Introduction
Investing in the stock market is not just exciting; it can also be profitable. You just have to understand it. In this article I approach the basics of share investing made easy. All you can read below has an Australian perspective.
The Stock Market
What is the stock market? Basically, it is a place where to buy and sell securities. These securities are: shares, warrants, options, etc. It is not a physical place, though, such as a market fair.
As a matter of fact, all trading and settling of shares in Australia is done through the Australian Securities Exchange (ASX) via a computer system called CHESS. This is operated by authorised traders around Australia who place buy and sell orders in it. The ASX web address is: http://www.asx.com.au/.
You can use the Internet to look for discount traders, but the cheapest of them is JDV which you can find at this web address: http://www.jdv.com.au/. JDV charges $17.99 for each trade up to $5,000. Another trader much in demand is CommSec whose address is: https://www.comsec.com.au/.
A share trade must be done for the minimum of $500 for purchases. This compares with the amount you would have to put up for a property purchase.
What is a Company?
A company is an entity with a life of its own. A company is distinct from sole tradership, partnership and trust. A company, as an entity, can trade, accept liabilities and own property as an individual would.
The most striking aspect of a company is that it has limited responsibility. This means that, upon liquidation, its assets and nothing more answer for its debts.
Each company listed on the ASX has a three letter code based on its name such as CDO for Colorado Group Limited. This code must be provided for share trading purposes.
A company’s life, from formation to closure, is regulated by the Australian Securities and Investments Commission whose web address is: http://www.asic.gov.au/asic/asic.nsf/. The ASIC, in its own words, “enforces and regulates company and financial services laws to protect consumers, investors and creditors”.
What is a Share?
A share is a parcel of the equity of a company. The equity of a company is made of its assets less its liabilities. So, a shareholder is a part-owner of a company.
A shareholder has no entitlement to dividends. Dividends are issued at the discretion of management of the company.
The amount a shareholder stands to lose with its investment is the paid-up value of its shares and no more.
Upon liquidation of the company, shareholders rank last. This means that liquidators, employees, creditors and others are paid ahead of shareholders. This also means that shareholders may not get anything in liquidation.
In Australia, dividends may attract franked credits. This happens if the company in question has earned its income in Australia and has paid income tax on it. Franked credits can then be offset against the shareholder income tax. If the dividend’s franked amount is 100 per cent, this means the shareholder will not pay any income tax on these dividends.
The issuance of franked credits makes dividends very competitive against interest. In fact, when you earn interest you pay full income tax on it while when you are paid fully franked dividends you don’t.
A Company’s Financial Statements
The financial statements for a company are three: Profit and Loss, now called Statement of Financial Performance; Balance Sheet, now called Statement of Financial Position and Statement of Cash Flows.
The Profit and Loss statement puts marketing, administration and financial expenses against sales to arrive at a net profit. This is then offset against tax payable to give the net profit after tax. The Profit and Loss purpose is to show the business performance within a period of time.
The Balance Sheet statement shows the assets, which are what the company owns, liabilities, which are what the company owes, and equity of a company. Liabilities plus equity equal assets. Assets and liabilities are further broken down into current and non-current amounts. The Balance Sheet purpose is to show the financial position of a company in a particular moment in time.
The statement of Cash Flows shows the operating, investing, and financing cash flows for the period. At its bottom it shows the net cash at the end of the period. The Cash Flow statement purpose is to account for the flows of cash after cancelling items such as depreciation and amortisation which don’t have a cash side to it.
You can find a company’s financial statements in its annual report to shareholders. This can be found in a company’s website under shareholders.
Financial Ratios
Financial ratios help you find out the characteristics of a business. They are many, but I will concentrate here on a few of the most meaningful.
Return on Equity (RoE) is, of all, the most important ratio. It is calculated by dividing the Net Profit After Tax (NPAT) by the Equity. The RoE tells you how profitable the company is.
The Net Profit Rate (NPR) shows what margins the business is achieving. It is calculated by dividing the NPAT by the Sales figure.
The Current Ratio (CA/CL) shows the current assets ability to cover for current liabilities. It is calculated by dividing the Current Assets by the Current Liabilities. A proportion of 2/1 is desirable.
Earnings Per Share (EPS) is not a ratio. It’s made of the NPAT divided by the number of shares outstanding in the company. Once you know the EPS, though, you can compare it with previous years EPS.
To find out the EPS growth rate you would have to use compound interest calculations. Such, though, is out of the scope of this article.
To find out free financial data for your company you can use this web address: http://money.ninemsn.com.au/shares-and-funds/research-a-company/intro.aspx?subsectionid=4060&inforeq=Overview. All you have to do is enter the company name or its three letter ASX code.
Styles of investing
The most basic principle of investing is to buy low and sell high. Some people, judging by the prices they pay, need remembering this principle. In fact, if you buy high, there is only a speculative possibility that you will make a gain.
The next basic principle of investing is that there are no free lunches. If someone is offering you something, he must be getting something else for it, be it in the form of money or risk.
There are different styles of investing. I will approach two: investing on trends and contrarian investing.
Most people invest on a trend they spot. Say Rio Tinto Limited has been going up for the last three days, and they buy. Conversely, if it’s going down, they sell. The problem with this style is that you have to detect the trends in order to take advantage of them. That, though, is not always linear.
The other problem is that, you must, in addition to spotting a trend upwards, identify its highest point in order to sell and make a gain. This might be hard to achieve.
The other investment style is the contrarian. The contrarian is someone who buys when prices of chosen companies fall. The contrarian sees value in some business and is happy to buy them at low prices, typically when they fall. This investment style, though, is only suitable for single minded people.
Fundamental and Technical Analysis
When you want to know in what company to invest, what you do? There are two approaches: fundamental analysis and technical analysis.
Fundamental analysis is based in finding out the characteristics of a business proposition, its product, its management, its goodwill, its financial characteristics. Fundamental analysis may also take into account the economy as the context where business operate.
Technical analysis or Chartism is based on deciphering trend lines in the share price history of a company and then projecting them into the future to determine future share prices. Technical analysis makes many assumptions such as that information in the stock market is reflected efficiently and rationally in the share prices, something which may not verify.
Value Investing
Value investing is based in finding the intrinsic value of a company and then buying it for a price much below such value. Value investing concerns therefore with determining a company’s value, which is distinct from its price. This difference constitutes a margin of safety.
Ben Graham started value investing during the great depression of 1928. These days it was possible to find companies trading for below their working capital (cash plus receivables and inventory) and Graham would buy them. He would then hold them for some time expecting its price to match its value.
To calculate a company’s intrinsic value, its cash flows are projected ten or more years ahead and then discounted to their present value. The details of this calculation are beyond the scope of this article.
In terms of value investing, when you buy a company for a price above its value expecting it to go even higher, you are speculating, not investing.
Ben Graham most prominent book is The Intelligent Investor, which had four editions, is published by Harper Business and whose ISBN is 0060155477.
Growth Investing
Growth investing is based on finding and buying a business which has a competitive advantage which will allow it to grow considerably in the foreseeable future. The growth investor is prepared to pay a fair price for an excellent business.
The current exponent of growth investing is Warren Buffett. Buffett started by working with Graham and being a value investor. He then realised that some business, not matter what, would just always under perform. This set him to discover businesses with a competitive advantage and to invest in them.