Stock Market Education For Beginners - Learning From Your Mistakes

Have you lost money in the stock market? Okay, that might seem like a stupid question with most major share indices down by almost 50% from their highs. But just humor me. Have you made some poor stock market investment decisions which have resulted in a permanent loss of capital (beyond the paper losses you're probably sitting on just now)? If you're like most average investors, including myself, you probably have.

It's never fun losing money, but if you look at it in a positive light, it's a great opportunity to learn a thing or two about investing and maybe even something about yourself. In fact you could even look at the funds you've lost as an investment in your stock market education.

In my recent post Analyzing Your Stock Market Investment Performance, I discussed the need to measure your investment performance and to benchmark that performance against financial returns generally. I don't want to labor the point, but I think it's a very important step in the investment process and one which some investors seem to ignore (the professionals as well as stock market beginners.

The next logical step in this process is to drill down and take a close look at the results of some of your individual investments. We have a tendency to congratulate ourselves when an investment goes well and we make money out of it. But many of us also have a habit of downplaying our investment losses, treating them as an aberration. "Let's just sweep that one under the carpet... move on - there's nothing to see here!"

But to become better investors we each need to be able to stand back and objectively analyze the losses we've made in order to work out what went wrong. In order to do this you really need to get inside the investment.

Objectively analyze the position the company was in when you bought into it. Now compare that to how it looked when you sold. Did the state of affairs deteriorate in the period over which you held the stock? If so, was that foreseeable? Did you pay a premium for what looked like a rapidly growing business, only to see the price plummet when that growth didn't eventuate or wasn't is high as the market wanted?

Revisit your thinking. Why did you buy the stock in the first place? Review any notes you may have taken at the time. See if you can recall the reasoning which led to the original acquisition. It's important to be honest with yourself and not just rationalize your actions after the event.

The goal of this exercise is not to shame and humiliate yourself, but rather to identify any shortcomings in your investment process or in your stock market strategy as a whole. Only then can you take steps to address these shortcomings, refine the way you make investment decisions and reap the benefits of out-performance of future gains.

The end result might be a fundamental shift in your investment philosophy. Or it may just be a minor adjustment to the process you follow - an extra filter, or another point to add to your analysis checklist- learning to get back to stock market basics. I'm a big believer in being patient - invest less frequently and only when you're convinced of the value being offered.

Investment Lessons I've Learned...

While there are way too many lessons for me to list in this post, here are a couple of the more expensive lessons I've learned in the past.

First Mistake - Too Much Debt!

As a stock market beginner, one of my first forays into the market resulted in me buying stock in a company which looked extremely cheap based on fundamentals. Things like price to earnings and dividend yield. In my efforts to learn stock market investing concepts I'd read that value investors like Benjamin Graham and Warren Buffett had made money by investing in extremely cheap bargain stocks - and being a contrarian, I figured this business fit the bill perfectly. What I didn't take into account was the amount of debt the company carried and that the cost to the company of servicing that debt meant that a decent breeze blowing through the economy might be enough to bring the whole thing down. Investors had marked down the price accordingly but I was too naive to recognize the very real risk of insolvency. I know - every half-decent stock market guide & tutorial you read will warn you about this but I had to find out for myself.

While the company did survive, it had to re-capitalize and in the process destroyed a significant amount of shareholder value. This investment resulted in a permanent loss of capital on my part. While I was diversified enough for it not be cause undue hardship, it still stung to lose money. That was a big leap forward for me in understanding the stock market.

Anyway, since then I've been much more careful when investing in companies whose debt may turn out to be a problem. Using tools like the quick ratio and debt to equity ratio I've been able to navigate my way through the latest financial crises relatively unscathed. I should explain that last statement. While I, like most other investors, am sitting on paper losses for a few of my investments, none of the companies I own have encountered any fundamental problems due to the credit crunch. Rather their prices have suffered along with the general market. But each of the businesses is strong and still growing in value and I believe in more stable market will sell for prices significantly in excess of what I've paid for them.

Second Mistake - Believing What Management Say.

This is another lesson I learned from the situation I described above. Management constantly downplayed the risks associated with the financial position of the company. They continually attributed low probabilities to certain financial events which may or may not have occurred. Without going into specifics, lets just say I think I had the wool pulled over my eyes.

When I looked back on the matter (hindsight's a wonderful thing) a couple of things became clear. The financial reports were at odds with the soothing noises which emanated from the upper echelons of management. And I noticed the guys running the show had no skin in the game - they had none of their own personal wealth invested in the company. No wonder they weren't worried!

