Ways to invest in stocks

July 19, 2018

There are thousands of  investors who want to own ‘good’ companies that avoid ‘trouble’.

  • they invest in stock shares [stock shares are equal units of part ownership]
  • a good company
    • operates a profitable, growing business
    • avoids financial distress and regulatory penalties

Investors purchase and sell shares in the stock market.  They hope to sell their stock at a desirable price and may also receive cash rewards from companies that pay dividends.  Investors earn a profit (called a capital gain) when the sales price is above their cost of investment or lose money (called a capital loss) when the sales price is below cost.  

Stock Analysis

Two ways of evaluating a stock are called technical analysis and fundamental analysis.  Technical analysis measures the performance of share prices and share volumes in the stock market.

  • Shares are units of part ownership which are traded in the stock market.
  • Price: the price of a share in the stock market.
  • Volume: the total number of shares traded in the stock market 

Fundamental analysis evaluates the business performance of a company by way of searching through its quarterly and annual filings.  The business description, financial statements, and CEO’s annual letter to shareholders are important sections of the filings.

  • CEO: Chief Executive Officer; top manager of the company.
  • Filings: periodic reports to shareholders that are required by the U.S. Securities and Exchange Commission (SEC).

Business performance is also assessed by the company’s market share and competitive advantage within its industry.  This information is available online.

Investment Strategies

The most common investment strategies for stocks are swing trading, value investing, and growth investing.  

Swing trading (cyclic trading) uses brief upward or downward trends in share prices to determine when to buy or sell stocks.  The typical holding period is from one day to several weeks.  The investor hopes to earn a capital gain (–if seeking a profit–) or capital loss (–if seeking to reduce the short term capital gains tax–).  The investor uses either a technical analysis or guesswork to judge the price trend.  The main risks of incurring a loss are due to price volatility and taxation of returns.

  • Hold: to own.
  • Short term: one year or less.
  • Short term capital gains tax: the taxation of a capital gain at the regular income tax rate.
  • Price volatility: the random fluctuation of prices based on the market forces of supply and demand.
  • Return: the profit or loss from an investment.

Value investing seeks a capital gain by purchasing the stock at an unusually low price (e.g., 60% of intrinsic value) and then selling it at approximately double the purchase price.  The holding period depends on the length of time for the stock price to become profitable. During the holding period, an investor will receive any dividends paid by the company.  The informed investor uses a fundamental analysis to assess the quality of the company and the intrinsic value of its stock.  The causes of an unusually low price include a market downtrend (e.g., economic recession) and poor company performance.  The main risks of incurring a loss are due to an eventual delisting of the company and taxation of returns.  

  • Intrinsic value: the share price calculated by a professional analyst’s secret formula.  However, you can estimate the intrinsic value as the net worth of the company (book value) per share, based on the idea that a wealthy investor could acquire the company at its intrinsic price by puchasing all shares of stock at the book value per share.   
  • Dividend: a cash reward paid to share holders from the company’s profits or cash reserves.
  • Delisting: removal of the stock from the stock market for various regulatory reasons, including bankruptcy of the company.    

Growth investing is a long term strategy for using the upward momentum of share prices to earn a capital gain. The capital gain is earned by simply holding the stock and reinvesting all dividends.  The rule of 72 estimates the holding period needed to double the purchase price of the stock at an assumed rate of annual return.  The growth investor uses a fundamental analysis of the company and market valuation to judge the fairness of the stock price.  The main risks of incurring a loss are due to deterioration of the company, decline in market value, and taxation of the returns.

  • Long term: after one year.
  • Momentum: an upward trend of share prices.
  • Rule of 72: [ Years to double the price = 72/percentage annual rate of return ] For example, a 15% annual rate of return will double the share price in 4.8 years. 
  • Annual rate of return: a constant percentage change in value every year that accelerates the growth of an investment; CAGR is an acronym for the annual rate of return.
  • Valuation: the art of judging if the price is low (discounted, undervalued) or high (expensive, overvalued). 

disclaimer: this article may not increase your investment profits.

Copyright © 2018 Douglas R. Knight


What is a good company?

