This time I wish to take a break in writing crypto articles and write about how I invest in stocks, instead. My intention of this article is to target beginners who wish to understand stock investing. For those who are considered experts, you may skip this article if you want to. Else, feel free to read.
How I Invest In Stocks
After learning about stock investing from my mentor and also read about Peter Lynch's book 'One Up On Wall Street', they make me have a better understanding of stock investing to the point I created my own style of investing. My style is short and simple as it only consists of 4 factors to consider and they are:
- logical thinking
- business mindset
- mathematical
- understanding the market volume
Logical thinking: What I mean by this, is to logically think of a product that would benefit people, discreetly important, and easier to understand its application. For example like WD40.
In my country, normally when we have a creaking door hinge, the first thing in our mind is to apply WD40 to the door hinge so that it will stop creaking. That's the kind of product I would love to invest in:
- a product where it benefits people
- it's essential yet not many aware of it as it is too small/ tiny to realize the impact (would elaborate further in Business mindset)
- it's easier to understand its application.
How do I normally do my logical thinking? I would simply observe everything around me, take note of the products that caught my attention, keep them in mind, and once I'm homed, I do my research on companies that sell such products.
Business Mindset: Now, doesn't mean a product that I find beneficial to people would be profitable. Hence, the next thing I would do is to analyze the product from a business perspective.
Take example as an airline; it is beneficial for the whole world as it provides transportation for the population to travel from country to country in a shorter period but to be frank, seldom airline business is profitable due to its high operating cost (I studied aerospace engineering and currently working for aviation company thus I have the edge about the business).
What I mean by business perspective is to state:
- the demand for a product
- the sales of a product
- the cost of producing a product
- the cost of operating a product
- the profit margins of a product
Now, let's go back to logical thinking as to why I prefer smaller essentials rather than those big and complex products? It is due to the cost. The bigger a product, the complex to produce and operate, the higher the cost. With such a product, despite there's a demand and also growing sales, but due to the high cost, it will eventually take the profit by so much. Here, we could take the example of the airline business where it requires a huge amount of capital to pay for repairs & maintenances, fuels, leasing, employees' benefits, compensations if an accident occurs, etc. With such amount of expenses as those, it's very risky for a company to sustain itself.
Thus to me, the smaller essential is always better as it also has demand which will drive the sales and at the same time, cheaper to produce & operate which later drives up the profit margins. When a company is profitable, logically it will stay for long.
Since we already understand the concept of business perspective, the next thing is to spot consistency in a company's business. My way of viewing consistency is by looking at these few factors:
- a product with constant or high demand yearly.
- a company that generates constant or increasing sales.
- a company with higher sales and an acceptable amount of cost of goods sold to generate higher gross profit.
- a company with a higher cost of goods sold and lower ending inventories. this is to state that the company able to sell more of their products out of their inventories and demand is maintained.
- Decreasing operating expenses.
- consistent gross, operating income, and net margin.
True, what I have stated above can be stated as a little too exaggerating as there is no such company that would ace almost all the time. Business is business, there are always ups and downs in every business; even Amazon has faced such setbacks along the way. Thus the reason why I rather state consistency than increasing results.
Why would I want to know such factors above? Again, logical thinking; since I'm investing, I definitely would want to invest in a company that stays for long. In order for a company to exist in a longer timeframe, it has to keep on making money yearly (LOGIC!).
Now; making money yearly isn't enough. For example like us; we can earn so much money but as long as we mismanage our finances, in no time, we would face a financial crisis. The same goes with a company. A company with higher sales or manage to achieve high results for the factors I stated, it is still pointless if the company is heavily in debt or mismanaged its finances.
Thus; after looking at the business side of a company, the next thing I would want to know about is the company's debt.
"Is there any long-term debt? If there is, is the long-term debt increases or decreases? If it increases, to what reason? is the company able to pay its debts? how?"
You can read up about a company's debts by reading its financial statement. If you wish to know more about their debts, you may read its' annual report. To me, I won't take too much time in such cases. So long as there's a huge amount of long-term debt, I would skip the company. To me, it's risky to invest in such a company (again, to one its own). Or if I still insist to invest in such a company, I would want to see a decrease in its long-term debt every year. This is Peter Lynch's style of analyzing a company's finances.
Mathematical: After tackling the business side, the next thing I would do is some mathematical calculations. Don't be shocked about it as this is not the kind of mathematics where you have to solve Algebra or some sort. What I mean by mathematical calculation is to understand the price you're paying for a company's stock in relation to its underlying businesses. To simply put, calculating the valuation of a company's stock with the use of these metrics:
- Price to Earnings Ratio (P/E)
- Price to Sales Ratio (P/S)
- Price to Free Cash Flow Ratio (P/ FCF)
There are other metrics you can use but for me, I prefer to look at these 3 often.
Among these 3; I would like to emphasize more on P/E especially after I found out that many would ignore it. True, P/E alone can't determine anything but you have to understand how to really use it to see a clearer picture.
For example; I bought a stock with a P/E of 40 and that usually means that I'm paying 40 times more of the company's earning. But there are two ways to see it. One, we can take a P/E of 40 as 40 years.
40 = P / E
40 = 40 / 1
Hence, for a company to become a $100 billion enterprise with a P/E of 40, the company has to earn $2.5 billion constantly for 40 years to reach that valuation.
Allow me to do the calculation as simple as I could:
40 = P / E
40 = 100 / E
40E = 100
E = 100 / 40 or 100 divide by 40
E = 2.5
It seems fair enough but the problem is, is it even possible for the company to achieve $2.5 billion every year, knowing the fact that there's no guarantee a business will stay booming constantly every year. If it's possible, then a P/E of 40 is fair valued. Else, it's overvalued.
