How to Select a Stock - Part I- Understanding a Business

In my previous post, I wrote that you need to make intelligent guesses to select a good stock. How do you do that is the topic of this post. There are many factors you should consider before you take a decision to invest in a stock. In this post I will talk about the most important thing you need to do before you take a decision.

You need to understand the business you want to invest in. You can ask why should you do that. After all, a stock price is just a number that keeps changing on a ticker. All you need to figure out is when and how this number changes. There are short cuts and there are long-winded ways to figure this out. Unfortunately, I am a believer in old-fashioned long-winded ways of doing things. Fortunately, these methods work. After having invested in stock market for some time and observing various players in the market, I have come to believe that all short cuts fall short of making money for you on a consistent basis. You need to face a reality here. If you want to invest in a stock, understand that you are going to own a company (even if you own only one share of a company, you technically become a partial owner of the company!) Does that make you want to buy a stock now? J Now, owning a business is not easy. You don’t want to own a business without knowing how it works. Try finding out everything you can to figure out the details of the business- key success factors, dynamics of the business, which companies are doing well, why they are doing well, what’s future going to look like, etc. And if all of this looks overwhelming, let me assure you it’s not. Even if you spend 2 hours every day for a week, you will be able to collect sufficient information on any business. To make it easy, start with a business you are already familiar with. This could be an industry you work in, or a business you are interested in, or any business you somehow have managed to understand to an extent.

If you are not willing to do this much of research, I am afraid you should not be thinking about investing in stocks. It’s very easy for me to tempt you into investing assuring you that you don’t need to devote much time. But that will be a lie- a lie that many people have used to fool innocent beginners- a lie that has been causing misery to many retail investors for decades. But if you are willing to invest some time in conducting research, I can assure you that you will reap rich rewards. Every second you invest in conducting research will be worth it.

Now, let’s talk about ways to understand a business. A very simple way could be using Google. You can read through industry reports, analyst reports, articles, etc on the industry and company to understand the basic dynamics of a business and relative standing of the company you are focusing on. A caveat though, use stock analyst reports only for understanding the dynamics of the business. You don’t have to believe their recommendation entirely. Stock analysts have their own reasons to recommend a stock.

Other ways of understanding a business could be speaking to somebody who is currently in the same business. You could also go through the annual reports of the company you are researching to understand the intricacies of the business.

At the end of your research you should be able to answer these questions:

1. What are the things that are required for a company to succeed in this business?
2. Who are the main players and what is their relative standing in the market?
3. Which companies have got competitive advantage over others in the industry and why?
3. What can change the fortunes of a company in this business?
4. How the future looks like for the business and the company?
5. If you come to know about an important event related with economy or industry, will you be able to assess its impact on the business?

If you are able to understand a business, you have taken your first step towards being a retail investor. There are a few more steps like past financial performance, quality of management, future growth potential, etc which you need to understand before you select a stock. I will discuss about them in my next few posts.

Till then, have fun.

How to select a stock- Value and Price of a stock

While many of you are aware that by owning a stock you own a company partially, I am not sure if everybody knows how a stock is valued or how its price is determined. For most of us, it is a number that keeps moving up and down based on the whims and fancies of some unknown factors. Most retail investors invest in a stock not on the basis of their research, but on the basis of tips and market rumors. Which is what makes investing in stocks a thrilling but self-defeating activity for most of them.

I think it’s important that we learn how a stock is valued and priced. This should give us an insight into how to select a promising stock later.

So, what is the value of a stock? Plainly put, it is the cumulative present value of the money the company makes at present and in future, divided by the number of total shares with various shareholders. How do you calculate it? Again putting very simplistically, you need to know the amount of cash the company is currently generating and will be generating in future. Calculate the present value of all this cash and divide it by the number of shares (I will not be getting into detailed calculations, as it’s not required. If you are more interested in finding out actual calculation, you can google ‘calculate intrinsic stock value’.) And you got the intrinsic value of a stock. Another method would be looking at the possible dividend stream of the company (current and future) and calculating its present value. Does this give you the actual price of a stock? No. I know you are disappointed with this answer and are wondering why on earth did I explain all this if the answer was going to be a ‘No’.

Let me try to explain.

When you calculate the value of a stock using any of the two methods given above, you have found out ‘intrinsic’ or ‘fair’ value of a stock. Unfortunately, calculating this value requires you to assume quite a few things including possible growth rate of the earnings as well as average discount rate (the rate of return for a risk free investment like government bonds). These assumptions vary based on each individual’s perception of the future. Therefore, agreeing on one particular value of intrinsic or fair value of a stock itself is a difficult task.

