The stock market can be a daunting place to start for beginners or investors who just want to get their feet wet. If you’ve only got a small amount of money, or don’t want to risk much, it’s often difficult to determine what the best course of action for your investment will be. We look at some simple tips to help you get started.
Note: I am not a professional financial services adviser or stockbroker and providing broad advice only. I am not providing any specific investment advice.
Okay, I’ll be brutally honest here. When I got my first job as an accountant, about six years ago now, I made one of the dumbest, bone-headed mistakes of my life that took me a while to fully recover from.
You see, all I ever wanted to do through my college studies was to invest in the stockmarket and make a fortune. I watched movies like Wall Street and Boiler Room with envious eyes and couldn’t wait to amass enough cash to jump in head-first and start making my fortune. I honestly thought it would be easy, that it was as simple as doing some background research, picking some good up-and-coming stocks and waiting for the value to increase.
About two years into this job, I’d saved up about $30,000 – enough money, I thought, to get me a good solid start in the stock market and enough that any significant increases in my shares’ value would lead me to a lifetime of riches. Oh, how god damned foolish I was. I did some preliminary research on Internet forums and found 3 to 4 ‘penny’ stocks with small market capitalisation, all in the mining and resources industry, that my sources had assured me had found ‘good plays’ and were potentially one announcement away from having their value increase 500-fold. So I plonked all my hard-earned into these stocks, and every day at work for the next few weeks I frantically checked the share price pages every half hour or so, just waiting for that big announcement.
You can guess the rest of the story – every single company I invested in went bust, and I lost everything. Two years of work basically down the drain for nothing. It hurt. A lot.
Which is why I’ve written this simple guide to help others avoid making the same ridiculously costly mistake that I did. You’ll probably be tempted. The thing is – it does happen, almost every day. People invest modest sums of money into penny stocks which subsequently take off, leaving the owners rich overnight. So it’s difficult to resist that initial temptation.
But rest assured, unless you are a trading guru – in which case, why are you reading this guide? – or you get extraordinarily lucky, it won’t happen to you. Your best bet is to invest for the long term and analyse the fundamentals of each company you are thinking of investing in. The fundamentals of a company relate to the its actual business and financial position, not its movement on a stock chart or its past trading data. Elements to consider when looking at fundamental analysis include the following:
- What is the company’s business? What makes it stand out in this industry, and what makes it unique compared to its competitors?
- What are the company’s plans for growth? Do they have a strategic plan, an overall objective, short and long term goals? Check their website and press releases to get this kind of information.
- Who are the company’s management team? Do they have a track record of guiding companies in similar industries to success? Or are they a bunch of newcomers?
- What are the actual finances of the company? Get an accountant to help you if you need, but look at the financial statements such as the balance sheet, profit and loss statements, and cash flow statements. Do they have enough cash to cover short term expenses?
You might also consider whether to invest in a managed fund or directly in companies. While I can’t give you a definitive answer, academic studies have shown that investment funds rarely, if ever, outperform the market index as a whole, sometimes even under-performing relative to the index.
Unless you are extremely confident that you’ve found an excellent fund manager, you might be better off investing directly in companies. In saying that, however, it is more hands-off and stress free to invest in a fund – they can diversify your investment in many different companies a lot more efficiently than if you did it all yourself.
The kind of investment fund you’ll invest with probably depends on what country you’re in – if in the United States, you’ll select from open-ended investment companies, SICAVs, unitized insurance funds, or unit trusts, among others, whilst if you’re in the United Kingdom you could go with an investment trust or a guaranteed equity bonds (GEBs). In Australia, there’s also a large number of managed funds to choose from. If you do go that route, however, be sure to do some research first and look up the highest performing funds in your sector. This information should be pretty easily available on Google.
Now, one of the most important tips I can’t stress enough to any new investor in the stock market is to NOT jump in head first with your money. Have patience and you will reap the rewards in the future.
I know it’s difficult to hold back, but it will lead to less stress and anxiety in the long run if you do. Before you put any money at all into the market, you should perform your own little market analysis first – pick some companies to follow for a couple of months, look at the results and compare their performance to your expectations to see how they did.
A key skill in successful investing is having a knack of knowing how a company is going to perform and what influences external factors will have on a company’s share value – and this knowledge can only come with practice. Practicing first, without investing actual money, is important to ensuring you don’t make irrational, emotion-driven decisions and to ensure you understand at least a little of how the stock market works before risking your precious cash.
The first step in our market analysis is to decide what sector(s) or industry you will invest in, and watch several key players in that sector for a period of time to see how they perform and where they move in the market. Write down your thoughts, do some brainstorming. What sectors do you know are going well, and have good prospects? Is there a sector you know something about personally that allows you to differentiate between the good and not-as-good companies in the market?
