This is a guest post from John Forman from The Essentials of Trading. Forman is the author of a book by the same name. He has been a trader of the stock and other markets for over 20 years, and is a professional stock market analyst for Thomson Reuters.
The wealth building potential of the stock market is enormous. I think we all realize that. The long-running debate, though, is whether one is better off investing in individual stocks (or funds that do just that), or whether it's best to just put your money in an index fund. Most funds fail to beat the market, so it would seem index funds are the better choice.
While it is certainly true that index investing has some advantages, and some mutual funds do perform better than the indices, no index or fund will ever offer the upside potential of investing in individual stocks. It's a matter of math.
Indices and funds include many stocks which move in all different directions. One of those stocks could double in price for the year, but because most others in the collection will do much less well, the index's or fund's performance will be much lower than that one stock's gain. An investor who held that stock by itself, though, would have done quite well.
Of course you need to be able to find the stocks that will beat the indices and funds.
How Do I Find Good Stocks?
The requirements for success in the stock market are much like the requirements for success in any other undertaking. Proper preparation is one of them — potentially the biggest — and a major part of preparation is having a firm objective in mind. As an investor, that normally means either seeking capital appreciation or pursuing income, or some combination. For the purposes of the discussion here, I will focus on the capital appreciation.
Another part of the equation is timeframe. I'm not talking about how long you have to retirement. There's plenty of literature in financial planning circles about how you should structure your investments from that perspective. What I'm referring to here is how long you will expect to hold any given stock position in your portfolio.
Are you a patient long-term buy-and-hold investor who will have no problem sitting through the inevitable ups and downs of the market? Or are you someone who wants more action, doesn't have the patience to hold stocks for years at a time, and/or cannot stomach the idea that at points your positions could go well against you for long periods of time?
You may not always be one or the other. It is, however, important to know which mode you are in when you are looking to pick good stocks. A lot of stock market players get themselves in trouble because they go into a position thinking they are one type of player only to change their minds once prices start moving.
If you are in the first category, then your focus in trying to find good investment stocks is to look at the big picture. You are Warren Buffett. You look at the company and its management team. You look at its business and, in many cases, the broader economy. What you are trying to identify is a company which will steadily increase in value over time.
How do you do that? By thinking about what it takes for a company to grow and profit in a sustained fashion.
What do companies like that have? They have strong management teams who know what they are doing, who have a long term view and who aren't worried about the quarter-to-quarter results or stock price fluctuations. They are in growing business sectors (or niches) where the competition isn't so intense that no one can really make any money.
This sort of approach to looking at companies is generally referred to as fundamental analysis. Fundamentals are the underlying elements that determine the long-term growth and profitability of a company.
The idea is that you are giving your money to some really capable people and having them put it to good use in their business. Then you let them do their thing in the way they best see fit. So long as they continue to do good things and keep the business on track for positive growth in value, you stay invested. Maybe somewhere down the line you will cash out your investment. Maybe you'll leave it to your kids or donate it to charity. Whatever the case may be, you would expect the value of your stake in the company to have grown nicely in value by that time.
Now, if you are in the second category where you're not just going to buy a stock and lock it away, you need to think more specifically about your holding period. By this I don't mean to imply that you will hold a stock for an exact period of time and that's it. I just mean you should have an idea of how long you would expect to be in the position. That could still be years, or it could be months or weeks.
The advantage of the long-term investor is that they need not worry about the fluctuations in the price of the stock. They are investing on the basis of the long-term growth of the company with the assumption that the stock price will generally follow along at about the same pace.
Less long-term players (often referred to as traders) have to be cognizant of the intermediate and shorter-term price action. Generally speaking, the shorter your expected holding time horizon, the more you will have to focus on the price action. This is because the fundamentals mentioned above are usually slow moving elements which play out over the longer timeframes. They don't change quickly, so they can't really influence short-term price movements much.
What I mean by that is stock prices can move in the short-term on a great many factors. It could be news, economic data, changes in interest rates, the general market environment, and lots of other things. Just because a company is making money hand over fist doesn't mean the stock price will be rising. If the company continues to do that, the stock will probably move higher eventually, but in the meantime other factors could cause it to go sideways or to even fall. This is something that baffles a lot of new investors.
Focusing mostly on price moves you into the realm of technical analysis. This approach seeks to identify patterns of price movement in the market for the purposes of determining likely future direction. This is also referred to as market timing, which basically means seeking to define good points at which to buy and sell. A lot of stock investors use fundamental analysis to find good companies, then use technical analysis to try to pick the best time to buy the stock.
To this point you'll notice that I haven't used the term value investing yet. Many people would refer to Warren Buffett as a value investor, and as such would put value investing in the long-term investing category.
Value investing need not be a “buy it and bury it” type of approach, however. In fact, I'd guess that most people consider it the process of identifying stocks trading out of line with the value of the company in question. They use any number of metrics to determine what a company's stock should be worth. If the stock isn't close to that value, they will either buy it or sell it in expectation that it will eventually get back in line. In most cases, once that happens, the stock position will be exited.
This probably all sounds very familiar. You've no doubt heard of Wall Street analysts putting out price targets and ratings and such. They generally use fundamental analysis to come up with what they think is the value of the company right now (adjusting it for new information, of course). Then they look at current price to see how it matches up with what their valuation calculations tell them.
If you'd like to learn more about value investing, consider Benjamin Graham's classic, The Intelligent Investor. The Motley Fool has an interview with Bruce Greenwald about the three steps of value investing.
It Takes Work
Regardless which type of stock market player you are, there are no approaches which don't require effort on your part to pick the good stocks. Even if you have someone giving you recommendations, you should still be doing your own due diligence to see if they really fit in with what you are trying to do in the market.
Also keep in mind that no matter what timeframe investing/trading you do, you should always take the longer-term view. It's extremely unlikely that any one stock position is going to make you rich in a short period of time. If you try to score it big on any one trade you're probably going to end up losing a lot of money. Wealth accumulation in the markets is best sought by steady growth, putting the power of compounding to work in your favor.
This article is part of Financial Literacy Month.