This guest post is by GRS reader Russell Kith, an avid value investor, fan of Warren Buffett and personal finance blogger. You can find more of his articles on investing on his blog, Money Street Smart.
Investing is a lot like going to college. You start off with a broad range of general options (mutual funds or classes), then once you have a solid foundation, you learn the value of specificity (investing in stocks or declaring a major). You don't have to go this route, of course—some people jump right into stocks, others never go beyond mutual funds—but the same basic advice applies to most people: start with a stable, diverse range of investments, then decide from there where you want to direct your money. The more confident a beginner becomes, the more likely they are to include riskier investments in their portfolio, such as stocks.
If you've gotten your feet wet with mutual funds and want to start investing in stocks, where do you begin? The process isn't as simple as picking a new or popular company and hoping for a decent return on investment (ROI). No, the rules of this investment game are slightly different in that stocks generally require more research and market analysis. Furthermore, there are multiple avenues through which stocks can be analyzed, but here I'm going to talk about two: fundamental and technical.
Warren Buffett once said, “Price is what you pay. Value is what you get.”
For beginning investors, this advice certainly applies to choosing a first stock. Owning a stock means you own part of a business and some experienced investors argue that you should examine the value of the business itself in order to determine the true value—short- and long-term—of the stock you're considering. This research is known as “fundamental analysis.” During this process, you evaluate a company's financial record through per-share value calculations. The Wall Street Journal's Market Data Center is a good place to research the background of the stock.
Methods of business valuation differ between investors. What works for a standard economist may not work for a market practitioner, and what works for these two professions may not work for someone looking for just a basic tutorial on investing in stocks.
Some investors take Buffett's advice (above) and focus on a company's liquidation value (physical assets minus the liabilities on a company's balance sheet, which you can find through NASDAQ). Others look long-term and determine which stocks have the highest propensity to increase growth (and overall earnings) over the course of time. This is done by looking at the company's “discounted cash flows,” or the future free cash flows of a company (minus the time value of money to prevent miscalculation errors). It's impossible to predict a company's future profits to a T, but the discounted cash flow method helps you better adjust to changes that could affect your calculations.
Growth investors tend to gravitate toward powerhouse companies, such as McDonald's, and newer markets, such as biotechnology, because the potential for significant growth is there. Of course, it's important to remember that while the quality of the company and rate of its expansion are important, there could be outside factors that growth investors don't always account for, such as income.
Income (or dividend) investors generally prefer to invest in companies with potentially limited growth, but high-yielding companies that offer investors a steady stream of income through dividends. Johnson & Johnson is an excellent example of this, having experienced modest yet remarkable increases in dividend payouts since 1997. There is a notable correlation between struggling companies with low share prices and high dividends that attract income investors. However, as with all fundamental analysis approaches, there is a considerable risk to these types of investments in terms of “fuzzy information” and human miscalculation.
Investors are always trying to get an edge over others. Perhaps not directly, but if everyone flocked to the same investments in hopes of massive return on investment, a bubble would form and inevitably burst. Technical analysts don't focus so much on numbers in regard to the company's performance—though quantitative analysts do—as much as they focus on the psychological background of a stock. This is done primarily through chart analysis. Logarithmic chart (and other charts) comparisons that examine price levels and trading volume are the most common approaches to technical analysis. Stock Charts' technical analysis resources can teach you how to interpret charts and determine the difference between trending and trading periods based on the charts.
The downside to the technical approach is that evidence is not as concrete and may not be as predictive as other methods. Technical analysts are more concerned with the price of the stock, both historically and currently, which tends to ignore the importance of in-depth knowledge of a stock's background.
Regardless of which analytical method you use, there are a few things you ought to beware of before jumping on the stock investment bandwagon.
Do your research
Warren Buffett correctly points out that risk comes from not knowing what you're doing. Investing in stocks is already risky enough; simplify the process by putting the hours of research into a company and market health before putting your money anywhere.
Earnings don't always correlate with sales
One mistake many beginning investors tend to make is placing too much emphasis on a company's earnings. Yes, this is certainly a leading indicator of a company's health. However, there is concept called alternate causality that can also be applied here. It means there are other reasons behind an event (in this case, earnings going up), such as cost-cutting. A company can only cut so much; eventually, they need to rely on more “organic” methods of boosting profit margins through sales.
Invest in what you know
Another common mistake beginners make is investing in over-hyped, latest and greatest companies, such as Facebook and new 3-D printer developers, that may or may not have a track record of steady profitability, but have been regarded as good investment opportunities by experts or gurus. Branching out beyond your industry background or interests and hobbies isn't necessarily bad for your portfolio, but for those just starting out, it's usually recommended that you invest in what you already know about. First, it makes the initial research phase more enjoyable, and second, you already have a head start by knowing the ins and outs of the companies in the industry. To use another tidbit of Warren Buffett wisdom: “Why not invest your assets in the companies you really like?” As Mae West said, “Too much of a good thing can be wonderful.”
Investing in your first stock can be an exhilarating and rewarding experience. It can also be a major learning experience (particularly if you don't research thoroughly beforehand). And even if it doesn't go flawlessly the first time around, remember this final piece of Warren Buffett wisdom: Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
Have you ventured into buying individual stocks? What research methods do you use?