There are two ways to invest in the stock market. The first way is to invest to get the market average return of 7%, which is the S&P 500. The second way is to invest in individual stocks to outperform the S&P 500 index.
***If you have specific inquiries or anything in my post that I can help clarify, please feel free to comment or email me.
1. Decide if you want to put in the time to beat the stock market average returns (Week 1)
Passive investing- The goal of passive investing is to achieve average stock market returns. The average return over the last 100 years in the stock market estimates 7% – 8%. To start passive investing you want to buy a mutual fund or ETF that represents the S&P 500. These mutual funds and ETF are provided by Robo-advisors or standard investment advisors.
- For Passive investors, you only need to go with low and cheap online services (i.e., Vanguard and Fidelity), robo-advisors (i.e., Wealthfront and Betterment), or anything that has management costs below 1% of your total asset value.
- A note about indexes: The S&P 500 represents the largest 500 companies, therefore, it’s often used as a proxy benchmark for the US stock market performance. Other indexes represent niche industries or smaller size samples. For example, the Dow isn’t a great representation of the overall stock market because it includes 30 companies, so it’s just a small cross-section of the thousands of companies in the market. This is the reason why the S&P 500 is used as the standard benchmark instead of other indexes.
- Passive investment services are easy to understand and they provide straight forward questions to help you set up an automated diverse portfolio to the S&P500 that would provide you an avg or slightly above average market returns.
- A note about Robo-advisors: Their financial method uses algorithms to replicate the average market returns of the S&P 500 index.
If you want to be a passive investor, you would only need to seek out cheap and simple services that can provide your returns similar to the S&P 500 index. These services are cheap because it replicates the S&P500 and other indexes.
Active investing- The goal of active investing is to pick stocks and beat the stock market average, which is the S&P 500. Active investment requires putting in the time to research and analysis. In becoming an active investor (or the DIY approach as I like to call it) you will want to learn key aspects to analyze a stock and strategies to develop above the stock market average.
- Learning about an industry, company, and competitors
- Learning about investment strategies can outperform the average return
- Learning how to read and create financial statements
If becoming an active investor is the path you want, then continue reading.
2. Start by reading about industries and companies you’re most familiar to you. (Week 2)
Determine a business industry that is easy to understand. The easiest industries to learn are from your profession or products you purchase.
For example, an Apparel company has simple operations. Apparel makes clothes that offer branding value with unique design distinctions. The Apparel industry is a multi-billion-dollar opportunity, but it is a very competitive industry. Apparels can offer their goods in physical and/or digital distribution channels. One of my favorite Apparel business is Under Armour.
In the beginning, learn general facts and find interesting facts on this business. Ask critical questions because if you don’t have enough confidence in your research you could cost your total life savings. But don’t worry, this should be a fun process. It’s like finding the perfect ingredients for a recipe so that you have an enticing outcome! Read everything you can on the company’s merchandise, management, and business risk. It may be tempting, but for now, let’s hold off on the financial statement. We should uncover the basics about the company first. Once you have learned about the company, the financial results will make sense.
Here are some initial questions I might ask about Under Armour:
- Why is Under Amour (UA) a better investment than its competitors?
- What makes UA better than other Apparel businesses?
- Does UA have any patent on their clothes and shoes?
- Who manufactures UA clothes?
- Is there a contract, partnership from the manufacturer?
- Why was this manufacturer selected?
- Who are UA shipping partners?
- Is UA shipping partner contract?
- Why does UA have its own stores?
- How many stores does UA have?
- How many retail partnerships do they have?
- Did Under Armour ship it from a warehouse, and which warehouse?
- How did they decide to pick this warehouse?
- Where were the clothes made?
- Who designs UA’s clothes?
- What is the designing strategy, are they into athleisure or not?
- Who’s the design team leader, how long did they work at the firm?
Notice that I did not list any financial or math-related questions. The point of this exercise is to get familiar with the industry and business. As you are learning, there will be more financial jargons and it will get more confusing. Do not be discouraged. If it is confusing, you are learning.
3. Learn about investment strategies (Week 3)
While there are many investment strategies, the best strategy to get an above-average market return is to buy undervalued companies, which is called Value Investing.
Also, value investing strategy provides a strong foundation for an investor to learn about other investment strategies. Value Investing is a popular strategy that created many billionaire investors, to name a few, notably Warren Buffet, Seth Klarman, and Bill Ackman.
What exactly is value investing?
Value investing is identifying companies with a current market price that is less than their intrinsic worth, which means the stock or company is “undervalued”.
How do I determine a value of a stock and know if a stock is undervalued?
The Discounted Cash flow – this method provides the net present value by estimating the company’s future profitability to help determine the company’s values. The discounted cash flow will help provide a range of value to the entire business.
Another way to find Undervalued stocks is by using the valuation ratio. A valuation ratio shows the relationship between the market value of a company or its equity and some fundamental financial metric (e.g., earnings). The point of a valuation ratio is to show the price you are paying for some stream of earnings, revenue, or cash flow (or other financial metric).:
- Price/Earnings – The historical average of the S&P 500 index P/E is 15, therefore anything under 15 could be considered undervalued relative to the historical average of the S&P 500 index.
- Price/Book – Price is the stock’s current market price. Book value represents what the total asset of the company is worth. So if the price of a company is worth $100M, and the book value is worth $110M, you will see a P/B= .90 ($100M/$110M)
Not all undervalued stocks are good investments, there are companies that may reflect undervalued but aren’t performant, and stay that way. We call these value traps. A value trap will have a valuation that appears cheap, but it has risks and troubles that will cause the company to continue declining.
Understand why stocks become undervalued
- Missed expectations and lower guidance: Shares can plunge if the company provides quarterly and annual reports that misses target earnings or provides guidance below Wall Street estimates.
- Market crashes and corrections: If the entire market drops, it’s a great time to look for undervalued stocks.
- Bad news: Just like when a stock misses analysts’ expectations, bad news can cause a knee-jerk reaction, sending shares plunging more than they should.
Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Sectors that are out of favor are good places to look for bargains. Again, not all out of favor sectors will ever return back to normal business operations. Think about how often restaurants and the retail industry go out of business.
Tesla stock priced at $200 could be a value stock as Apple is a value stock. Investors underestimated the technology and complexity of Tesla, comparing Tesla to other traditional auto companies. Similarly, it is much like how investors compared Apple’s iPhone to BlackBerry Rim. Investors underestimated the software, ecosystem, and design.
If you could buy a $100 bill for $70, wouldn’t you jump at the chance to do so? While value investing is a little more complex than that, it’s the general concept behind finding undervalued stocks for your portfolio. Value Investing is not the only investment strategy, but it is the most simple, and the most difficult strategy to master.
4. Learn how to read financial statements and how to create it from scratch (Week 4)
Financial statements will be disconcerting to learn. If math isn’t one of your strong skills, it will be more difficult. But, most of the investment math is simple algebra. If you cannot interpret a financial statement well, don’t rush to buy stocks. Start a stock account with only the amount that you can afford to lose, but still assert the same spending habits. The amount of money you need to buy an individual stock depends on your investment experience and skills.
How do you know when you are fundamentally ready to invest?
- Q: Can you identify seasonality in a financial statement?
- Q: What happens to cash flow if customers are paying with credit cards instead of cash?
- Q: How much profit does a company have to pay off its current debt obligations?
- Q: Can you teach someone how to read a financial statement?
Learn how the financial statements are connected. If this financial statement is confusing to you, email me at TomNguyen@agarwoodcapital.com for investment courses or learn from the investment videos from Agarwood Capital Youtube Channel