Written by: on , Information Verified by a CPA.

Fundamentals of Investing in the Stock Market

11 Min read

Topics

, , , ,

Table Of Contents

    This post is looking to cover the tools and framework necessary for any person to develop confidence in generating safe and reliable growth over years in the stock market. I have included tons of links to short YouTube videos and blog articles that explain things better than I would.

    In the 1970s and 1980s, Peter Lynch was advocating for the participation of individual investors in the stock market. He believed that individual investors had all the tools for large gains. Today in 2020, we have the internet and commission-free trading. There’s no reason individual investors can’t outperform the market, but clear principles and goals must be in place and a plan must be developed and followed.

    The building blocks for financial security and independence:

    1. Dave Ramsey principles of debt management and emergency fund cash savings
    2. Additional cash savings placed in an asset

     

    The wealthy put their money to work by buying assets. Purchasing a share of stock is trusting that the company can grow your money better than you can. You're exchanging your cash for a slice of the company. The stock market allows average individuals to participate in the growth and profits of larger companies.

    Education

    “I have never succeeded very much in anything in which I was not very interested. If you can’t somehow find yourself very interested in something, I don’t think you’ll succeed very much, even if you’re fairly smart.”

    • Charlie Munger, Berkshire Hathaway

     

    Invest in companies that you know, the industries and products or services that are familiar and hold your interest. This is your circle of competence. You have conviction in the direction of the industry as a whole, and you have a company that is prepared to continue leading the direction of the industry. 

    Figure out which sectors, industries, and trends you follow, know a bit about, and interest you. Information and accessibility to the stock market has been democratized.

    The information in this post isn't just pulled out of my head. It's largely a collage of my takeaways from studying legendary investors.

    I have listed some individuals and content producers that provide solid and interesting information about the stock market. Learn their philosophies and principles by reading and watching them. Takeaways could be anything from your comfort level with risk, your timeline, new areas or concepts you may be interested in, and your circle of competence. Similar to learning any new subject, if you hear a phrase, term or concept that’s unfamiliar, take a sidebar on your research and figure out what it means.

    Individuals

     

    YouTube Channels

     

    Websites

     

    Example: You see P/E ratio mentioned in several articles, so you go to Investopedia and read about P/E ratio. Through this, you’re exposed to many other ratios and indicators that investors use, such as the Buffet Indicator and the Schiller P/E Ratio.

    Example: You watch a video comparing dividend paying stocks, but you don’t know what dividend yield is. So you search specifically for dividend yield to understand that dividend yield is the percentage of the share price paid out as a dividend over the course of the year.

    Example: You watch this Ray Ralio Bloomberg interview and learn that he’s investing heavily into international emerging markets, China, and gold because he believes the dollar is under a real threat as the reserve currency.

    Example: You may listen to this presentation by Cathie Wood about the five platforms of innovation in the world today and begin considering what that disruption means for their industries in the stock market.

    Example: You may be looking to learn about diversification and risk with a video like this, and hear that Ray Dalio's opinion is 10-20 companies or funds, with low correlation, is a balanced portfolio with low risk. You may agree or disagree, but you understand his reasoning.

    How to Buy - Dollar-Cost Averaging vs. “Buying the Dip"

    There are so many different factors that can influence the market price of a publicly traded company. The popular theory of dollar-cost averaging states that it is more prudent to invest consistently in smaller increments than it is to invest in one large lump-sum at one time. Doing this spreads out your risk and smoothly averages out your position as opposed to being locked in to an average cost per share that will be very hard to adjust.

    Dollar-cost averaging states that you invest a fixed amount of money on a regular basis. Instead, many investors tweak that strategy a bit. If you choose a great company, and its price doesn’t ever decline, you’re continuously buying more on the high side. When dollar-cost averaging, make sure you pounce with larger investments once/if the stock price drops below your average price per share. Ultimately, regardless of the frequencies of your buys, you’re looking to both drive down your average price per share and increase your total position in a company you trust.

    “Profits are made in the buying, not in the selling.”

    • Robert Kiyosaki

     

    Purely buying the dip would be pooling your cash and buying in bulk when the market is falling. It’s likely that a combination of these two strategies is ideal, especially if you're plugged in to the market. As the market rises, it’s still wise to invest consistently and cautiously. However, when stocks go on a flash sale, a lump-sum of cash is important to grab companies at a discount.