What sector do you believe will perform well in the future? Do you believe the banking sector will thrive? Maybe the utilities sector? Information technology?
Once you’ve picked a sector to analyse, pick 10 companies from that sector – it can be at random, or it can be based on your prior knowledge of the industry or what’s in the media. Download the financial information of each company, which is usually available from their public website, and analyse and compare them. If you can’t read financial information, ask a finance or accounting-savvy friend to help you or do some Google research – you probably won’t be able to understand the real nitty-gritty of the balance sheet, but as long as you can grasp basic terms such as assets, liabilities and cash at bank, and can calculate a few simple accounting ratios based off these numbers, you should be okay.
There are a few key financial ratios that you can calculate from these financial reports that’ll give you an indicator of a company’s fundamentals. They are:
- Earnings Per Share (EPS) – This is calculated by the following formula: (Net Income – Preferred Dividends) / Weighted Average Outstanding Shares
I’ll run through a simple example to help you understand this formula. Let’s assume a company has a net income of $10 million, and it pays out $500,000 in dividends for the year. The number of shares a company has fluctuates throughout the year, remember, so let’s say it has 5 million shares for half of the year and 7 million shares for the other half. The EPS ratio would therefore be $1.58 (9.5/6). We deduct the $500,000 in dividend payments from the $10 in net income to get the numerator, then we take the weighted average as (0.5 x 5 + 0.5 x 7 = 6).
- Price/Earnings Ratio (P/E). This calculated by the following formula: Share Price/Earnings per Share (EPS). Compare the Price/Earnings ratio of all of the companies you have selected for analysis. A Price/Earnings ratio higher than the other companies in the sector suggests that the company may be overvalued and thus avoided, and a lower value suggests under-valuation and could mean a promising investment target.
- Return on Equity (ROE) – This can be calculated by taking the net profit and dividing by the shareholder’s equity. It’s an indication of how much profit (or return) the company is making relative to its value and is an excellent measure of the overall profitability and performance of a company. Again, calculate this ratio for each of the companies you have selected and take note of them all.
There are many other financial ratios that may help your analysis, but for now, I’d stick with these three. Of course, if you want to go deeper, you certainly can but these three ratios are usually sufficient for getting a broad idea of a company’s performance and profitability.
Once you’ve taken this information on all of the companies you have chosen, make a judgement call on which companies you think will perform better. Write down 3 companies, based on their financial information, business model, and historical performance, that you think will outperform the others in the sector. Write down these companies and the reasons why you think they will perform better.
Next, sit back and watch for a period of time – I’d give it at least three months, but it’s really up to you. Make it a minimum of one month though, and after this time has elapsed, go back and revisit the companies you selected. Look at the share price of each one, and note whether they have increased or decreased, and how they’ve performed relative to the market in general. Were your predictions accurate? Whether they were or not is not really the point of the exercise. It’s more about you making judgement calls on the value of companies based on the available information and seeing how they perform as compared to your analysis.
Doing well in the stock market is all about getting a feel for the market, and knowing when to hold onto your shares and when to sell them. This exercise will help you do just that, by getting you to track the price movements of various stocks over an extended period. You might have been spot-on and potentially missed out on some nice profit. That doesn’t matter, as you’ll more than likely recoup that money and more once you dip in for real next time using the same fundamental-based principles.
More than likely, though, you were a bit off, which is great. Note the companies out of the ones you picked that had the highest increase in share value, and see what factors could have contributed to their success. See if the performance of the stock matched the preconceived notion you had about that company before you began this exercise. Once you have a better idea of what you want to invest in, then I’d say go for it and invest your actual cash, but not until that point.
One final tip, based on my horrible experiences – it’s pretty likely that shortly after you buy shares that they’ll decrease in value. Stock markets these days are filled with day traders, short sellers, and pump and dumpers who will often make share prices fluctuate wildly within the space of a few days – it’s imperative that you don’t get freaked out by this, especially if you have a solid stock with strong fundamentals.
The worst thing you can do is buy a stock, watch it decrease in value, freak out and sell it, only to see it rise in value shortly after, sometimes even to well above the level you first purchased it at. If you’re going to invest wisely, choose a fundamentally sound stock and just let it be. Your investment will grow with the market over time, and, more often than not in the stock market, rewards come to those who have patience.
If you lack the virtue or the luxury of patience, however, and need to see results faster, there are some proven trading patterns and techniques that will help you to achieve a profit sooner than the average investor. Tim Huang, a prominent American investor has a book called Stock Market Winners that I personally recommend. The book provides proven and meticulously detailed instructions on how to navigate the minefield that is the stock market, and whether you’re a beginner or an experienced trader, it’s full of advice that will help steer you away from the sharks and well into the green and early retirement.