As usual, I've gone on much longer than I intended, but the upshot of all of this is that I now have a couple of extra boxes to tick before I'm willing to part with my hard-earned cash.

So take some time to learn from your investment mistakes. After all, you've already parted with the funds so you may as well get value for your dollar and advance your stock market education.

Quick Ratio Formula

A discussion of the formula for quick ratio calculation for the stock market beginner.

Following on from my article on debt to equity analysis, today I'd like to talk about the quick ratio, also known as the acid test ratio or just acid ratio. This measure takes into account the more immediate liquidity or cash flow requirements of a business. Investors should use this tool when conducting their financial analysis of potential stock market investments to confirm a company's ability to meet its short term obligations.

The most common representation of the formula is as follows:

QR = (Current Assets - Inventory) / Current Liabilities

There are other variations (which I'll discuss shortly) but this simple calulation does the trick in most cases. A quick explanation of the above formula is probably in order.

Since we're trying to determine an organization's ability to meet its short term funding requirements, we take cash and cash equivalents and divide them by current liabilities. The reason we subtract inventory is that it may not be easily converted into cash or if it is, it may be at less than face value (think of 50% off sales).

At this point you may be thinking "But what about other current assets which can't easily be converted to cash?". If you weren't thinking that, or if you're now wondering what current assets are, stay with me - I'll try and make this as painless as possible.

This school of thought is where one of the more common variations of the quick ratio comes from.

QR = (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities

The difference in this representation of the formula is that we are only using truly 'liquid' assets in the numerator. By only using cash, cash equivalents (short term investments and the like) and accounts receivable (short term money owed to the company) we'll be leaving behind the other potentially non-liquid current assets (things like prepayments or income tax benefits which can't really be converted to cash).

So What Is A Good Quick Ratio?

Common wisdom has it that anything over 1 is acceptable. But as with many of these financial ratios and with financial statement analysis in general, they should be compared among companies within the same industry and also for the same company over time (is the position improving or deteriorating). This should be the approach taken with all stock market formulas.

Is A High Quick Ratio Good?

This is very subjective. In general, an excessive quick ratio may mean the business is not using its assets efficiently (I'm sure shareholders would prefer to look after the cash themselves rather than having it sit on some company's balance sheet). But there maybe legitimate reasons to build up a buffer of cash. It might be in anticipation of lean times ahead for example.

The quick ratio is especially important now. As I write this, world stock markets are in turmoil after the collapse of Lehman Brothers. With consumer spending down and debt funding in short supply, businesses need to be able to survive on internal funding now more than ever.

One criticism of the quick ratio is that it doesn't take into account the timing of cash flows. For example, analysis of current liabilities may show a large proportion of short term commitments fall due within 30 days but accounts receivable may be 60 or even 90 days. This mismatch or cash flow timing could cause problems.

An Example:

What follows is the calculation of the quick ratio for Johnson & Johnson (JNJ) based on the 2008 figures from Yahoo Finance.

JNJ QR = (35,817,000 - 5,700,000) / 21,780,000
= 1.4

or

JNJ QR = (12,646,000 + 412,000 + 13,151,000) / 21,780,000
= 1.2

As you can see, the second version of the formula gives the more conservative result.

I know I've covered some fairly technical stuff today, but if you're serious about making money in the stock market (or perhaps more accurately - not losing money) then you'll need to do your homework. After all, even beginners' stock market investing requires thorough research and the quick ratio provides an important indicator as to the financial health of any business.

Investing In The Stock Market

A beginners guide to investing in the stock market.

Before we get started you might like to review one of my earlier posts titled "Stock Market Investing - Is It For You?". In that article I discussed some of the things I think you should consider before diving into direct investment. Don't get me wrong - share market investing can be very profitable, but the market can be volatile and is no place for the faint-hearted. So you'll need to make sure you're well prepared before embarking on this journey.

I'd like to discuss stock selection today, but prior to that I should mention that there are a number of options you can use to gain exposure to equities without needing to choose individual stocks yourself. You could go for a Mutual Fund (either open-ended or closed) or maybe an Exchange Traded Fund (ETF). These types of investment typically hold publicly listed companies as the underlying investment, but by purchasing units or shares in one fund you gain exposure to a broad selection of companies. This negates the need for you to research each of the individual companies yourself. The fund employs a team of stock analysts who do the legwork for you. Mutual Funds and Exchange Traded Funds are quite often constructed around a particular theme (ie. value or growth) or around a particular market sector. These types of investments can be a good way to get your feet wet when you're just starting out or if you need help investing in the stock market.

