The beginner stock market investor could be forgiven for thinking that the end of the world is nigh. With share prices having fallen dramatically the world over and the economies of most developed nations entering or already in recession things certainly do look grim. That's why I thought it was time to put together another "how to buy stocks for beginners" type of post.
So lets get back to basics. When you purchase shares in a publicly traded company, what does it mean? Well the first point I'd make is that your investment is more than just a number next to a stock symbol on the Yahoo Finance website (or whatever financial website you prefer). Your investment represents ownership of a portion of a real business. That ownership entitles you to a share of that business's future profits.
This is a very important concept to grasp. Don't be taken in by the daily fluctuations of share prices. These prices are driven by investor sentiment, by a bunch of people trying to guess what the future may hold. The rate at which these prices change belies the stability of the underlying value of your investment. The value of the business - your business - doesn't change that quickly. Sure there are times when a company makes an announcement about a fundamental change in their operations which may cause the price to plummet. But more often than not, it's just the general mood of investors pushing prices up and down.
Don't get me wrong - I'm not suggesting that we can ignore the current economic problems. But by the same token, don't let the current gloom and doom terrify you to the extent that you're willing to ignore quality companies trading at bargain basement prices just because you don't know if the stock market has bottomed yet.
That brings me nicely to my next point. I'm a firm believer in buying stock for the long term. One of the advantages of this approach is that it frees up your mind from worrying about the day to day gyrations of the stock market. By fixing your eyes firmly on a point 3 to 5 years (or even longer) down the track, you can afford not to worry about what your shares will be selling at next week or next month. You'll be able to focus on what really matters - watching the business, making sure it continues to perform as you expected when you bought it.
However, in order to do this you'll first have to put some effort into learning how to understand stock market concepts. Learn how to read a company's financial statements. Compare profitability ratios with those of it's competitors. Consider the financial strength of the company - does it have excessive debt and will it be able to make the interest payments on that debt?
There are a number of very good books available on investing in the stock market. I wrote a post some time ago about what I thought were some of the best investment books for beginners. The books mentioned in that post are all very good and well worth readying.
When To Buy Stocks
This is the essence of being a long term investor and is what I was alluding to before. If you're willing to take a long term view, you can afford to think more about the best stocks to buy rather than the best time to buy stocks. Accept that you wont pick the bottom. There's every chance that prices may go lower. However, if you're happy that you've bought stock in a good quality business who's earnings are going to grow over the long term, you'll be able to ignore the short term price movements. If it's any consolation, you probably wont pick the top either.
I think if you can remove this focus on short term results, you will remove one of the biggest impediments to beginners buying stock.
Friday, March 20, 2009
Friday, March 21, 2008
How can stock market beginners use the return on equity formula to start investing in quality companies?
In recent articles, I've discussed dividend investing, price to earnings ratios and net current asset value as ways for beginners to find value in the stock market. Today I'm going to discuss return on equity, or ROE for short. While dividend yield, price earnings ratios and net current asset value are great methods for value investors to find undervalued stocks, they don't necessarily uncover quality businesses - just cheap ones. But let's not get ahead of ourselves.
What Is Return On Equity?
The first thing we should do is define return on equity. In simple terms, ROE is just the rate of return a company earns on it's stockholders' funds. What it represents is the efficiency with which the management of a corporation is able to use its net assets (net assets are total assets less total liabilities). In other words, how much profit is generated from shareholder funds.
How To Calculate Return On Equity.
The return on equity formula or equation can be expressed as follows:
ROE = Net Income / Stockholders' Equity
Net Income, known in some countries as Net Profit After Tax is the total revenue of the company less all expenses including interest and tax. Stockholders' Equity can be calculated by subtracting the total liabilities from the total assets of the business. Because stockholders' equity changes over time, it's common to use average stockholders' equity in this calculation. This means you will need to take an average of the figures as of the start of the year and the end of the year.
Unlike dividend yields and price earnings ratios, ROE is not always published in the financial press. But some of the financial websites (like Yahoo Finance) do publish the figures. However, beginner stock market investors should definitely know how to calculate this financial ratio.
