How to invest in the stock market and not lose your shirt.
Investing in the stock market has always been a lucrative way of generating income. Investing is at the core of the capital markets system around the world. It is a very complex subject in general, so I’ll try to simplify it and share my insider perspective on investing in the stock market. I spent almost 9 years in the industry [awesome time] and would love to use this article as an opportunity to share some of my knowledge and experience and help an average person to better understand the basic principles of investing in stocks.
First of all, let me distinguish investing from short-term trading (otherwise known as “day trading”) and speculation. Both day trading and speculation are more like gambling at the casino – you may get lucky and make a quick fortune, or you may end up losing your shirt (seriously, why would anyone want that?). They are very risky and for an average American it’s a sure way to lose money long-term.
When I refer to investing, I’m talking about making investment decisions with at least a horizon of 12 months or longer. Let me explain why… Taxes. That’s right. Taxes. It’s the most basic and simple explanation. If you hold an investment (a stock) for more than a year before selling, your profit is considered a long-term gain and is taxed at a lower rate than in the case with short-term gains and day trading. Most of the educated and institutional investors (i.e., banks, mutual funds, hedge funds, venture funds, registered investment advisors, etc.) know this and don’t just trade in and out of their positions frequently. They buy and hold. That’s why their portfolio positions are called HOLDINGS. However, it doesn’t mean that they simply buy and hold their positions forever either. Trading has its place in the industry and is very important, but we’ll save this topic for another conversation.
Investing usually involves two of the most basic and popular financial instruments: stocks (equity) and bonds (debt). And then of course a bunch of other asset classes (oil, gold, currencies, etc.) and a variety of derivatives (options, futures, warrants, swaps, etc.). For the sake of simplicity and understanding, let’s try to first understand stocks, otherwise known as equity.
Fundamental analysis and key metrics
Equity (i.e., stocks) investing is equally as popular with retail investors (i.e., average consumers) as it is with institutional investors (i.e., funds). In the world of equity investments, it’s important to understand the two most basic principles of understanding and valuing a stock: 1) fundamental analysis and 2) quantitative analysis.
Since stocks that trade on various exchanges represent actual corporations (i.e., businesses), fundamental analysis aims to understand the profitability of a company by looking at its books (i.e., income statement, balance sheet, cash flow statement). The key metrics that nearly every institutional investor follows [and so should you] are Gross Profit (revenue ‘minus’ cost of goods sold), EBITDA (earnings before interest, taxes, depreciation, and amortization – often referred to as “cash flow”), Net Income (profit), EPS (earnings-per-share), Gross, EBITDA and Profit Margins (expressed as percentages ‘%’). By looking at these various metrics (numbers and percentages) it is possible to make certain assumptions about a company’s profitability. The more profitable the company, the higher its trading multiple will be (typically), and the higher the stock price will be (typically).
The earnings multiple (P/E)
The price of a stock divided by its earnings per share (EPS) will give you a P/E multiple (price-to-earnings ratio) that a stock is trading at relative to its earnings capability, in other words, “the earnings multiple“. Every industry has its own criteria, comparisons, and benchmarks for the earnings and other types of trading multiples. At the time of this writing, the current P/E multiple for the S&P 500 index is 24.56 (according to the Wall Street Journal’s data and based on the trailing 12 months). In layman’s terms, the market collectively values the profitability of the combined 500 large-capitalization businesses in the S&P 500 index at 24 times its earnings capacity. Imagine that you had $100 dollars in earnings and someone else is willing to pay $2,400 for it. That’s the power of the earnings multiple. And that’s the power of investing in the stock market. The market recognizes the earning power of money. That’s why it’s important to know the multiples of the stocks that you would invest in, and it’s important to compare them to industry multiples and index multiples for Dow Jones, S&P 500, NASDAQ 100, Russell 2000, and many others.
Cash flow multiple (EV/EBITDA)
Another popular metric that most investors use is EV/EBITDA multiple, otherwise known as cash flow or EBITDA multiple. EV stands for enterprise value of a company, calculated by taking the number of shares outstanding multiplied by the price of the stock, plus any long-term debt and minus any cash on the balance sheet. If you take EV and divide it by the cash flow (EBITDA) of a company, you will arrive at a number that will indicate a multiple at which that stock is trading compared to the cash flow generation of the company. Most investors prefer to use cashflow (EBITDA) metrics VS. earnings (P/E) metrics because they are more difficult to manipulate (with accounting) and better show the real health and profitability of a business.
I hope this wasn’t too technical. If you want to invest in stocks, you’ll have to learn this. It’s a matter of repetition and practice, just like with anything. There’s no way around it and you’ll be gambling your shirt away if you don’t know and follow these basics.
