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.
Wednesday, October 15, 2008
Friday, June 6, 2008
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.
Tuesday, February 26, 2008
What is a P/E or Price to Earnings Ratio and how can beginners use it when investing in the stock market?
As a beginner in the stock market, one of the first investing concepts I learned about was the price earnings ratio or simply P/E. This ratio is simply a measure of how many multiples of a company's earnings you are paying for it's shares. This is useful because it provides a standard measure which we can use to compare the value of two or more companies. Using share price alone to compare various stocks is meaningless (I'll explain why a little later) - we need a way of comparing apples with apples. Price earnings ratios provide this mechanism.
All other things being equal, a stock with a lower PE ratio would provide better value than one with a higher PE.
How To Calculate Price Earnings Ratio.
P/E ratios are published in the financial pages of most major newspapers. They are also published online on websites like Yahoo Finance as well as the research areas of most online brokers. However, it can still be useful to know how to calculate it yourself. If nothing else, know how it's derived will help you to understand how to apply it to your investing activities.
The price to earnings formula is as follows:
Price To Earnings Ratio = Company Share Price / Earnings Per Share
The Company Share Price is the price that a company's stock is currently trading at. The simplest way to work out Earnings Per Share is to take a company's total earnings and divide by the number of shares on issue (technically you should make some adjustments to this depending on the company's capital structure, but I'll discuss this more in another article).
So if a company's stock is trading at $50 and it's earning $2 per share, then the price to earnings ratio for that company is 25 (50/2).
What Is A Good Price To Earnings Ratio?
As I said at the outset, one of the benefits of using P/E's to value companies in the stock market is that it enables us to compare apples with apples. If we take the example of two companies each trading at $40 per share. Using this information alone, can we determine if one is better value than another? No. The price is the same, but what do we get for that price? Now what if we take these same two entities and say that Company A has earnings of $2 per share while Company B has earnings of $4 per share. Not we can see that for the same price, we'd get twice as much earning power if we were to buy company B. The price earnings ratios would be 20 (40/2) and 10 (40/4) respectively. By comparing the PE's we can confirm that Company B with a PE of 10 is much better value than Company A with a PE of 20.
But what is a good price to earnings ratio? Well there is no simple answer to this. Some value investors advocate using a P/E of 10 as a benchmark. Others say that a P/E ratio of 25 is as high as they'd go. They are a number of way to use a price earnings ratio when investing in the stock market.
I think that it's best used in comparative analysis. Use it when comparing a group of companies. If you extend the example above from just 2 companies to an entire industry sub-group, you will quickly see where the value lies.
Another way to use the price to earnings ratio is to turn it upside down. This then becomes the earnings yield (earnings divided by price). To convert an existing P/E ratio into an earnings yield use the following formula:
Earnings Yield = 1 / Price To Earnings Ratio
So continuing on from the example above, a PE of 20 would give an earnings yield of 5% (1/20) while a PE of 10 would yield 10% (1/10). Now we can take this figure and compare it to returns from other investments. A useful benchmark is the long term Government Bond yield. If you can get a risk free return of say 7% from a government bond, this gives you a good benchmark with which to compare your earnings yield. I'll write more about earnings yields in an upcoming article.
What Are The Limitations Of P/E Ratios?
I must now stress that although this ratio is very useful, it must not be used in isolation. It should be used in conjunction with other measures of value, financial performance and stability. Apply it as a filter to create a short list of investment opportunities. I said at the start of this article that all things being equal, a company with a lower PE provides better value. While this is true, just remember that things are never equal. That's why you need to look at other things like debt levels and the ability to service debt, return on equity, return on assets and so on.
But as a beginner in the investing game, the price to earnings ratio is a good why to start exploring value in the stock market.