Once you're ready to jump in and start buying individual companies directly, you'll need to make sure you've got your investment strategy sorted out. How are you going to go about selecting what stocks to buy? How many different stocks are you going to hold? How long are you going to hold a particular stock? Under what circumstances are you going to sell? You'll need to consider each of these questions. By having a plan in place, you'll be able to approach your investment activities in an organized and structured way. You'll be able to keep a cool head while everybody else is panicking. It's at times like these that your best opportunities may arise.

When it comes to investing in the stock market for beginners, my preference for picking stocks is to apply fundamental analysis. This involves rolling up your sleeves and actually learning about the company. A full treatment of fundamental analysis is a textbook in its own right but in short you'll need to delve into a company's return on equity, debt to equity, price to earnings ratio, dividend yield and so on. By understanding a company and its business in great detail you will give yourself every opportunity to make a good return on your investment. One of the best books I've read on this topic is The Intelligent Investor by Benjamin Graham.

Technical Analysis is another way that some people approach mainly short term investing in the stock market. I use the term investing loosely as I'm not a big believer in using technical analysis to make money in the share market over the long term. In a nutshell technical analysis is the use of price and volume data to predict future price movements of individual stocks or of equities markets as a whole. You'll read about terms such as charting, moving averages, resistance levels and RSI (relative strength index) among others. I won't dwell upon it here because in the past I haven't really used much in the way of technical analysis. Having said all that, I have been considering technical analysis as a way of timing the purchase of stocks which I plan to hold over the long term as I believe it may offer some insight into investor psychology.

There are almost as many systems for picking stocks as there are investors in the market, but most of them have their foundations in either fundamental or technical analysis. For example, the Dogs Of The Dow system (in its simplest form) advocates buying the cheapest stocks of the Dow Jones Industrial Average (DJIA) once per year. And in order to determine what is cheap, the fundamental statistics of each company is used as a yardstick.

I'll discuss more about this in my next post for which I think I'll use the incredibly creative title of Investing In The Stock Market - Part 2.

Stock Analysis - Debt To Equity Ratio

What is debt to equity and how can it help beginners when investing in the stock market?

A company's debt to equity ratio or it's gearing ratio is a measure of the level of borrowings a company has used in proportion to stockholders' equity to finance it's assets. It's often used as an indicator of the amount of risk inherent in the shares of a particular corporation.

How To Calculate Debt To Equity:

In it's simplest form, the debt to equity ratio formula is as follows:

Debt To Equity = Total Liabilities / Stockholders' Equity

While there are many variations on this basic formula, I find this one to be easy and convenient to apply. Both these figures are readily available in the Balance Sheet contained in a company's published Financial Statements. Variations are mainly around what is included in the Total Liabilities. I've seen some analysts subtract cash on hand from total liabilities or leave working capital out altogether.

The only major difference is when gearing is measured as debt to total assets (or debt / (debt + stockholders equity). Using these figures will normally give a materially different result. The reason I mention this is that gearing ratios and debt to equity ratios are sometimes used interchangeably and you need to understand whether gearing is being quoted as debt to equity or debt to total assets.

Why Do We Care About This?

I mentioned earlier that it can be used as an indicator as to riskiness of a stock market investment. Normally a company with more borrowings is seen as being more risky than a company with less. This is because these loans, or more specifically, a company's ability to service it's theses loans, is key to it's survival. If a corporation fails to pay interest on borrowings on time or is unable to repay the principal when it falls due, it's creditors' may move in. In the worst case scenario, insolvency could result and that could lead to significant or even total loss of capital for investors.

So why do companies borrow money at all? It's not all doom and gloom. When managed correctly, gearing can be used to help grow a business, leverage shareholders' capital more efficiently and ultimately increase returns to shareholders. If a business can borrow money at 7% and generate a return of 10% on those funds, the excess earnings will accrue for the benefit of holders of the company's stock. This means higher profits and more money to invest in growing the business or to pay out as dividends. That's why the use of borrowed money is sometimes described as leverage.