Advantages Of Return On Equity?
As I said at the start of this article, return on equity differs from the value investing types of financial ratios I've discussed in recent articles (P/E, dividend yield, etc) in that ROE is a useful measure of the quality of a company's business. Companies with low P/E ratios and high dividend yields are normally trading at relatively low prices and this is part of what value investors should be looking for. But this doesn't give any indication as to the quality of the company. In fact, often the stock price is cheap because the business is just an average one. That's not to say there may not be value there. I tend to think that there is value in the stock of most corporation if the price is low enough.
By using return on equity, you should be able to find good quality businesses. The theory goes that a superior business is able to achieve and maintain higher returns on its stockholders' funds. A company with a consistently high ROE probably has good quality management or operates a business in an industry with high barriers to entry or both.
Things To Consider When Using Return On Equity.
One of the things to keep an eye on, especially when first starting out in the stock market, is the level of debt. Because of the how return on equity is calculated, high levels of debt can inflate the figures. I wont go into great detail on the maths behind this, but by being more highly leveraged a company can generate higher returns for shareholders given the same level of stockholders' funds. And while these higher returns are good up to a point, you will need to make sure that the company's debt levels are not excessive. I will write more about this in a future article, but using a gearing ratio of 50% makes sense - that is stay away from stock where the gearing ration is greater than 50% if you want to maintain a conservative investment stance - even if the ROE is high.
You may also want to look at return on equity vs return on capital. Return on capital essentially uses total assets instead so it will account for debt levels. I'll write more on this in the future.
Another thing to consider is the industry in which a business operates. I noticed that Wikipedia made the point that consulting businesses which have very low capital requirements tend to have high return on equity ratios. They also note that because of the low barriers to entry they are much more susceptible to competition than companies operating in capital intensive industries. I think another thing to consider here is whether the company has some other intangible asset (think of brand name or intellectual property) which may make it's position more defensible. I'm thinking of a company like Coca Cola which I believe has relatively low capital requirements but which is in a very strong position because of both brand and intellectual property. I think the main point is to compare ROE of companies in the same or similar industries.
Return On Equity And Growth.
ROE in isolation wont necessarily identify growth companies. You will need to have a look at what a company does with its profits. If a corporation has a high rate of return on equity but it pays out all of its profits in dividends, then it's unlikely to be a growth company - that's not to say it's not a good business. But if it's paying out all of it's profits in dividends it probably doesn't have any way in which it can reinvest its profits to grow the business. This may be because it's in a mature industry, or it may be the dominant player in it's industry with no room to grow it's market share. The fact that it earns high returns on its shareholders' funds probably means its a good business - just not a growing one. At the right price, it may still make a good investment though.
If we now look at the opposite situation, where a business earns high return on its equity and pays little of its profits out as dividends, this is a candidate for a growth stock. If it can consistently reinvest profits back into the business and consistently generate a good return on this expanded equity (reinvested profits add to shareholders' equity) then this is most likely a growth stock. Companies like these tend to trade at higher multiples because of the compounding effect of having profits reinvested in the business.
But there are a couple of things to watch out for with growth stocks. A business wont stay in this high growth phase forever. At some point growth will start to slow. Markets and not infinite in size. It will reach a point where the market is saturated, or a competitor may enter the market. So look at the trend of ROE over time. A falling ROE may indicate it's nearing the end of its growth phase.
And this is the other thing to watch out for. As the stock market gets a sniff that growth is slowing, the price will normally be discounted. Stock market participants tend to be very future-focussed. They will try to anticipate when a company will go ex-growth then move on to find the next big thing. Stock market beginners need to make sure they don't pay too much for a growth stock nearing the end of its growth phase.
I've written more than I intended on this subject, so if you've made it this far - well done. There's just one more thing I wanted to mention before I finish up, so bear with me. Joel Greenblatt (I always find that name amusing - like a character out of The Hitchhikers Guide To The Galaxy - no offense intended to Joel) wrote a book called The Little Book That Beats The Market. Joel seems like a pretty smart guy and in the book he advocates using a variant of return on equity along with a kind of modified price to earnings ratio as a way of ranking stocks. I think there's a lot of merit in this idea as it brings together a measure of quality with a measure of value. I'll need to re-read Joel's work to refresh my memory, but I think that was the gist of it. I will write more about Joel Greenblatt's Magic Formula in a future article.
