Monday, April 14, 2008

Basic Principles of Stock Investing

The Basics of
Stock Investing

Principles of Stock Investing) 

Selecting a Brokerage

Choose lowest cost brokerage.
Generally you want the brokerage that charges least for trades. The only other concern is
the finical stability of the brokerage.
This is to ensure that the broker be able to deliver your money. So you want the cheapest brokerage that seems stable enough to return your money to you in hard times.
A broker’s advice is of little value because the broker’s interests are not necessarily aligned with your interests. Further more keeping in mind efficient market theory, which will be discussed below, it is doubtful whether the brokerage’s advice will help you in anyway.
If the brokerage is a large broker it is difficult for their advice to be of value or to lead to market beating performance. This is because if a large group of investors with a large amount of money decides to buy a stock the stock price will go up. So if a large brokerage firm like Merrill lynch recommends a stock to their clients if will have a short term effect of driving the price up but only the first investors who act on the recommendation will benefit, the great majority will have to pay a higher price for the stock because of the recommendation. Unless you know that you have knowledge of recommendation ahead of everyone else it is of no value. Because of this reality when a large brokerage gives a strong buy rating on a stock it means you have bough this stock 6 months ago.

The bottom line is shop for price. I currently use Brown & Company because Brown & company charges only $5.00 a trade for market trades.

Evaluating stocks
There are only three ways that companies can return money to investors. Companies can pay dividends, they can buy back their own stock and the company can be liquidated with the money returned to investors. These are the only ways that money is returned to stock investors. Investing without focusing on the money that companies pay back to investors is just gambling that there will be a bigger fool to sell to down the line.
Companies can only pay money to investors that they have earned. So earnings are important both current and future earnings must be considered when evaluation stock. But earnings are not the only thing you need to consider, you should also ask yourself whether this company will eventually pay a dividend or buy back its stock in sufficient volume to justify the price of the stock. Some companies have good current earnings and good rapid growth but are in businesses that are temporary in nature an extreme example of this would be the companies who prior to the year 2000 where making their money fixing Y2K bugs. You need consider whether a company's business model will be viable in 15 years, if not the dividend must be big enough to give you not only a return of your money but additionally some extra to cover for the eventual capital loss.
The value of any stock is based fully on the amount of money that is will eventually return to the stock holders. 
How much return is enough?
In economics there is a concept called the discount rate. (htp:// That is the
value of having your money to spending today as compared to having to wait to spend it.
It is considered that it is 3% better to have your money now. So inflation plus 3% is the minimum return one would want on zero risk investment. (Note: no such investment exists although short term government securities, the kind that money market funds hold are about as close as you can get. They still have some risk due to inflation or some major calamity).

When investing, stocks like bonds, are judged by return on investment. For example if a particular stock is currently paying a 3% dividend appears to be able to pay that dividend indefinitely and there is no inflation then that stock is just matching the discount rate.
Beyond the discount rate a good rate of return is based on the return provided the alternatives like bonds, money markets and real estate.
Keep in mind that a stock that is not currently paying a dividend will have to
payout enough dividend in the future to make up for the return that you
are not receiving now.

Before buying a stock try to think of all the things that could make the company’s
earnings fail to reach the level required to produce the returns that you are looking for.
There will always be some things that can ruin any investment even very wise investments.
Examples include:
Economic collapse
Natural disaster
These should not keep you from investing but you should be aware of them
Company specific things that might be enough to keep you away from an investment include:
Is the company running out of market (like in the example above of software companies specializing Y2K fixes)
Limited lifetime demand for the product produced. (IE buggy whips being
replaced by cars).
Lack of franchise products. (What we call "me too" products with nothing specific to differentiate the company from others have little franchise value.)
Rising competition.
Finally a caution about companies that buy back stock rather than paying a dividend is in order.
To calculate the annual rate of yielded from a stock repurchase you must take the annual reduction in the number of shares outstanding and multiply that by the price of the stock. You cannot just look at the amount of money that the company spent on the repurchase. This is because many companies that buy back stock also compensate employees with stock. If they buy back 1,000,000 shares but compensate employees with stock giving them 1,000,000 shares then they have in effect returned nothing to share holders. They have used the money to compensate employees and have done noting for the shareholders.

What accounts for the rise in stock prices over the years

An important question to start off with on this subject is: How much of the stock market gains over the years where due to the increase in earnings and how much due to growth in the average PE (PE = the price of the stock divided by the earrings per share) of stock. Growth in PE indicates a growing comfort with stocks but I would assume that at some point when the long-term return of stocks drops below the discount rate (about 3%.) the growth in PE will stop.
Another factor keeping stock rising is the growth in the population. More customers for coke
means more profits for Coka-Cola (KO).

Another factor is the growth in productivity of public companies?
Another factor is the rate at which public companies have grown in relation to private companies? (If public companies relative to private companies, do a growing portion of business then this can justify a growth rate in stock prices in excess of growth in productivity plus growth in population).
All returns should be measured in fixed dollars that means that each years growth rate should be reduced by that year’s rate of consumer price inflation?