December 15, 2017

Good companies attract investors.  They do so by selling a desirable product that sustains the company’s growth of sales and earnings.  The growth of sales is a good measure of market success.  Durable companies convert their sales invoices into cash and use the cash wisely.  Accounting items such as the free cash flow, sustainable growth rate, quick ratio, and debt-to-equity ratio are easy measures of the company’s health and durability.  Growth stocks should be assessed by the quality of the company.


Where do good stocks come from? From good companies!

July 17, 2015

Good companies issue good stocks!
There’s a strong relationship between good companies and their stocks. That’s why some of the most successful investors rely almost exclusively on picking good companies for investment (ref. 1). Conversely, companies on the verge of bankruptcy are very risky investments. Some investors don’t understand this. Case in point was the declaration of bankruptcy by Lehman Brothers. After Lehman declared bankruptcy and its stock was delisted from the New York Stock Exchange, some investors continued to trade Lehman’s stock in the over-the-counter market at pennies per share; it was a big loss for them.

References
1. Growing Rich with Growth Stocks, by Kirk Kazanjian. New York Institute of Finance, Paramus, ©1999.


Investment styles

June 14, 2015

An investment style describes the way an investor earns a total return. The many possible investment styles can be characterized by the holding period (i.e., length of ownership) and method of valuation. Individual investors typically choose between the cyclic, growth, and value styles. Day traders hold stocks less than a day to earn small change from each share. This style is favored by a group of professional speculators and will not be discussed in this article.

A stock investor’s total return is an accumulation of dividends and capital gains. Dividends are the company’s occasional cash distributions to shareholders. Dividends can be withdrawn from the investor’s brokerage account, saved in the brokerage account as cash, or reinvested in stock. Capital gains (‘price appreciation’) are the increase in market value of a stock as calculated by the change in price since purchase multiplied by the number of shares owned. Conversely, capital losses (‘price depreciation’) are the decrease in market value caused by a price change. Capital gains(losses) are realized or unrealized cash flows. The realized gain(loss) produces an actual change the investor’s cash balance resulting from a sale. The unrealized gain(loss) is a theoretical change in cash balance at the moment of accounting.

Investors generally expect capital gains to exceed dividends. Capital gains are only earned by selling shares above the purchase price [this is the principle of ‘buy LOW’, ‘sell HIGH’; remember that a trading fee is charged for each transaction]. The following chart illustrates 3 strategies for earning capital gains:

styles

The “share price” (built into the Y axis) is what traders quote for one share of stock at a particular moment in time. The smooth curves show 3 different trends as the share price moves into the future (along the X axis). In reality, the share price oscillates throughout the trading day as a result of various market forces. However, the curves are drawn as smooth lines for the purpose of forecasting the share price. The future price can’t be predicted with absolute certainty. It’s always true that the further into the future, the less certain an investor can be about predicting the price. Investors can choose to manage the uncertainty in different ways as illustrated by the position and shape of the curves in the graph. The first way (red curve) is to earn a quick profit from a cyclic market. This method requires a gift for timing the market so that the investor can buy at a low price and sell at a high price in a relatively short time period of weeks to months. Second (blue curve), the investor can place a future value on the stock by forecasting the long term growth of company earnings in the belief that stock market participants will pay a higher price for the growth of earnings. If the investor’s analysis is correct, the future selling price will be higher than the present purchasing price. Third (black curve), the unit price may be ‘beaten down’ by a market panic or by other mechanisms causing market participants to lose interest in the stock. The analyst may find that the economic value of the company is worth more than the value of the stock by an amount called the ‘margin of error’. If that margin of error is 50%, then ‘value investors’ are fond of describing their stock purchase as buying a dollar for 50 cents. They will hold the stock as long as it takes for market participants to restore the stock price to the intrinsic value of the company. They are taking a risk that the stock price continues to fall as the company goes out of business.

Analysts make a distinction between the economic value of a company and the market value of that company’s stock. The cyclic investor pays more attention to market value. Growth and Value investors analyze the relationship between company and market value. They believe that over a period of years, the market value of the stock will rise with the economic value of the company. During the holding period they will accumulate any dividend payouts in their cash account or reinvest the dividends in more shares of stock. The accumulation of dividends and capital gains is called compounding the returns.

The future is uncertain. Many unexpected events can affect the share price following the initial purchase. Re-valuation of the company and its stock are essential to managing the risk of a long-term stock investment.


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