Well that's definitely enough now. I think this is the longest post I've written so far. Hopefully stock market investing beginners have gained a decent grounding in return on equity after that.
Tuesday, February 26, 2008
What are the best books about stock market investing for beginners?
In my recent article on stock market investing basics, I mentioned that stock market education was very important first step towards investing for beginners. In this article I want to take a look at some of the books I have found helpful in understanding investment principles and strategy. I've read a lot of investment books over the years and while they're all contributed to my knowledge to some degree, the following tomes are the ones that have stood out for me.
Having said that, I'm always on the lookout for new ideas so if you have any ideas - something you've read which stands out in your mind - then let me know. I would love to add a few more books onto my "to read" list.
The first investing book I'd like to discuss is The Intelligent Investor
Benjamin Graham is considered the father of value investing. He is credited with bringing discipline to the activity of security analysis. Before Graham, there was little structure in security analysis and through his writings and teachings he brought stock market investing into modern times. Although a successful investor in his own right, he is perhaps more famous for playing the part of mentor to a man who many consider to be the greatest investor of all time - Warren Buffett.
When I first read the Intelligent Investor, it was a revelation. Graham did such a great job of focusing your mind on what's important. He advocates stepping away from all of the noise in the stock market and instead concentrate on investment fundamentals. He concedes that over the short term, the market is a popularity contest. But over the long term, if you buy stocks at a significant discount to their intrinsic value, you should beat the market average.
What I like about Graham's writing is that he puts forward his ideas in a clear, concise and logical manner. He develops his arguments slowly but surely then counters any potential counter-arguments which may arise. He's also very strong in his research. He provides empirical evidence to support all of his main arguments. Although this book was first published over 50 years ago, I was astounded how relevant it is to today's market conditions. I highly recommend "The Intelligent Investor" by Benjamin Graham.
The next most influential investment book I have read is called Common Stocks and Uncommon Profits
Fisher thought the best results could be had by identifying the very best companies but studying the structure of the industry it operated in, management, commitment to research and so on. Price was less important as over time these companies would expand to many multiples of what you paid for them. What would it matter whether you paid $50 or $100 for a stock when in the future it will trade at the equivalent of $10,000 or more. Fisher's idea of having a small number of very high quality "growth stocks" was in contrast to Graham's theories of having a large number of heavily discounted stocks, but by reading both points of view, I think you will become a much better investor.
The last book I'm going to discuss in this article is One Up On Wall Street
One Up On Wall Street is a great read. It covers Lynch's first steps in the stock market, then takes you through his philosophy for choosing stocks. Lynch advocates sticking with what you know. He believes that we all comes across great investment opportunities everyday. We just need to keep our eyes open and be aware of the companies which operate around us in our daily lives. Lynch says that we have the opportunity the uncover these hidden gems and profit from them by buying in before the market at large becomes aware of the stock.
Lynch also categorizes the purchases he makes into one of 6 types. These are Slow Growers, Medium Growers, Fast Growers, Cyclical Stocks, Turnarounds - Special Situations and Hidden Assets. But I think what is more important than remembering the categories, is to understand why you are buying a stock. What do you expect from it? Do you expect to hold it for the long term? Will you hold it until some hidden value is realized. Or are you expecting a short-term reversal of fortune. I think this a very important concept. Understand why you are buying a company and know under what circumstance you would be willing to sell.
I decided to limit the list to only 3 books, partly because this article was long enough already, but also I didn't want to dilute the quality of the list. Don't get me wrong - there are a lot of other great investment books out there. Other books which just failed to make the cut include The Little Book That Beats The Market by Joel Greenblatt, The Warren Buffett Way by Robert G Hagstrom and The Money Masters by John Train.
There are also some great online resources which I'll cover in an upcoming article. But for now the above list should be more than enough information about investing in the stock market for beginners - and everyone else who hasn't read these books.
