There are two ways to invest in the stock market. The first way is to invest in getting the average market return of 7%, just following 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 (TomNguyen@agarwoodcapital.com).
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 at 7% – 8%. To start passive investing, you want to buy a mutual fund or ETF representing the S&P 500. Robo-advisors or standard investment advisors provide these mutual funds and ETF.
- 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 Jones (DJI) isn’t a great representation of the overall stock market because it includes only 30 US 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.
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 analyze both individual stocks and the overall market. 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 end your year 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 that’re the most familiar to you. (Week 2)
Determine a business industry that is easy for you to comprehend. The easiest industries to learn are from your profession or products you regularly purchase.
For example, an apparel company usually has simple operations. Apparel companies make clothes that offer branding value with unique design distinctions. The apparel industry is a multi-billion-dollar investment opportunity, but it is a very competitive industry. Apparel retailers can offer their goods in physical and/or digital distribution channels: take note of these differences. For example, one of my favorite apparel business is Under Armour.
At the beginning of your active investment journey, learn general facts, and find interesting tidbits on your chosen business. Ask critical questions because if you don’t have enough confidence in your research, it could cost you your entire 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 much more 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 patents on their clothes and shoes?
- Who manufactures UA clothes?
- Is there a contract or partnership from the manufacturer?
- Why was this manufacturer selected?
- Who are UA shipping partners?
- Is UA shipping partner contract?
- Does UA have its own stores? Why does UA have its own stores?
- How many stores does UA have?
- How many retail partnerships do they have?
- Did Under Armour ship their apparel from a warehouse, and from which warehouse?
- How did UA decide to pick this warehouse?
- Where were the clothes made?
- Who designs UA’s clothes?
- What is the designing strategy, do they create athleisure clothes or not?
- Who’s the design team leader, how long did they work at the firm? Do they have experience at other firms?
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 jargon 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 called value investing.
The 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 identifies 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 the 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 a company’s market value or its equity and some fundamental financial metric (e.g., earnings). The point of a valuation ratio shows the price you pay for some stream of earnings, revenue, or cash flow (or other financial metrics).
- 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 suitable investments. Some companies 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 an analysts’ expectations, bad news can cause a knee-jerk reaction from shareholders, sending shares plunging more than they should.
Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Industries that are out of favor are the right places to look for bargains. Again, not all out of favor sectors will ever return 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 the BlackBerry Rim. Investors underestimated the software, ecosystem, and design of the iPhone initially. 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 complicated than that, this is the general concept behind finding undervalued stocks that are perfect for your portfolio. Value Investing is not the only investment strategy, but it is the most straightforward and yet the most challenging strategy to master.
4. Learn how to read financial statements and how to create one from scratch (Week 4)
Financial statements will be disconcerting to learn. If math isn’t one of your strongest skills, it will be considerably 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 or paper trading account with only the amount that you can afford to lose, but still assert the same spending habits that you would with a larger account. 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