Another way is:
Let's say I bought a stock with a P/E of 50 and that means I'm paying 50 times more than the earnings. Since P/E is 50, that means a company has to maintain its earning of $1 to maintain at P/E of 50.
P/E = 50 = 50 / 1 or 50 divide by 1
Now, what if the P/E drops to 25? Here's the calculation to have a clearer picture:
50 = 50 / 1
50 / 2 = (50 / 1) / 2
25 = (50 / 1) / 2
25 = (50 / 1) x (1 / 2)
25 = 50 / 2
Hence, 25 = 50 / 2 = P / E
To put it in words, now the company has to earn $2 when the previous P/E of 50 drops to 25. In which to state, compare to the previous P/E, the company now has to earn double.
Again, it seems fair but is it logical? knowing the fact that now the company has to earn double? does the company has what it takes to earn double this time? what if the company only able to earn just $1 earnings? or worse 0.50? Think about it.
Thus from here, solely on P/E alone, we could evaluate the price we're paying for the stocks. With P/E, it helps us to see the bigger picture as to whether a company is able to keep up its P/E with its earnings.
Topic about high P/E: There's no right or wrong answer about buying high P/E but again, the goal of stock investing is to achieve higher ROI in a shorter period.
Now, if you buy stocks with high P/E, you need the stocks to go even higher so that you could gain profit or increase your ROI. But again, what makes you think these stocks will go higher than high? Think about it. Or you can take the example above. a P/E of 50 drops to 25. Why so? That is to state a company can only grow so much to a certain point and eventually, slows down and matures. Just like Mcdonald's. Thus, you must be very careful in buying high P/E.
Understanding the market volume: After describing all the factors to consider in stock investing, finally we have reached the last point (thank you to those who continue to read until this far). Now about the last point, it might confuse you as it doesn't make sense at first but it will after some time.
The last point is, after all the factors I've written above, they're actually mean nothing- to some degree. Why?
That is because the price of stocks is not based on the actual value of an underlying company and its businesses but rather, a speculative value by the market participants.
What it means: Let's called this stock, Orange and it's stock priced at $0.50 per share. Then comes, John, who is one of the market participants (trader/ investor). To him, the current Orange stock is undervalued because he believes it could worth $1 in months' time and so he bought it at $0.50. Now, that's just John. What if there are other market participants that have the same beliefs as John and execute the same action? That whole lot of participants would drive the stock price to $1 as the volume increases, demand increases, and supply decreases. Soon as the stock reaches $1, John and others decide not to sell the stock but rather hold, as they believe it could go even higher.
Then comes, Alice, who is another group of the market participants. This time, Alice believes that Orange stock could worth $2 in months' time, and buying the stock at $1 is a bargain. So Alice and her group decide to buy the stock at $1. However, the supply of stocks pricing at $1 is limited due to John and the group decides not to sell at $1. So Alice and her group, bid for $1.20 instead. In which later John and his group decided to sell the stock at $1.20. Till then, Orange stock now is priced at $1.20.
From here; I can state that it's not about Orange's businesses that drive the stock but rather, due to the increasing demand for the stock. What drives the demand, its due to the speculation of the market participants.
"Then what's the point of me knowing about the company businesses, when it's the market participants who decide the value of the stock?"
You have to understand that the existence of stock is due to the existence of its company, and the existence of a company is due to its businesses. Thus without profitable businesses, the company may suffer bankruptcy. When the company bankrupts, it will be delisted from the stock exchange. When it got delisted, the stock of the company will have lesser value than what you paid for which means you're facing losses.
Thus; that's the reason why it is also important to understand and research a company, its products, and businesses so as to refrain from investing in a bad one.
Now, since I stated that the market participants are the ones that drive the stock; means you have to understand how the volume in the market moves. But how? Technical Analysis.
I understand many would state that technical analysis is a method to time the market but actually isn't. Technical analysis is there to provide you the areas where the buyers and sellers would come in.
"Why is it important to know about their movements?"
My answer to that question is simple; why would I buy the stock at a price where the trend is still bearish? Why would I want to face paper loss at the early stage whereas I could simply wait for the trend to reverse and buy it at the lowest point so that I could gain paper profit once the trend changes?
For example: Let's say I found a stock, research its fundamentals & prospects, calculate its valuation with many metrics, and finalized that the stock fair value would be $1. True, I could just buy the stock soon as it reaches $1. Nothing's wrong with it. But with technical analysis, I able to know that the stock can go even cheaper than $1. So why would I rush and buy at $1 whereas I could buy at $0.80 or maybe $0.50? Do you see the idea?
True, many would recommend dollar-cost averaging; means a strategy that tells you to buy every dip or every month at fix amount. But what if I'm a small investor who has no constant capital to do such a strategy? It would be a waste to buy at a higher price whereas I could buy at cheaper and not miss that extra gain (again, to one its own).
"But technical analysis is complex to learn!"
You don't have to learn the advance or expert level of technical analysis. Just the basics will do such as learning few indicators that would tell you the areas where the buyers and sellers start coming in.
Like when the indicators state that buyers about to come in, that's where you buy. And if let's say the stock you research has its fundamentals deteriorate and now you wish to sell, sell when the sellers about to come in. Simple as that.
Now; I have finally covered all the factors to consider for stock investing in my style. I hope readers could learn 1 or 2 from this long article I wrote. To be honest, this is just 60% or 70%, I wish I could write more but it would be lengthy to read. If you wish to learn more from me, simply contact me instead. Till then, thank you for reading.