What I described above are some of the valuation methods. When you compare multiples of different companies, it’s possible to find multiples that are way below the “average” trading range of the group of related companies. Such companies often attract a particular type of investor – the so-called “value” or “deep value investor”. As the word “value” suggests, such investors are looking for a bargain. They want to find good or even decent companies, or those undergoing changes, turnarounds, transitions, and therefore could be temporarily mispriced by the market. Lower multiples may point such an investor in the right direction. Many securities (stocks) in the market are not efficiently priced. Typically, the smaller the company (in the U.S., anything that’s smaller than $2 billion in market capitalization (i.e., market cap) is considered to be a “small cap” stock), the more likely their stock can be mispriced and undervalued. One of the main reasons for that is because of the lack of public information about such companies and a limited amount of financial analysts who follow such companies and publish research about them. That’s why value and deep value investors can often find real “bargains” and “diamonds in the rough” among smaller, less covered companies.
On the other hand, some of the companies trading at a discount to the industry are trading at a discount for a reason. They could be underperforming, or losing their competitive edge, or losing market share, or going through management changes, or lost their key customers and contracts, got into legal trouble, or just being overlooked/unknown to the broader market. The risks with such companies are always higher, but the potential reward is also much higher.
Warren Buffet’s way of investing
Many people don’t know the full story about how Warren Buffet really made his money early in his career. It was similar to the process I referred to above – finding companies that were undervalued, buying their stock, and selling for a significant profit later. Beforehand, he would analyze their books and recognize the potential for returns. Then buy enough shares to take board seats and influence managerial decisions, bring new members of management, improve financial results, create value for the shareholders, and later sell for a significant profit when the broader market gave the company credit for such turnaround performances. Financial analysts’ recommendations (i.e., endorsements), better publicity, and consequently a higher demand for such shares would typically push the stock price higher. Bingo. Warren Buffet made tons of money that way. His No. 1 Rule of investing was: “Never lose money”. His Rule No. 2 of investing was: “Never forget rule No. 1”. Funny guy… And he had a valid point and it made him and all of the people that invested with him (i.e. Berkshire Hathaway holders and partners) all of his and their billions.
It all sounds simple, but it isn’t of course. If everyone knew how to do that – we’d all be rich by now. And not all of us are. Warren Buffet didn’t do it alone though. He had partners. Many partners. He also had connections, resources, and capital to pull off such turnarounds and transactions. So having a good team around you is important. My point is that if you’re thinking about investing in the stock market, surround yourself with a team that can help you research and value stocks. It’s definitely a path to follow if you want to make better-educated investment decisions for yourself. It’s not rocket science. A lot of it is about knowing how to evaluate a company. Fundamental analysis helps you to better value companies. If you can learn valuation methods described above (P/E and EV/EBITDA), you’ll be ahead of the majority of people who don’t even have a clue of what that is. Next time you hear about earnings on TV, I hope you’ll know that it’s all about public companies reporting their quarterly or annual results, financial performance, profitability, and earnings.
Earnings season is typically a volatile time for most stocks because investors are looking to match their forecasts and predictions with real numbers (i.e., results). As you can imagine, a lot of mismatches happen between the estimates and actual results, so stocks tend to trade more volume and have wider swings around the earnings season. If you add day traders and speculators looking to make a quick return, it’s a recipe to lose money for an average retail investor. The market gets more volatile and is difficult to predict. Even if you get your numbers and forecasts and predictions right, the stock may trade based on a rumor or a projection, or some major announcement that you had no idea would come out. And again you could lose your shirt that way. So, for an average investor, I’d recommend staying away from the market during those periods (roughly during the month-and-a-half after every calendar and fiscal quarter). However, if your risk tolerance is higher – then please be my guest and gamble. The reward can certainly be very enticing if you get it right.
Quantitative analysis and key metrics
Speaking of trading and volatility, let’s also briefly talk about quantitative analysis. What I mean by that is looking at the same security (i.e., stock) not as a fundamental business but as charts, patterns, statistical models, ratios, trading volumes, momentum, moving averages, and a bunch (I really mean it) of other ways of looking at stocks that often have nothing to do with the fundamentals of the business. Let me correct myself. “Most of the time” have nothing to do with the fundamentals of the actual business. It’s like a completely different world here. The world ruled by charts, probabilities, and patterns. Many different patterns. Head and Shoulders, Tops, Bottoms, Triangles, Cups, Wedges…to name a few. I’m not going to waste your time trying to explain all of this here. What’s important to know are the following key metrics:
1) 52-week high and low (i.e., trading range) are the low and high trading prices of the stock within the last year. You wouldn’t necessarily want to buy a stock at its peak and on the other hand sell at its lowest point. Things tend to be cyclical in the markets, so pay attention to where the stock is trading in the 52-week cycle (1-year).