But, interest rates vary over time and corporate profits fluctuate with the business cycle. What happens when interest rates rise? Can the company still meet it's interest obligations? And similarly, as the economy slows and cash flow drops, can its loans still be serviced. The recent (ongoing?) sub prime crisis also illustrates what happens when borrowings fall due and companies are unable to refinance. All of this illustrates why I prefer to invest in the stock of companies who use borrowed money conservatively.

What Is A Good Debt To Equity Ratio?

As with much of what goes with investing in the stock market, there is no hard and fast rule here. It will depend on the company and on the industry in which it operates. Capital intensive businesses will tend to have higher debt to equity ratios. Businesses that have reliable earnings (ie. earnings which don't fluctuate much through economic cycles) like utilities and consumer staples can normally sustain higher gearing ratios as well.

You could apply a rule of thumb and say you'll steer away from businesses whose debt/equity ratio is greater than 1 (ie. it's financed more through borrowings than through stockholders' equity) but you may exclude some industries altogether. However, this may not be a bad thing as some may argue that corporations which require large amounts of borrowed funds probably don't have very strong businesses - I believe Warren Buffett is said to prefer the stock of companies with low levels of borrowing. When looking for prospective investments, I look at a company's debt to equity ratio over time and also compare it against other companies in the same industry.

Another useful stock market ratio is interest coverage or times interest earned. It measures a company's ability to service it's loans. The higher the coverage the better - there's more leeway if things turn sour. I'll write more about this in an upcoming post.

Some of my biggest mistakes in my early beginner attempts at investing in the stock market were the result of high debt. That's why I always consider debt to equity as part of my stock analysis.

Update: I've since written a post on the Quick Ratio, another useful indicator of the financial health of prospective stock market investments.

Stock Market Value Investing Concepts - Net Current Asset Value

What is net current asset value (NCAV) and how can beginners apply it in stock market value investing?

Benjamin Graham, author of The Intelligent Investor, is credited with developing an investment strategy to find undervalued companies in the stock market by employing a measure called the Net Current Asset Value. Benjamin Graham was a big believer in buying stocks at a significant discount to their intrinsic value. His theory was that eventually the underlying value in the company would be reflected in the share price and in the worst case scenario, an investor would be protected from significant losses because the price of the stock shouldn't fall much further.

What Is Net Current Asset Value?

Put simply, net current asset value is the value of a company's current assets less all of it's liabilities. This means that you discard the value of any tangible non-current assets like plant and equipment as well as any intangible assets like goodwill. You only take into account current assets like cash (and cash equivalents), receivables and stock on hand. You then take away all liabilities - both current and non-current (this means things like long term debt, trade creditors and any provisions).

The idea is that this number (either on a per share or an aggregate basis) should be what a company is worth in the worth case scenario if the company is wound up. In the event of a company being wound up the value of assets like plant and equipment is normally greatly diminished and so is not taken into account in this calculation. In the other hand, all creditors will be lining up to claim what's owed to them, so all liabilities need to be considered at 100% of face value.

If you wanted to be even more conservative, you could discount the value of stock on hand as well, as the carrying value may not be realized in the case of a fire sale. You could discount it be 50% or even more.

The main concept to grasp with this stock investment strategy is that the net tangible asset value should be the absolute minimum amount that a company will be worth.

How Can Stock Market Investors Use Net Current Asset Value?

Benjamin Graham advocated a portfolio approach to value investing. He suggested buying a group of companies which exhibit favorable characteristics. In this way investors are further insulated from risk by minimizing the potential for a loss in any one company to cause significant pain to an investor.

Investors would buy and hold stocks in such a portfolio until either the value of any company was realized in it's share price, or the fundamentals of a company changed to such a degree that holding it was no longer deemed worthwhile.

How Can Investors Find These NCAV Bargains?

To my knowledge, there are no screens available to identify companies trading at a discount to their net current asset value. And it's not a figure that's published in any stock market data on any of the finance websites (Yahoo Finance and such).

Your best option is probably to find a short list of companies trading below their book value then work from there. Some sites allow you to display a selection of financial statistics and in addition apply a filter to the list. By selecting Current Assets, Current Liabilities, Non-Current Liabilities and Market Capitalization (or a similar set of statistics) then filtering on companies trading below book value, you should then be able to download the resulting data to a spreadsheet to complete your calculations.

However in my experience, patience is required. There have not been many companies trading at a discount to NCAV in recent times. I should say that in my search, I normally require a company to be profitable and also have a minimum market capitalization such that costs of liquidation wouldn't absorb all of the margin between the current price and the net current asset value.