    Broad Categories of Stocks

    Investors are searching for companies that have a strong potential for future growth, earnings, and market share. This could be tied to emerging markets, dominant companies in established industries, technological developments, and growing companies that have contracts with key industry players, among a huge list of indicators that a company may be a solid long-term investment. In the sections below I describe the traditional classifications of publicly traded companies.

    Growth

    Broadly, companies classified as growth stocks can provide you the highest returns and they also come with the highest risk and volatility. Growth stocks traditionally have a higher P/E ratio, meaning that the stock’s value in the market is high relative to its actual earnings. Investors are paying a premium for a share today with the expectation of large future growth. In growth companies, management tends to reinvest earnings rather than pay a dividend. Disruptive and creative companies may experience years of slim profit margins, but investors may still flock to the stock due to the revolutionary future potential of the company.

    We’re currently in one of the busiest times in history for industry-disrupting technology. Innovation is creating new markets and revolutionizing existing markets. Investors in growth stocks usually see a huge long-term potential, even if this means short-term operations or financial position may be shaky.

    The future of technology and dominant industries is very interesting and difficult to accurately project. ARK Invest is leading the way in this area and their recent performance proves it.

    Examples of Growth Stocks:

    Tesla (TSLA): Tesla does several things that are typical of a growth stock. They reinvest earnings and they develop unique, market-disrupting technology and hold patents for their creations. Clearly, many investors believe Tesla has incredible long-term potential to influence both the automotive and energy industries.

    Stmicroelectronics (STM): In 2016, this company was trading at about $7 a share. It was announced that they entered a long term contract with Apple to develop a few key components for new iPhones. Investors who caught this news and purchased STM at $7 a share see a return of about 250% today to $24 a share. Now this likely isn’t the only reason STM has grown over the years, but monitoring technological development and the contracts that key industry players like Apple have with smaller upcoming companies is an example of keeping your eye out for potential growth stocks.

    Amazon.com, Inc. (AMZN): Amazon is a hallmark example of a growth stock. Amazon exhibits a telltale sign of a growth stock: management spends significant time and money on expanding... aka growth! Bezos is known for being relentless and is always expanding into new markets.

    Value

    At the heart of value investing is the knowledge that a company is undervalued by the market. According to Warren Buffet, value investing generally involves buying when others are looking to sell and selling when others are looking to buy.

    The nature of investing in value stocks is accurately determining that a company is undervalued by the market. This can be very difficult, and many investors begin by looking at companies of the same market and size, then find which companies trade at a comparatively lower price. From there, true value stocks will often have a low P/E ratio, low amounts of debt on the balance sheet compared to others in their industry, and likely have some event(s) that have negatively influenced the public perception of the company.

    One does not simply just find value stocks, this is very difficult to do. To find growth stocks, just start by going to the technology sector. Dividend and defensive stocks are even easier to find. Value stocks, however, are very tough to pin down. If everyone knew a stock was undervalued by the market, it wouldn’t be undervalued by the market for long.

    Over time, we’re assuming that companies will be priced accurately based on their true value.

    “In the short run, the market is a voting machine. In the long run, it is a weighing machine.”

    • Warren Buffet

     

    Example of Value Stocks:

    Bank of America (BAC): Bank of America is one of the largest banks in the world and ranks in the top 2 in the United States for deposits, small business lending, and home equity loans. Bank of America isn’t going away anytime soon, and it's significantly less volatile and trades comparatively cheaper than other banks.

    Cisco (CSCO): Cisco has a worldwide presence in computer networking systems. As the hardware, software, and pricing landscapes change, many investors have turned on Cisco. Their success over previous decades means they need to pivot and reevaluate their revenue mix.

    Intel (INTC): Intel has lost it's status as the No. 1 chipmaker and has been losing market share to companies such as Samsung, NVIDIA, and AMD. However, the financials are very healthy and the company is generally quite profitable because of their vertical integration.

    Defensive

    Investing defensively may be the safest way to ensure you don’t lose in the stock market. These companies are very popular among those wishing to set themselves up for decades to come. Gains may not be as significant as other strategies, but investing in the utilities, energy, telecommunications, food, and distribution industries can provide you stable returns no matter the state of the economy because they provide essential services.

    These are generally the safest companies and are considered mature. They have established track records of stable and reliable earnings and steady increases in dividends.

    Depending on the size of your holdings, you can even receive material quarterly cash flow from these investments in the form of dividend distributions. Dividend yields and dividend payment history are public information, and dividends are paid on a per-share basis. 