If you intend to follow Warren Buffet’s Rule #1 of investing (see above), then Buy Stocks Low and Sell Them Higher.
2) Beta is the indicator of the volatility of the stock compared to the overall market. The higher the number (beta), the more volatile the stock is, and the more unpredictably it can trade. It can go up and down by a lot. Approach high beta stocks with caution (but don’t be afraid to investigate them further, it’s not necessarily a bad thing per se).
3) Average trading volume (i.e., volume) is how many shares of a particular stock trades daily. For fund managers and investors, this metric demonstrates a company’s liquidity. The more shares of a company trade, the better liquidity of that company is in the market, the easier it is for investors to buy and sell that stock (i.e., get into and out of a position). And trust me, no institutional investor wants to be stuck in an illiquid (i.e., low trading volume) stock. If something goes wrong with the company and you can’t sell it quickly – you’re doomed for big losses (and losing your shirt again).
4) 50, 90, 200-day moving average is the average trading price of the stock over 50, 90, and 200 trailing days. Those are the microcycles that stocks go through and that traders pay close attention to. If a particular stock is already trading at or above its moving average it could be a signal of strength and interest in such stock or on the flip side that the stock is overpriced and may run out of steam soon. Again, it’s always a case-by-case situation. Always research and investigate other metrics too. Don’t just use any of the metrics on their own. It’s a combination of different factors that can help you make better investments and returns. I’m just sharing some basics with you here.
5) % held by institutions AND insiders are the percentages of shares that are held (i.e., owned) by major accredited investors like banks, other financial institutions, and funds AND by the management/owners of the company. Higher institutional holding percentages typically indicate higher confidence in the stock because “smart institutional money” owns these stocks. Higher insider ownership percentages typically suggest that the management’s wealth and therefore decision making is aligned with shareholders – they have lots to lose otherwise.
6) Shares short show how many shares of the company are actively being shorted by investors. Shorts indicate bets against the company or in other words show a belief that the price of the stock will decline (for whatever reason). The higher the number of shares short, the more you should research why investors are betting against the company.
7) Relative Strength (RSI) is a good way to learn the sentiment about a particular stock. In other words, RSI shows if the stock is being overbought or oversold by the market. Any time the RSI is above 70, it’s an indication that the stock is overbought (i.e., potentially overpriced) and you should be cautious about buying. Any time it’s below 30, it’s a signal that the stock is oversold (i.e., potentially undervalued and mispriced) and it may be a good time to make a purchase.
All in all, I want you to understand that both fundamental and quantitative analysis play crucial roles in how stocks (and other securities) are priced and are traded in the markets. If you can understand the fundamentals of both, you’ll have a solid foundation to make better investment decisions. When it comes to picking individual stocks, besides evaluating the company and its fundamentals, always check the sector to which that company belongs. Check the industry multiples. Research the competitors. Check the public filings (i.e., financials) available on https://www.sec.gov/edgar.shtml Check the recent news and announcements about the company and the industry. Look up the members of the management, check if they have significant or even any holdings in their own company. If not – I’d question investing in such a company. Leverage free resources like Yahoo Finance, Google Finance, www.investopedia.com, www.seekingalpha.com, www.bloomberg.com, www.wsj.com, www.finviz.com, www.barrons.com, www.whalewisdom.com, and many others. Google is also your friend. A financial advisor is also your friend. But this article is intended to help you figure this one out on your own, so let’s skip the advising part here.
I hope that you understand that investing in itself is not really difficult. It’s similar to placing a bet at the casino. If your bet is educated and calculated, if you practiced and know what you’re doing, chances are pretty good that you’ll win and make money. But there is always a chance that you’ll lose money too. No one can ever promise you any guarantees. Sometimes the market goes through unpredictable and inexplicable swings like during this COVID-19 pandemic. Don’t try to time the market. Play the longer-term game because your shirt is at risk:).
As long as you 1) understand the risks associated with investing (such as a partial or total loss of your principal), 2) act less on emotion and more on the analysis (fundamental and quantitative), 3) have a strategy or a game plan in mind, and 4) have other people in your network with whom you can share your due diligence and research – go for it.
Investing is like scuba diving, you should never do it alone.
There is a reason why the stock market has always attracted and will always attract investors, traders, and speculators – its unique ability to multiply money. In essence, all you have to do is to place your bet and let time do its magic. The more research and due diligence you’ve done before placing your bet, the more likely you are to succeed. Good luck my friend. See you on the future pages of the Gambit’s blog.
With much gratitude,
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