Even if you don't find many prospects, you'll be surprised how much beginners can learn about stock market investing while doing this sort of in-depth analysis.

Dividend Yield Investing For Beginners

What is a dividend yield and how can beginners use it in their stock market investing?

Dividend yield is one of the handy fundamental analysis tools we can use when scanning the stock market for good value stocks to buy. It simply measures the cash return an investor can expect in the form of dividends on in investment in any particular stock. In my last post I discussed price to earnings ratios as a way to value stocks and dividend yield can be used in conjunction with the p/e ratio. In fact Benjamin Graham was a proponent of both of these measures.

How To Calculate Dividend Yield.

Like the price earnings ratio, the dividend yield of most stocks is published in financial newspapers and online on websites like Yahoo Finance. However the dividend yield formula is very simple and easy to calculate yourself. Here is the formula:

Dividend Yield = Dividends Per Share / Share Price

As an example, if a company pays an annual dividend of $2.00 and the current share price is $100 then the dividend yield calculation would be as follows:

Dividend Yield = 2 / 100 = 0.02 or 2%

So in the above example, you could expect a cash return of 2% on the hypothetical company at the price quoted. Of course as the price of a company's stock fluctuates, so does it's dividend yield. A higher stock price pushes the yield down and a lower price will raise it. You will notice that I said cash return above. By this I mean the income you will receive from the investment each year. On top of that, you would expect the capital value of the stock to appreciate. That is, you want the stock price to go up so that ultimately you will make a capital gain when you sell the stock.

So How Can You Use Dividend Yield In Your Stock Market Analysis?

The simplest method to do this would be to just buy a group of stocks with the highest dividend yield as listed in your local financial press. In doing so, you should end up buying the best value stocks on offer at a given time and receive a handy annual income from your stock market portfolio at the same time. But what might the pitfalls be with this method?

One of the first things you might like to check is the payout ratio or times covered figures. The dividend payout ratio is the percentage of annual profits paid out by a company as dividends. Check for companies with payout ratios over 100% - this means they are paying out more in dividends than they are earning. There may be a legitimate reason for doing this in the short term, but over the long term it's not sustainable. Dividend times covered is simply another way of expressing this ratio. It indicates how many times a company's profits cover their dividend. In this case a measure of less than 1 again indicates that they are paying out more than they're earning.

Another thing to consider is what the average dividend yield is. While the return may look good in the most recent year, you will need to look at what was paid out in years past? It could be that the company has paid a larger than normal amount in the most recent period and that this is not expected to continue. This will sometimes explain an unusually high dividend yield.

The main problem with high dividend yields is that it usually means the market doesn't think much of the company's stock. This could be because the company is not expected to exhibit very high levels of profit growth in the years ahead. Or it could be because the company is experiencing financial difficulties and is therefore considered to be a high risk proposition. Whatever the reason, it is usually a result of negative market sentiment.

But this is the type of situation in which value investors may be interested. A value investor may see the high dividend yield (and therefore relatively low share price) as a buying opportunity. A value investor may see the company's difficulties (whatever they may be) as temporary in nature. They may expect to see considerable share price appreciation once the uncertainty is passed.

Another option in dividend investing for beginners is to find high dividend yield mutual funds. Some funds specialize in this area and as such can be well suited to investors looking for income but who don't have the capital, the confidence or the time to enter the stock market directly.

When Is A Low Dividend Yield Good?

There is a school of thought that says that high dividend yields are an indication of a poor quality business. If management have adopted a dividend policy which sees the bulk of profits distributed to shareholders, it means they don't have any more profitable ways in which to reinvest it in the business. I think Warren Buffett is an advocate of management retaining earnings within the business when they can continue to generate high returns on invested capital. He believes that shareholders will benefit more in the long run from growth in the business than they would if earnings where distributed. And I read somewhere that Berkshire Hathaway has only paid 1 dividend under Warren Buffett's leadership.

Measuring Stock Market Strength.

Dividend yields may also be used as an average to measure the relative strength of the stock market over time. The dividend yield of the Dow Jones Industrial Average or the S&P 500 has been used as an indicator of the overall value of the market. At market peaks, the average sinks below 2%, whereas during extreme lows it's been known to creep into double figures. Just keep in mind when comparing figures that payout ratios tend to be lower now than they've been in years gone by.

Hopefully this article has given you some useful background to another tool you can use in your fundamental analysis. Beginners in stock market investing can now add dividend yield to their fundamental analysis toolkit.