Consider as many of the possible causes of the rise in stock prices as you could discover?
Inflation is due to growth in the supply of money. Deficit spending is only one way that the money supply grows. Friedrich Hayek, he won a noble prize for his is work on the business cycle and money supply.
The 1920s, the 1960s, 1970s and the 1990s where periods of rapid growth in the
money supply.
In the 1960s and 70s money supply growth was driven by Deficit spending.
The 1920s and 1990s money supply growth not driven by Deficit spending but by loose
  monetary policy by the federal reserve.

Each period of increase led to bubbles and crashes.
Money supply is important because more money makes for higher prices, with more money in the economy people can pay more for stock bidding up the prices.
Also on the subject of money supply consider that when money supply increases the upward pressure on prices is uneven and those products with highest demand and least short-term supply elasticity, like oil, tend to rise more than other products and can bring the end to the boom.

Efficient market theory
Be aware of and respect efficient market theory. Over confidence is a great danger for investors. As I heard one famous investor say what makes you think that you can invest better than anyone else.
The Efficient Market Theory says that security prices correctly and almost immediately reflect all information and expectations. It says that you cannot consistently outperform the stock market due to the random nature in which information is spread and the fact that prices react and adjust almost immediately to reflect the latest information. Therefore, it assumes that at any given time, the market correctly prices all securities. The result is that securities cannot be overpriced or under priced for a long enough period of time for investors to consistently beat the average.

The theory holds that since prices reflect all available information, and since information arrives in a random fashion, there is little to be gained by any analysis. It assumes that every piece of information has been collected and processed by thousands of investors and this information is immediately reflected in the price. Studying historical data since past data will have no effect on future prices cannot increase returns.

So if Efficient Market Theory is correct or close to correct and it deserves “great respect” why shouldn’t I invest in a index mutual fund?
The following are some reasons why I think that despite efficient market theory investing in individual stock rather than index mutual funds can be worthwhile:

a. Because the .5% cost that index mutual funds charge is high. For a portfolio valued at
$100,000.00 a .5% cost is $500/ year.
At a cost of $5.00 per trade that is 100 trades a year that is allot of cost.

b. I believe that at times the market can be beat. For example in the year 2000 it became obvious that the market was a poor investment.

Note: This does not mean that it could not have gone up but that the return as noted above was very low.

c. Even if the market cannot be beat it is fun to try.

Risk aversion verses ignorance of the risks

Sociologists who study such things tell us that people are naturally risk averse. So why do so many people blindly take huge risk in the stock market?
Sociologists study people’s aversion to risk by making simple models where the subjects in the study understand the risk.
In contrast many people invest in what they see as sure things. In this case they are taking on huge risks but they think that they are not taking much risk at all.

In the case of the stock market the longer a bull market lasts the more comfortable people become with the market. Even though the market gets riskier and riskier the higher it goes, people's perception of the riskiness of the market is diminished because looking backward it looks less risky. Thus due to ignorance the riskier stocks get the more likely the risk averse are to invest in stocks. This is the explanation of the paradox of if people are risk averse why do they take such great risks in the market.
To lessen the risk of the market you must evacuate stocks based on returns. You should judge your investing on the returns that it produces rather than the value of your portfolio. 

Profit margin and economic problems

The profit margin of a company effects its valuation because in a recession companies with wider margins will generally be more able to last out the recession and recover market.
Economics pages and principles verses stock information.
I find the economics web pages much more objective than the stock web -pages


If a balanced coin is flipped 49 times and every time it comes up heads what are the chances that it will come up heads again? Well we should all know that the answer is: it has a 50% change of coming up heads.

Have Realistic expectations

One of the surest ways to get scammed it to have unrealistic expectations. Always respect efficient market theory. With the discount rate of 3% plus inflation 4% plus inflation is a good return 25% above the discount rate return.


The demographic argument is that the aging baby boomers may pull their money from the market creating a long down turn. This should increase the caution with which one engages in the stock market during this ore baby boomer retirement period. Caution even more highlights the need to focus on divided as the return from stocks. Seniors needing money to live on are more likely to hold onto dividend paying stocks beyond the retirement age. Also if the stock is paying you a good dividend and you view dividends as the end (rather than price appreciation) you should be in a much better position to just sit back and collect dividends.
Balance your portfolio with “puts”
A “put” is an option that bets that a stock fall in price below that specified, “strike price” by a “strike date”. Puts can be bought and sold. An alternative to the put is to write a covered call. When you write a call you are selling a “call”. A call is a bet that a stock will rise above a given “strike price” by a given “strike date”
believe that as a hedge against a general market downturn investors should include some down positions in their portfolios. If the S & P 500 drops 20 percent in one day it is comforting to watch the value of your puts rise.
I like to buy puts on story stocks. Companies that unlikely to even make it to profitability. Using puts rather than “shorting” the stocks limits you liability for the occasional case where one of these story stocks does become a great success.