    Examples of defensive, dividend-paying stocks:

    Home Depot (HD): In addition to providing warehousing and sales for construction, building, and home improvement materials, Home Depot has also transitioned nicely to e-commerce by improving their distribution. They also operate in a mature market and construction materials have historically been recession-resistant. They aren’t at risk to lose their market share to a new competitor in the space. Their dividend also steadily increases.

    Waste Management (WM): This one is relatively straightforward, everyone needs garbage removal. Similar to utilities, this is an essential service. They have a huge customer base in several countries, a large fleet and fully developed infrastructure, and do much more than just dump garbage in landfills. They handle all aspects of waste processing, including the interesting relationship between waste disposal and energy creation. They also pay a dividend.

    Duke Energy (DUK): Some may classify Duke Energy as a growth stock because it consistently outperforms the S&P 500, but for illustrative purposes, I think it belongs in the defensive category. A very strong utility company that continuously improves and has grown to serve customers in six states. They also pay a steadily increasing dividend.

    Exchange Traded Funds (ETFs)

    ETFs are an investment vehicle that I find extremely interesting.

    You diversify across many companies with a single purchase into a single fund.

    The following paragraph is ETFs in a nutshell. The concept of an ETF is nothing new - a grouping of securities or similar assets into a single offering, where the purchase of the single offering offers exposure to all of the assets contained in the group. This concept of index investing takes many forms, such as mutual funds or closed-end funds. ETFs are unique in that they are actively traded on the stock market, completely transparent in their holdings, capital gains taxes are only incurred upon sale, and their (generally) passive management results in lower fees and operating costs.

    ETFs are managed by finance professionals. Vanguard is historically and currently one of the most popular managers of ETFs and is regarded as an authority on these funds. ETFs are a relatively new investment vehicle and investment into ETFs has been on a historic tear since their inception. In 2000, roughly $100B total was invested in these funds. Now, in 2020, we’re pushing a $4T total investment in ETFs.

    ETFs began by tracking the S&P 500 - now, ETFs exist for almost any investment strategy or industry you could wish for. There are ETFs designed specifically for growth, value, and dividend stocks, and even bond markets and specific countries. There are ETFs that track the mining industry, the airline industry, tech companies, the gaming and eSports industry, the clean energy industry, and hospitality and tourism industries, to name a few. You can find an ETF for literally anything. ETFs can also be specific to small-, mid-, and large-cap stocks. More examples include German small-cap companies, Indian companies, emerging global markets, mature global markets, U.S. value companies, gold, internet companies, robotics.

    Now in 2020, any investor can likely find an ETF to fit their needs and diversification goals.

    Once you’ve found an ETF that sparks your interest, consider using a free tool such as ETFdb.com or etf.com to further analyze the fund. Begin looking at the holdings, P/E ratio, and dividend payout.

    Looking into the top holdings of successful ETFs is also a hack to finding good companies. For example, you may look at ARKF and realize that Square is a great investment. You could look at the iShares Value ETF and see that Cisco, Johnson & Johnson, Walmart, and telecommunications are good starting points for identifying value companies.

    Wrap-Up

    In picking a winning stock, the company is either undervalued by the market now or will grow to dominate its sector(s) in the future. When investing for decades, it’s important to also look forward. Analyzing broad societal trends, such as how we consume food and energy, can shed light on the fact that certain traditional key industry players may fall and be replaced by entirely new companies. Following technological developments can also uncover companies that may be relatively young but are going to stick around for the long-haul.

    Feel free to reach out to me on LinkedIn with any comments or questions!

    Disclaimers

    No Rendering of Advice
    The information contained within this report is provided for informational purposes only and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. Presentation of this information is not intended to create, and receipt does not constitute, a tax consulting or advisory relationship. Readers are advised not to act upon this information without seeking the service of a professional tax and/or financial planner.
     
    Accuracy of Information
    While we make reasonable efforts to furnish accurate and up-to-date information, we do not warrant that any information contained in or made available through this report is accurate, complete, reliable, current or error-free. We assume no responsibility for any errors or omissions in the content of this website or such other materials or communications.
     
    Disclaimer of Warranties and Limitations of Liability
    This report is provided on an “as is” and “as available” basis. Use of this report is at your own risk. We and our affiliates disclaim all warranties. Neither we nor our affiliates shall be liable for any damages of any kind due to the use of this website.

    Recent Articles

    ★★★★★

    After working with multiple CPAs, we didn't think we'd ever find the right one. However, working with The Real Estate CPA was easy, quick, and efficient. They answered all our questions till we understood, this is exactly the kind of relationship we were looking to build with our CPA so that we can grow our tax knowledge.

    Dominic and Jessica Franco - Business Owners