stocks they consider
to have potentials of enhancing sales, earnings, and other vital business
metrics at a certain minimum level yearly. Usually, growth is seen as a
contrasting measuring stick in relation to value by many investors; however;
the distinctions can blur at times.
Income
Even though many
people buy common stocks, expecting the shares to grow in value, many others
still buy stocks principally for the regular dividends they provide. These
people are called income investors, who commonly neglect businesses offering
shares with high prospects of capital growth to buy high-income,
dividend-generating businesses in slow-growth industries. They prefer
businesses that offer attractive dividends, such as real estate investment
trusts (REITs) and utilities, in spite of the possibility of investing in firms
going through dire problems and whose share prices have dipped substantially
low that the dividends are subsequently so high.
GARP
GARP stands for
“growth at a reasonable price” – and we know how much easier it is to use
acronyms. To GARP investors, the best approach is to unify the value and growth
approaches and incorporate a numerical twist. GARP practitioners prefer
companies with sound growth potentials and high resent share prices which do
not represent the fundamental value of the company, earning a "double
play" as earnings grow and the price-to-earnings (P/E) ratios of those
earnings also grow. GARPs most popular practitioner is Peter Lynch, the former
Fidelity fund manager.
GARP involves one of
the most common methods of buying stocks when the P/E ratio goes below the rate
at which share earning can grow later on. As a business’ share earnings grow,
the P/E of the company will decrease if the share price stagnates. Since
rapid-growth firms can ordinarily maintain high P/Es, the GARP investor buys
shares which will be low-priced tomorrow if the growth happens as predicted.
But, if growth fails to arrive, the GARP investor's expected gain can go up in
smoke.
Since GARP offers so
many chances to only consider numbers rather than the business per se, many
GARP methods, such as the almost pervasive PEG ratio and Jim O'Shaughnessy's
ideas in What Works on Wall Street, are actually mixtures of fundamental
analysis and quantitative analysis.
Quality
Nowadays, majority of
investors apply a combined approach using growth, value and GARP strategies.
They seek excellent companies offering "reasonable" prices. While
they possess no compact guidelines for the type of mathematical connection
between share price and business fundamentals, they do have a common philosophy
of evaluating company valuations and their intrinsic worth. Generally, they
utilize quantitative analysis, such as return on equity (ROE) and qualitative
measurement of the management’s capability. Most of these investors call
themselves value investors, even though they focus more on the worth of the
company being a dynamic organism instead of a static asset that has value.
Warren Buffett of
Berkshire Hathaway is considered the most well-known defender and practitioner
of this method. Having learned from Benjamin Graham of Columbia Business
School, he subsequently partnered with, Charlie Munger, who helped shift
Buffet’s focus on Phil Fisher's mantra of growth-and-quality.
Misgivings about fundamental analysis
Critics of the
fundamental analysis point to two primary points against it. First, they think
that the approach uses precisely the kind of information that all primary players
in the stock trade know and use beforehand. This, they say, does not add any
genuine edge. Why bother with the fundamentals if all you do is remain as
knowledgeable or as unaware as the next guy beside you? Second, a bulk of the
fundamental stats is “muddy” or “blurred”, any person can make one’s own
interpretation. A few talented investors may have succeeded with this method;
however, detractors believe the ordinary investor can save a lot of trouble by
leaving fundamentals alone.
Quantitative Analysis -- Using Numbers to Buy
The method of
analyzing only the numbers with practically no regard for the business involved
is called pure quantitative analysis. So, if you talk, walk and eat numbers
more often than not, you must be a quantitative analyst. Whereas fundamental
analysis considers numerical analysis at times, the main thrust is the
concerned business, looking closely at management's capability, the nature of
the competition, potential markets for innovative products, and others. Such
things, for quantitative analysts, belong in the realm of personal opinions and
not in the field of solid, raw facts that generate objective analysis.
Benjamin Graham, a
major proponent of fundamental analysis, also helped popularized this method.
At Graham-Newman partnership, he urged analysts to avoid talking to management
in evaluating a business and told them to wholly focus on the numbers, thus
eliminating biased management views.
With the proliferation
of computers, many "quants" (as proponents are called) have cranked
up the numbers more efficiently and, thereby, buying and selling businesses
purely on quantitative evaluation while totally disregarding the present
valuation or tangible business involved. Quite a revolutionary step away from
fundamental analysis, we must admit. Moreover, "quants" will commonly
inject concepts, such as a stock's comparative strength, which is the level at
which the stock has stood in relation to the market, in general. These
investors are fully convinced that discovering the appropriate figures can
assure positive results. The company, D.E. Shaw, utilizes complex mathematical
algorithms to determine tiny price differentials in the markets.