There are some other factors too. You would have seen stock prices moving by more than 10 to 20% in one single trading session for a few stocks. Does that mean that the value of a stock has changed in a single session? No. But the perceived value of the stock has changed. And all of us may have different perceived values for the same stock. Which is what matters as none of us know the actual intrinsic value of a stock. All of us can make guesses. Some of us make intelligent guesses. Some of us make foolish guesses. The difference in perceived values of a stock in the eyes of different people keeps a stock price moving. Factors like supply and demand of a stock, economic conditions, market sentiments, liquidity in the market, etc apart from the intrinsic value play a major role in determining the price of a stock at any point in time. You would have seen many stocks tanking by more than 30%-50% in the recent economic downturn. This is because now the perception about the future of these stocks has changed in the eyes of the investors.

All this is fine. But how can we ensure that we make money in the stock market. The answer is simple- by making intelligent guesses rather than foolish ones. How do we do that- that will be the subject of my next post. Till then, think about what I have written in this post.

Make money by Investing in Stocks

A new investor always grapples with a lot of questions like:

How can I start investing in stocks?
What are the things to know before I start investing?
How should I research a stock?
How much risk should I take?
How long should I invest in a stock for before selling it?
Should I invest in stocks, or mutual funds or derivatives?
How should I select a stock for investing?
How can I ensure that I don’t lose money in the stock market?

So, if you are a new investor, and you are having these questions, don’t worry. All the investors face these questions and struggle finding right answers of these queries. In this blog, I will try to help you find your own answers of these questions to the best of my abilities. However, before we start discussing how to invest in stocks, let’s discuss a few basic issues, which are very important and will lay the foundation of our discussion.

Research: Buy stocks only if you are willing to spend some time researching stocks. If you don’t do research yourself, but still want to invest in stocks, then you should invest in equity oriented mutual funds. Hopefully, you will get decent returns on your money. Finding a good mutual fund in itself will require you to do some research on its past performance vis-à-vis its competitors, current philosophy of investing and fund management. In that sense, there are no free lunches- a little bit of effort is required if you want to make money anywhere. But once you have identified a good mutual fund, you don’t need to actively research stocks.

Investing in stock based on tips, or what others are buying or saying, is like gambling. And you don’t want to gamble with your money. If you still want to go ahead with gambling, then there so many other places to lose money.

Day trading: Only people who benefit from day trading on continuous basis are stockbrokers. They make money irrespective of your loss or profit, as they earn a percentage on every transaction you do. I have not seen anybody else making money consistently in day trading. If you have been lucky, may be you will make a few quick bucks. After that, the law of averages will catch up with you. To my mind, it’s a big farce and pure gamble that has been created to get people hooked to the stock market and keep up the volume of trades. Therefore, if you are thinking that I am going to give you tips on how to make some quick bucks, sorry to disappoint you. If anybody knows where exactly a stock is going to be in next one hour or two, he would not be advising you. Instead he will play the game himself and become a billionaire. This should help you understand the reality of day trading.

Derivatives: While finance professionals talk fondly about derivatives as investment instruments, these are complicated products and work primarily on speculation of large players in the stock market. You don’t have a good chance to make money in derivatives, as it’s not a level playing field. A retail investors should stay as far from derivatives as possible.

Short-term Vs Long-term: Short term investing is not investing; it’s speculation. At the cost of sounding repetitive, let me say again that short-term investment is gambling. There is a chance that you can make money in short term, but that will be pure chance. A stock price at any point in time is dependent on its intrinsic value (the real and reasonable potential of a stock), sentiments in the market, liquidity in the market, etc. When you are investing in a stock, you are trying to believe that the market will value this stock more in future and reward you for your early discovery. In a sense, you buy a stock at a price below its intrinsic value, and you will sell it when the market realizes that the stock is worth more. However, if you bought a stock when the liquidity and sentiments were good. And, suddenly, everything changes. The stock market crashes, liquidity dries up and everybody looks pessimistic about future. What happens to your stock? It tanks in the short term. However, sooner or later, things will get better and liquidity, sentiments will be positive; and you will find that the stock realizes its real potential. If you were a short-term investor, you would have sold the stock when the it tanked and lost money. However, if you invested for long term, you would hold on as you believe in the value of your investment and finally make money on your stock when things get better. Therefore, your chances of making money on a stock in long term are better than those in short term irrespective of the market sentiments and bull or bear phases. This is assuming that you have identified a good stock and bought it at a price, which is cheaper than its intrinsic value. A corollary is that if you need your money back in short term, you should not invest in stocks; instead you should invest in safe financial products like FD, debt oriented mutual funds, government bonds, etc.

It’s been a long post and I can go on and on. However, you should take rest and think about the points I discussed so that you can digest them and develop your own thoughts. Whatever I discussed today sets the tone for the things to come. Stay tuned.

Basics of investing in stocks

Welcome to Basics of Investing in Stocks for beginners. This site will provide tips, insights and techniques for investing in the stock market to help beginners make money without losing sleep. If you want any particular topic to be covered or have any specific question, you can post a comment mentioning the same. I will try to answer your queries honestly and to the best of my abilities.