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Fundamentals of Investing in the Stock Market

Posted by Ben Isley on May 21, 2020

Investing in the stock market is a tried and true long-term investing strategy. There are many different ways to trade the stock market. In this article, I’m focusing on the long-term perspective of saving for retirement.

At the time I'm writing this article, it's May 2020 and the Coronavirus crisis is in full-force. For a stock market investor, this is a period of huge discounts on some great long-term investments. We're seeing older generations take their money out of the stock market and younger generations are seeing this as an opportunity to jump in. The fall in the stock market as a result of the Coronavirus crisis is seen as an opportunity to enter the stock market for the first time after many younger generations have been sitting out the last 10 years of unprecedented growth and consistent all-time highs.


Before we get started: regardless of your investment vehicle, monitoring the economy is always wise. Changes in tax law, developments in technology, significant changes in corporate strategy, and unemployment rates can all influence the value of your portfolio - or provide signs that the market value and intrinsic value may change, for better or worse. When you’re self-directing your investments, you absolutely must be consistent in monitoring the global economy and developing news. I have learned this the hard way. There have been companies that I spent countless hours digging for, invested at the correct time, and ended up neglecting their progress and news around their activity which led to me ultimately missing out on huge gains. From this experience I have learned that there are two things necessary to be successful investing in the stock market: 1) Develop a plan and stick to it - not just for buying targets, but set a target time for holding and a target price for selling. Or hold until retirement and 2) Keep an eye on the share price. Make strategic smaller buys as the price goes up, and if the price dips, dump more cash in.

Those two points are very important, but you may be most successful if you treat the stock market like a part-time job. Don’t buy like a part-time job, but you must read and research like a part-time job.

Dollar-Cost Averaging

The stock market is notoriously volatile from almost every perspective other than the long-term of saving for 20+ years to retirement. 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.

With dollar-cost averaging, your recurring investments result in a lower number of shares as the price increases and a higher number of shares as the price falls. Your average cost per share changes with time - sharply at first because their weight is lower, and as time passes, the change will be less noticeable. When using this strategy, it’s important to note that it’s popular to make your initial investments larger, because we’re operating under the assumption that the economy and stock market as a whole will consistently and continually rise.

Dollar-cost averaging by definition would state 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 your strategy, you’re looking to both drive down your average price per share and increase your total position in a company you trust.

Exchange Traded Funds (ETFs)

ETFs are an investment vehicle that I find extremely interesting. The following paragraph is ETFs in a nutshell, you must understand this before going forward. 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 passive management results in lower fees and operating costs.

Diversify across many companies with a single purchase.

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 VR industry, the clean energy industry, and hospitality and tourism industries, to name a few. ETFs can also be specific to small-, mid-, and large-cap stocks. 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.

Individual Companies

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 high P/E ratio, meaning that the stock’s value in the market is high relative to its actual earnings. This is typically because the earnings are growing quickly. In growth companies, management tends to reinvest earnings rather than pay a dividend.

What about companies without much history?

Whenever I’ve asked this question about a company, the reason I’m usually on that company in the first place is because improvements or innovations in technology are creating new markets or entirely shaking up 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.

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, or confidence that the company will exceed its current valuation simply by continuing on its current trajectory. 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…

one-does-not-simply

...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.

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

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. In the past 10 years BAC has been trading in the $17 - $35 range and pays a dividend.

Cisco (CSCO): Cisco has a worldwide presence in computer networking systems. Internet use is only growing and one can only imagine how important this market share could become for Cisco in the future.

Dividends/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 companies, telecommunications, food, and distribution industries can provide you stable returns no matter the state of the economy. Investing for dividends and investing defensively are generally synonymous - companies in the industries above are generally resistant to market fluctuations and pay dividends.

These are generally the safest companies and are considered mature, those that have established track records of stable and reliable earnings and steady increases in earnings. Sustained success overtime means company leadership fine tunes strategies for the constantly changing economic times.

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 hefty, steadily increasing dividend.

Wrap-Up

The categories described above are traditional - there are many different ways to classify a company. At the end of the day, it’s important to consider the current market price of the stock vs. the value of the company. Either the company is undervalued by the market now or the company 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.

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Topics: Investing, Foundational, Lifestyle, Stocks, ETFs

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